St. Gallen, Switzerland, August 22-28, 2010

Transcription

1 Session Number: Parallel Session 4A Time: Tuesday, Augus 24, PM Paper Prepared for he 31s General Conference of The Inernaional Associaion for Research in Income and Wealh S. Gallen, Swizerland, Augus 22-28, 2010 Compuing Nominal Bank Services: Accouning for Defaul Kyle K. Hood For addiional informaion please conac: Name: Kyle K. Hood Affiliaion: U.S. Bureau of Economic Analysis Address: This paper is posed on he following websie: hp://

2 Compuing Nominal Bank Services: Accouning for Defaul Kyle K. Hood * U.S. Bureau of Economic Analysis 1441 L. S., NW Washingon, DC kyle.hood@bea.gov * The views expressed in his paper are hose of he auhor and no necessarily hose of he U.S. Bureau of Economic Analysis. The collaboraion of Marshall Reinsdorf is graefully acknowledged. 1

3 I. Inroducion Banks offer a variey of financial services o cusomers. For some of hese, hey levy explici charges. For ohers, he charges are implici. Such services include inermediaion (finding borrowers for deposiors funds), recording, bookkeeping, safekeeping, liquidiy (making funds available for wihdrawal whenever needed and a convenien locaions), paymen services, loan underwriing, informaion provision, risk managemen and advice. 1 Unlike oher indusries, banks offer hese services in bundles ha are priced using an ineres rae ha is eiher higher (in he case of loans) or lower (in he case of deposis) han he marke rae for a similar, service-free insrumen. The difference beween he rae of reurn on a service-free insrumen and he rae of ineres offered or charged by he bank is ermed an ineres margin. As he ineres margin varies, banks service provision may also vary eiher over ime or in he cross-secion (Fixler e al., 2003). This urns he problem of compuing nominal oupu of banks rivial for mos oher indusries ino a ricky one. The Sysem of Naional Accouns (SNA 2 ) saes ha he margin beween a reference rae of ineres and he rae on a loan or deposi accoun is considered o be he service charge (paragraphs ). 3 For loans, he enire ineres rae margin above he cos of funds as measured by he reference rae is considered remuneraion for services provided o borrowers, and is couned as oupu of commercial banks. This ype of oupu may be ermed implicily-priced financial inermediaion services, financial inermediaion services furnished wihou explici paymen, or financial inermediaion services indirecly measured (FISIM). In his paper, I argue ha a porion of he ineres margin on loans is used as insurance agains credi losses (losses of principle due o defaul), and hus should no be included in measured oupu. On average, he loss rae from defauls on loans is nearly a hird as large as he margin used o compue bank services. The effec on he accouns of excluding losses due o defaul from measured oupu of banks depends on how his exclusion is handled, bu i may have effecs on measures of banks profis 4, final consumpion of financial inermediaion services, saving of banks and borrowers, ne borrowing and lending of banks and borrowers, and value added for borrowers in he business secor. I include a discussion of five possible reamens of he associaed flows. The SNA and NIPAs exclude he porion of gross insurance premiums ha is earmarked o cover he cos of seling claims for insured losses from measured oupu of he insurance indusry. This paper argues ha credi losses should be reaed in an analogous way. In fac, he 2008 SNA suggess ha some loan guaranors be reaed analogously o non-life insurance premiums and losses (6.182). I show ha banks ake defaul raes ino accoun 1 Fixler and Reinsdorf (2006) and Fixler, Reinsdorf, and Smih (2003) enumerae services for which banks may charge explicily. 2 In general, all references are o he 2008 SNA unless oherwise noed. I generally reference he SNA using a parenheical conaining he relevan paragraph(s). 3 The U.S. Bureau of Economic Analysis (BEA) compues implicily-priced financial inermediaion services in he Naional Income and Produc Accouns (NIPAs) in a manner ha conforms o his SNA prescripion, wih some minor excepions. 4 By profis, I do no mean operaing surplus as defined by he SNA, which is he balancing iem in he generaion of income accoun (see chaper 7). Insead, profis refers o enrepreneurial income as defined by he SNA, which is operaing surplus or mixed income plus propery income receivable on asses owned by he enerprise(s), less ineres and ren payable by he enerprise(s) (7.18). 2

