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Want to stay on top of cutting-edge finance research from Wharton? Every two months, the Rodney White Center highlights the latest studies by Wharton’s finance faculty. In this issue: preventing bank failures, mortgage lock-in, the feedback loop between financial distress and competition, stablecoin runs, and the benefits of bank diversification.

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Itamar Drechsler and Luke Taylor

How should banks optimally hedge risks and prevent runs?

Motivated by the recent regional bank crisis, Professor Itamar Drechsler and coauthors model the impact of interest rates on banks’ liquidity risk. Prior work shows that banks hedge the interest-rate risk of their assets with the value of their deposit franchise. Since the franchise allows banks to pay deposit rates that are low and insensitive to the market interest rate, its value rises when the Fed raises rates, and hence dominates the value of banks when interest rates are high. (In contrast, when interest rates are low the bank’s value is dominated by the gains on its long-term assets.) However, the franchise value hedge only works if depositors keep their money in the bank. As a result, when rates are high there can be an equilibrium where uninsured depositors have an incentive to run, fearing the loss of the valuable franchise hedge. Therefore, banks relying on uninsured depositors may become exposed to a run when interest rates rise, even if they are otherwise hedged to interest rates. To manage this run risk, banks should adopt a risk-management policy that acts as if their deposit rates are more sensitive to market rates than they are.  Doing so leads banks to shrink the duration of their assets at a rate that mitigates the run incentive of uninsured depositors.

Mortgage lock-in and the decline in household mobility

The sharp increase in mortgage rates since 2022 has discouraged many Americans from moving to new homes, as it requires remortgaging at significantly higher interest rates. Professor Lu Liu quantifies these mortgage lock-in effects by analyzing household-level credit records and exploiting variations in the timing of mortgage origination. A one percentage point decline in mortgage rate delta, measured as the difference between the mortgage rate locked in at purchase and the current market rate, reduces moving rates by 9%. Mortgage lock-in reduces housing transaction volume and labor reallocation. Households who are more locked in are less responsive to higher-paid employment opportunities. 

The dangerous spiral between financial distress and competition

Firms that are in financial distress tend to compete more aggressively. This intensified competition in turn reduces profit margins, pushing the firm into deeper distress and adversely affecting other firms. Professor Winston Dou and coauthors study these feedback and contagion effects by incorporating strategic competition into a dynamic model with long-term defaultable debt, which generates various peer interactions like predation and self-defense. Owing to the contagion effect, high leverage can compromise an industry's financial stability. 

Are stablecoins really stable?

USD-backed stablecoins are cryptocurrencies designed to maintain a stable value by promising to back each token with at least $1 in US dollar-denominated assets, providing a reliable and predictable store of value and a potentially new means of payment. However, Professor Yao Zeng and coauthors highlight a potential risk: the promise to redeem stablecoins on demand for US dollars could lead to panic and instability in the financial system. This risk is amplified when there are highly efficient arbitrageurs involved in the market, which potentially explains why stablecoin issuers only authorize a surprisingly small and concentrated set of arbitragers. This centralized arbitrage comes at the expense of maintaining a stable secondary price, which points to the inability for stablecoins to achieve price stability and financial stability at the same time. 

The benefits of bank diversification

Over the last three decades, banks in the U.S. have become much more diversified as changes in regulations have allowed them to operate across state lines and invest in different business segments. While this new diversification is often blamed for increasing fragility and systemic risk, Professor Goldstein and coauthors find evidence of a bright side to bank diversification. Diversification encourages banks to lend more, particularly in periods of financial distress, as it reduces the bank’s idiosyncratic risk and stabilizes its stream of earnings. Diversification-induced lending, as well as its resiliency, leads to positive spillovers to the economy. 

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