Bank portfolio choice and the macroeconomy

Yunus Aksoy, Henrique Basso

Banking activities have received increasing attention in the aftermath of the Crisis. This column focuses on the effects of bank portfolio choice on asset prices. The term spread is strongly influenced by banks’ expectations of their future profitability. Banks' funding activities, through the securitisation market, create conditions for higher leverage and may lead to a reduction in risk premia. Through its effects on asset prices, bank portfolio choice impacts the real economy, increasing its importance for policymaking.

The Global Crisis placed banking activities at the centre of the economic debate. Several studies explored the amplification effects of different forms of collateralised debt, based on the frameworks of Bernanke et al. (1999) and Kiyotaki and Moore (1997), to analyse the Crisis and its aftermath. One prominent aspect of banks, namely their balance sheets and their impact on asset prices, and hence on the macroeconomy and monetary policy, has more recently gained some attention. Particularly, Adrian et al. (2014) and Adrian and Shin (2010) stress that the growth of assets in the balance sheet of security and broker-dealers influences asset prices and risk premia. Bank portfolio decisions shape banks’ balance sheets, being an important element in the link between financial intermediation and the macroeconomy.

Liquidity, bank portfolio choices, and term spreads

Banks are holding a large variety of assets in their balance sheets and play a crucial role in funding long-term capital investment. In a recent article (Aksoy and Basso 2014), we first study a theoretical model where banks face a portfolio decision that is essentially a choice between long-term credit assets (loans) and short-term assets when these markets are segmented. Banks may hold a portfolio of equities, short- and long-term lending funded by short-term borrowing, ultimately bearing the risk of maturity transformation. We assume banks may need to make a liquidity injection to their balance sheet to maintain the long-term assets in their books. This formalises the maturity mismatch risk.

We show that term spreads – an important component of the difference between short- and long-term interest rates – which ultimately denote the cost of hedging this potential exposure, are determined by future short-term rates and the premium for bearing the maturity risk. We also show that cash-flow patterns of banks’ investment affect their profitability and hence their balance sheets, altering the risk premia derived from their portfolio decisions. We label this mechanism the bank’s ‘portfolio channel’.

The term spread is strongly influenced by banks’ expectations of their future profitability – the higher (lower) the expected profits, the lower (higher) interest rate spreads will be. We look at bank level data to understand the relevance of the portfolio channel. By studying 22 large US financial institutions, we show that a one percent increase in banks’ expected profitability leads to a 13 basis points decline in the term spread. Thus, banks’ asset portfolio decisions to hold long-term or short-term assets affect the nature of the price of risk associated with long-term entrepreneurial activity and its funding through financial intermediation.

Term spreads and their feedback effects on the economy

While the overall economic performance and expected bank profitability affect term spreads, term spreads in turn affect the macroeconomy through physical investment finance. Endogenous spread movements arise in our model since changes in economic conditions (as reflected by the path of future profits) alter the relationship between the bank's shadow value of funding costs (paid as the long-term assets are held in the balance sheet) and their payoffs (materialised when these assets mature). This ‘endogeneity’ of term spreads and their feedback effects to the macroeconomy should be important considerations for policymakers when taking decisions since their actions through quantitative easing (QE) or short-term interest changes affect banks’ profit outlook and their behaviour in funding long-term investments.

Term spreads and unconventional monetary policy

The Global Crisis triggered a rapid and extensive response of central banks in the form of asset purchases. Our model proposes a new channel by which QE affects the economy. Unconventional policy protects banks from potential liquidity shortages in the future and relaxes future balance sheet constraints. This, in turn, leads to an increase in banks’ willingness to carry maturity transformation risk and to a reduction in term spreads. We find that allowing banks to sell long-term assets to the central bank after a liquidity shock leads to a sharp decrease in term spreads, matching the results presented by several empirical studies of QE policies in major economies. Central banks are thus able to affect real output by altering bank balance sheets. This is achieved through a market mechanism and central banks require no superior information about the state of the bank balance sheets.

Securitisation, portfolio choice, and asset prices

Finally, we would like to stress another important link between bank portfolio choice and the macroeconomy by exploring the role of the funding and portfolio decisions of shadow banks. In the 15 years preceding the Global Crisis, the volume of securitised assets has increased remarkably. During the same period the share of assets held by shadow banks and securities and broker dealers relative to other sectors and commercial banks has also increased substantially. In Aksoy and Basso (2014b) we explore those changes in financial intermediation and show that increases in the volume of new securitised assets lead to a decline in bond and equity premia.

By looking closely at the portfolio choice of financial intermediaries and incorporating one of the key aspects in their decision, namely, the ability to create and sell synthetic assets, we are able to identify another potential channel that links financial intermediation and asset prices. We show theoretically that pooling and tranching of credit assets effectively relaxes both liquidity and risk constraints banks face while setting their portfolio of assets. This leads to increased leverage, higher demand for assets, and lower premia. Crucially, while the compensation for risk-taking in the economy declines, the underlying payoff characteristics of assets, or their riskiness, remain unchanged. As pointed out by Rajan (2005), reduced premia/volatility might not imply absence of risk.

Risk taking and the volatility of asset prices have come to the forefront of policymakers’ concerns. Bank funding and portfolio choices, particularly in periods of overreliance on securitisation practices, may be crucial to understand the role of financial intermediaries in the determination of asset prices and their feedback effect on the real economy. Hence, our results indicate the importance of analysing and monitoring the portfolio decisions of financial institutions, particularly the ones with a diverse portfolio of assets.

References

Adrian, T, E Etula, and T Muir (2014), “Financial Intermediaries and the Cross-Section of Asset Returns,” The Journal of Finance, 69(6), 2557-2596.

Adrian, T, and H S Shin (2010), “Financial Intermediaries and Monetary Economics”, in Friedman, B M and M Woodford (eds.), Handbook of Monetary Economics, ed. by , vol. 3, chap. 12, pp. 601-650. Elsevier.

Aksoy, Y and H S Basso (2014), “Liquidity, Term Spreads and Monetary Policy, The Economic Journal, 124(581), 1234-1278.

Aksoy, Y, and H S Basso (2014b), “Securitization and Asset Prices”, Birkbeck Working Papers in Economics and Finance, 1411.

Aksoy, Y, and H S Basso (2014b), “Securitization and Asset Prices", Working paper.

Bernanke, B S, M Gertler, and S Gilchrist (1999), “The financial accelerator in a quantitative business cycle framework,” in Taylor, J B and M Woodford (eds.), Handbook of Macroeconomics, vol. 1, chap. 21, pp. 1341–1393. Elsevier.

Kiyotaki, N, and J Moore (1997), “Credit Cycles,” Journal of Political Economy, 105(2), 211-248.

Rajan, R G (2005), “Has financial development made the world riskier?,” Proceedings, (Aug), 313-369.