4 when seing ineres rae margins, suggesing ha hey are reaing defaul analogously o he way in which insurers rea losses. Wang (2003a, 2003b) and Basu, Inklaar, and Wang (2008) discuss he reamen of risk in measuring bank oupu. Their main argumen is ha because reurns are noisy, a risk premium is required by holders of bank equiy, and a porion of he ineres margin on loans serves his purpose. They exclude his risk premium from measured bank oupu. They also argue ha removing expeced credi losses from measured oupu is appropriae. Wang (2003b) does so by subracing mean charge-off raes from loan ineres raes. 5 The quesions of he reamen of risk premiums and he reamen of expeced credi losses do no have o be decided a he same ime. In paricular, a bank charges a defaul margin as par of he ineres rae on risky loans o cover expeced coss of fuure defauls. On he oher hand, risk premiums compensae asse holders for holding asses having high-variance reurns; linking higher momens of asse reurns o he firs momen of payoffs requires ha he model be given addiional srucure, and i is his srucure ha has generaed conroversy. This paper inroduces a jusificaion for exclusion of anicipaed losses from defauls from he measure of implicily-priced bank and considers alernaives for incorporaing his exclusion ino he SNA and NIPAs. Addiionally, i discusses an alernaive model for measuring expeced defaul and defaul margins. This model fis well ino he heory of he SNA, is racable, and follows preceden se by mehods for oher indusries. Removing anicipaed defaul raes from ne ineres squeezes he measure of banking oupu, which has he unwelcome effec of adding subsanial volailiy o he allocaion of he oal ne ineres margin o borrower and deposior services. This pracical problem mus be addressed when removing he defaul margin from measured oupu, so his paper also develops a mehod for sabilizing he reference rae ha is used o spli ne ineres ino hese wo componens, borrower and deposior services. This mehodology is described in appendix A. This paper begins wih a discussion of he curren mehods for measuring nominal bank oupu in he SNA and NIPAs. I hen considers he advanages and disadvanages of changing hese mehods o ake credi losses ino consideraion and argues ha anicipaed credi losses should be reaed as analogous o expeced claims in he insurance indusry. Finally, i presens esimaes of he impac of doing his on measures of banking and borrower value added, saving by banks and borrowers, ne lending and borrowing by banks and borrowers 6, and bank and borrower profis. II. User Cos Theory and Mehods for Measuring Bank Oupu in he NIPAs The concepual framework for measuring bank oupu in he SNA and NIPAs is based on heory of he user cos of capial (Fixler, Reinsdorf, and Smih, 2003, and Fixler, 1993). In his heory, user cos for a capial asse 5 This suggess modeling defauls (for a paricular loan ype) as a mean defaul rae plus a whie noise componen. Any difference beween he curren defaul rae and he mean are unexpeced, and hus canno be refleced in prices. I argue laer ha his is no he case, ha is, ha charge-off raes are o some degree predicable, and ha banks change heir margins o compensae. 6 Ne lending (borrowing) is defined in he SNA as he balancing iem of he capial accoun. Ne lending is he sum of saving and ne capial ransfers (capial ransfers receivable less capial ransfers payable), less ne acquisiions of non-financial asses. Ne lending represens he resources ha are available for lending. This iem is called ne borrowing if i is negaive, and represens he financial resources ha mus be obained o finance spending above disposable income. 3

5 equals he value of he asse imes is heoreical renal rae, which mus cover ineres coss plus depreciaion, less any increase in he price of he asse. This rae may be expressed as: uc = r + δ π In his expression r represens a cos of funds, and is usually equaed wih a risk-free ineres rae, δ represens depreciaion, and π represens appreciaion in price. When used for financial asses, he expression for user cos omis he erm for depreciaion. The user cos rae for loans simply becomes he risk-free rae. For his reason, he services provided o borrowers and lenders can be calculaed by subracing he user cos from he rae paid on hese asses or liabiliies. In paricular, he borrower service margin can be compued as: s = r = r loan loan uc ref r Here, he reference rae is wrien wih he superscrip ref. Implicily-priced deposior services are calculaed as he user cos margin muliplied by he deposi balance. The user cos margin is he difference beween he reference rae of ineres and he reurn on deposis, or, s = ref r r deposi. In he NIPAs, raes paid on deposis are compued by dividing quarerly ineres paymens by he average quarerly deposi balance for each ype of deposi. (For compuing he overall oupu produced by banks, disinguishing deposi ypes makes no difference; however, for allocaing uses of oupu o secors and indusries, decomposing he componens of bank oupu by deposi ype is imporan.) The reference rae of ineres is defined as he effecive rae of ineres on federal and governmen agency obligaions held by banks, excluding morgage-backed securiies. The NIPAs compue he user cos margin for borrower services by subracing he reference rae from he reurn on each ype of asse. Reurns on loans are compued by dividing ineres receips by he average loan balance ne of he allowance for loan and lease losses. Reurns on all oher asses and liabiliies are compued by dividing he ineres income or expense by he average quarerly or annual asse or liabiliy balance. Toal oupu of each asse and liabiliy ype is compued by muliplying he user cos margin by he average quarerly or annual asse balance. 7 The NIPA mehodology does no address defaul. The guidelines for naional accouns in he SNA are also silen on he quesion of allowing for credi losses in measuring FISIM. 7 Mehods employed by many European counries are similar o hose used in he NIPAs, excep ha hey base heir reference rae on raes for inerbank loans and impue oupu only from loans and deposis. 4

