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
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.”