By Rebecca Lindell

A lot can change in a few decades, especially in the banking industry.

Until fairly recently, banks were mostly restricted to taking deposits and making loans. And most of those loans were in the banks’ own backyards — to local businesses and home buyers.

Fast-forward to 2002. With the rollback of Depression-era regulations that limited banks’ ability to participate in financial markets, and the introduction of a dizzying array of new financial instruments, U.S. banks have become far more integrated with the global marketplace.

But has all this activity made the economy more stable, or less? That’s what Kellogg Professors Kathleen Hagerty and Janice Eberly intend to find out.

“We had had a long period without a recession, and one of the reasons given for that is that financial institutions have been better integrated with the markets and are better able to share risk,” Hagerty says. “But the question was, could you see that in the data? Could you see if economic activity at the local level had stabilized as a result of this integration? That’s what we wanted to look at.”

Hagerty, the First Chicago Distinguished Professor of Finance, and Eberly, the John L. and Helen Kellogg Associate Professor of Finance, are undertaking a research study to answer those questions. They are particularly interested in finding out whether the banking laws currently on the books are adequate for modern financial markets.

These laws have allowed U.S. banks to engage in securitization, trading local loans for a portfolio of other securities. Regulators have tended to sanction securitization, believing that it will help banks diversify their holdings and be less vulnerable to fluctuations in the local economy. But as Hagerty and Eberly note, little is known about whether securitization actually reduces risk.

“Skeptics of banking liberalization argue that banks are just trading local risk for ‘aggregate risk,’” the professors write. “They fear that while banks are less exposed to local economic conditions, they are now exposed to fluctuations in global financial markets — which they’ve never faced before. Thus, a local downturn may have less severe consequences for the bank, but the bank may instead be exposed to financial upheaval in Russia or Argentina.”

The possibility that this exposure is common across many banks raises the specter that banks are better insulated from local shocks — but Hagerty and Eberly wonder whether the exposure to global shocks risks the integrity of the entire banking system. “One of our goals is to understand this tradeoff better, the impact of past regulatory changes, and the best path for future regulatory policy.”

An important piece of evidence for the pair is that mortgage rates are far more consistent throughout the country now than they were 20 years ago. This suggests that rates no longer reflect local economic conditions, but that securitization has evened out these regional variations. This finding, among others, indicates that more pooling of risks is occurring across the nation.

But has this apparent risk-sharing muted the effects of shocks to local economies? To answer this question, Hagerty and Eberly plan to examine regional and local economic activity, such as unemployment and bank lending, and how it responds to shocks such as natural disasters, changes in commodity prices and fluctuations in local industry.

“We can then directly test whether economic activity is better insulated from local shocks as local lending becomes increasingly securitized,” write the pair, who also seek to learn whether financial markets provide more efficient financing than do regulated financial institutions.

“The beneficiaries of this improvement are not only borrowers, but also the broader economy, which may then be less vulnerable to unforeseen shocks.”