6 III. Raionale for Changing he Treamen of Defauls For mos indusries in which prices are observed direcly, he 2008 SNA prescribes ha oupu be valued a acual cos o purchasers (2.64). Prices for financial inermediaion services canno direcly be observed, however, as was noed above. I argue here ha he ineres rae charged on loans remuneraes he financial inermediary for more han is cos of funds and service provision, bu also for losses in principal due o bad deb. This margin should be removed from he compued service margin. For a financial inermediary o survive, is conracual loan ineres raes mus cover is service provision, cos of funds, and principal losses due o bad deb. Figure 1 shows charge-off raes 8 by ype of loan. For some ypes of loans, charge-off raes are almos always small. However, for credi cards and oher consumer loans (including auo loans), credi losses are quie large on average (2-10%). On average, he defaul rae on all loans is approximaely a hird as large as he ineres margin compued using curren mehods. Any bank ha does no include in is ineres rae a margin o cover hese losses will no be able o coninue o operae. Indeed, banks are clearly charging differen raes for loan ha have differen raes of defaul. Figure 2 shows charge-off raes and ineres raes for credi card and commercial and indusrial (C&I) loans, relaive o charge-off raes and ineres raes for loans secured by real esae. The ineres rae curves represen he differences in margins beween C&I loans and real esae loans, and beween credi cards and real esae loans; he charge-off rae curves represen he differences in charge-off raes. Credi cards experience higher charge-offs han do C&I loans, and banks charge higher ineres raes for credi cards. Thus, banks respond o higher anicipaed defaul by charging higher raes of ineres. In none of he references cied above are bad deb losses menioned as a ype of service provided by a financial inermediary. However, he user cos heory presened above omis a discussion of he margin ha covers anicipaed fuure defauls. If loan ineres raes are given by r loan = r ref +s loan +d where d remuneraes he financial inermediary for anicipaed losses in principal due o fuure defauls, hen he currenly compued service margin differs from he one ha does no include remuneraion for defaul by he defaul margin, d. Tha is, he service margin should be compued as s loan = (r loan -d)-r ref. Anoher way of looking a his is as an aemp o produce a beer measure of r loan. Loan oupu is he difference beween he expeced afer-defaul loan rae and he reference rae 9 bu he loan rae is currenly measured as he rae which banks charge o cover service provision and defaul. Insead, wha should be used is he loan rae ha banks expec o receive afer defauls. The new loan rae r loan * = r loan -d can hen be subsiued back ino he original mehod. 8 Charge-offs represen wrie-offs of bad debs, and are discussed below. 9 I should also be noed ha he ineres income is booked on a cash basis for non-performing loans. The rue conrac loan rae (which is supposed o be measured above in r loan ) should be compued wih such ineres income in i booked on an accrual basis. An adjusmen for his is no done in his paper. 5

7 The SNA and NIPAs ignore non-paymen of deb in compuaion of oupu and profis. 10,11 This is in reference o he reamen of acual bad deb losses, and does no apply o anicipaed credi losses presen in he ineres rae charged by a financial inermediary by whom services are priced implicily. I argue below ha if he margin ha remuneraes a financial inermediary for bad deb losses is excluded from he measured service spread, a differen reamen of acual defauls from he one currenly prescribed may offer a preferred picure of a variey of oher measures in he sequence of accouns. Noneheless, even in he absence of such a differen reamen, a measure of anicipaed credi losses should be excluded from he measure of FISIM. 10 From he 2008 SNA, paragraph : However, he unilaeral wriing off of deb is no a ransacion beween insiuional unis and herefore does no appear eiher in he capial accoun or he financial accoun of he SNA. If he credior acceps such a wrie off or defaul, i should be recorded in he oher changes in he volume of asses accoun of he credior and he debor. 11 According o BEA (2002), Corporae profis reflecs he income earned by corporaions as a resul of curren producion; he measure is defined as receips arising from curren producion less associaed expenses. Receips exclude income in he form of dividends and capial gains, and expenses exclude bad debs, naural resource depleion, and capial losses. 6

8 Charge-off Raes Percen Q1 1985Q4 1986Q3 1987Q2 1988Q1 1988Q4 1989Q3 1990Q2 1991Q1 1991Q4 1992Q3 1993Q2 1994Q1 1994Q4 1995Q3 1996Q2 1997Q1 1997Q4 1998Q3 1999Q2 2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2 2009Q1 Quarer All Loans Ag Loans C&I Loans Real Esae Loans Credi Cards Oher Consumer Loans Figure 1: Charge-off raes by caegory of loan, quarerly. Source: Federal Reserve Board of Governors' calculaions from Call Repor daa. 7

9 Charge-offs and Ineres Rae Margins, Quarerly Rae (Relaive o Real Esae) Q1 2001Q2 2001Q3 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q4 2005Q1 2005Q2 Credi Card Charge-offs Rel. o Real Esae Credi Card Ineres Rel. o Real Esae Quarer 2005Q3 2005Q4 2006Q1 2006Q2 2006Q3 C&I Charge-offs Rel. o Real Esae C&I Ineres Rel. o Real Esae 2006Q4 2007Q1 2007Q2 2007Q3 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 Figure 2: Charge-off raes and ineres rae margins, quarerly. Source: Federal Reserve Board of Governors' calculaions from Call Repor daa, auhor's calculaions. 8

10 IV. Ineres Rae Margins as Insurance Credi losses could be reaed in he naional accouns in a way ha is similar o he reamen of non-life insurance losses. The porion of he ineres rae margin ha is used o proec he bank agains borrower defaul is se by he bank based on expeced defaul raes. The mehod for measuring he oupu of non-life insurance in he NIPAs was developed by Chen and Fixler (2003). They sugges ha premiums are se in a way ha indemnifies he insurance provider agains he loss ha hey expec o experience, wih a markup o cover he cos of providing services including risk bearing. Only he markup is couned as oupu, whereas he porion of gross premiums ha covers normal losses is considered a curren ransfer. A similar reamen is recommended by he SNA ( ). Insured losses and credi losses are analogous. In non-life insurance, an adverse even resuls in a cash paymen by he insurer o he insured (or someimes i involves a direc purchase of replacemen goods by he insurer). Adverse evens include, for example, auomobile accidens, fires, and hefs. In commercial banking, an adverse even resuls in he de faco forgiveness of a liabiliy raher han a direc cash paymen. The adverse even is less well-defined, bu ofen may include an unexpeced drop in income. Jus as insurers will no be able o pinpoin exacly who is going o experience a loss, banks will no be able o deermine which individuals will defaul. In addiion, he 2008 SNA saes ha volailiy in claims should no direcly affec he measure of oupu of non-life insurance services. According o he 2008 SNA (17.21), [n]eiher he volume nor he price of insurance services is direcly affeced by he volailiy of claims. The 2008 SNA ( ) recommends employing adjused claims (implemened as normal losses in he NIPAs, following Chen and Fixler, 2003) o compue oupu of insurance companies, as earned premiums plus premium supplemens less adjused claims. The difference beween acual and adjused claims is considered a curren ransfer (17.34, 17.39), excep in he case of a large naural disaser (17.40). Thus, oupu should be measured similarly in banking. Numerous examples of lending o individuals of varying risk caegories show ha a bank considers expeced defaul probabiliies when choosing ineres rae margins. Figure 2 shows ha margins for differen loan ypes relaive o hose for real esae loans rack charge-off raes. Margins are higher for credi cards, which exhibi higher charge-off raes. For earlier daa, Ausubel (1991) discusses compeiion in he credi card indusry, noing ha he relaxaion and repeal of various saes usury laws in he early 1980s saw large increases in ineres raes charged on credi cards and an opening of credi card markes o riskier borrowers, conribuing o rapid growh in his form of deb. 12 Banks were able o expand credi in his way because hey were able o charge sufficienly high raes o indemnify hemselves agains expeced credi losses. Alhough Ausubel (1991) rejecs high charge-off raes as he complee explanaion for high credi card ineres raes, he excludes charge-offs from his profiabiliy calculaions. As compeiion inensified in he credi card indusry, margins did no decrease (Sango, 1999), suggesing ha hese margins had been a leas loosely derived from coss. 12 According o Federal Reserve Saisical Release G.19, here was a doubling of revolving consumer credi relaive o non-revolving consumer credi beween 1980 and 1990, consiuing nearly a four-fold nominal increase in ousanding revolving deb. 9

11 An addiional example of he relaionship beween ineres raes and defaul is provided by Adams e al. (2009), who noe ha ineres raes of 25-30% prevail in he subprime auo loan marke. A subsanial porion of hese margins covers credi losses, as only 39% of he loans in heir sample are repaid in full. In his marke, lenders assume ha large credi losses will occur, while consumers are willing o ake on hese exremely high ineres raes in he expecaion ha hey will probably no pay he loan off in full. This suggess aci undersanding by boh paries ha defaul is a likely ending o he loan conrac. Currenly, such an arrangemen would be reaed as a large producive service provided by subprime auo lenders, offse by a large, negaive below-he-line charge for credi losses. V. Measures of Defaul Banks repor wo basic accouning measures of credi losses. The firs, he provision for loan and lease losses (he provision), is an expense ha represens he charge-offs ha a bank expecs given is curren loan porfolio ha are no already covered by he allowance for loan and leases losses. 13 The second, he charge-off, represens an ex pos measure of defauls, when banks recognize bad loans. The provision has he poenial o represen an ex ane measure of defaul expecaions, albei one ha is a he discreion of banks managemen. However, he available daa on provisions are insufficienly deailed, as he Call Repors do no ask banks o repor he provision by ype of loan. Provisions are also unsuiable for measuring he anicipaed credi losses ha are aken ino accoun when he ineres rae on a loan is se because heir iming is ofen ex pos (see Wall and Koch, 2000, and Laeven and Majnoni, 2003). Generally, provisions will be an unknown mixure of ex ane informaion regarding expeced defaul probabiliies a issue and ex pos adjusmens o he allowance as charge-offs occur or condiions change. They also may be conaminaed by ax and income smoohing consideraions. Since charge-offs happen only as losses are recognized, hey are no a measure of expeced fuure defauls. However, he Call Repors (which are he main daa used o esimae FISIM in he NIPAs) collec charge-off daa by loan caegory. In his paper I use acual credi losses as repored (ha is, charge-off daa) o develop a model of he anicipaed credi losses, which I presume o be equal o he defaul margin. Figure 1 shows clearly how noisy charge-off rae daa are. The mehodology discussed below will smooh charge-off raes by loan ype. These smoohed charge-off raes will be used as a proxy for expeced charge-off raes, and will be ermed anicipaed defaul o mirror wha is done for non-life insurance. Alhough charge-offs are quie noisy, banks do make an aemp o respond o changes in anicipaed fuure charge-off raes by increasing or decreasing margins above cos of funds. Figure 3 shows ha senior loan officers repor increasing spreads when charge-offs are growing and reducing spreads when charge-offs raes are decreasing, wihin he caegory of business loans. I also appears ha changes in charge-off raes end o lead changes in 13 Colangelo and Mink (2009) discuss he possible use of he provision as a measure of defaul. They rejec i for a variey of reasons, bu hese reasons do no apply in his case. In paricular, hey rejec i based on availabiliy of daa and on comparabiliy of accouning measures across EU member saes. These are no relevan o he U.S., as daa availabiliy is complee and here is no issue wih comparisons wih oher saes (he mehodologies used are already differen). In any case, I do no recommend using he provision (see below). 10

12 spreads. Thus, employing a consan charge-off rae in esimaes of oupu would have he poenial o disor measured oupu, as well in fac, a rae ha lags acual charge-offs appears o be he mos appropriae. Senior Loan Officers Reporing Increasing Spreads versus Changes in he Charge-off Rae Ne Percen Reporing Increasing Spreads Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 Increasing Spreads (MA) Quarer Change in he C/O Rae (MA) (Secondary Axis) 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 Figure 3: Charge-off raes and ineres rae margins from senior loan officer survey. Source: Federal Reserve Board of Governors, auhor's calculaions Change (Basis Poins) 11

13 VI. Proposed Mehodology The margins ha commercial banks incorporae in loan ineres raes o compensae for credi losses reflec anicipaed losses, no acual losses. Thus, for he purposes of removing he defaul margin from FISIM, anicipaed defauls mus be used. For defaul raes I use charge-off raes by loan ype, repored by he Federal Reserve Board of Governors. 14 These are expressed using he symbol d. Figure 1 above shows ha defaul raes are highly variable during recessions. For his reason, smoohed defaul rae series will be used. To smooh defauls, an adapive expecaions model will be employed. This corresponds also o he mehodology used in he NIPAs for esimaing normal losses for insurance oher han life insurance. In a similar fashion, hese will be ermed anicipaed credi losses or anicipaed defauls. Defaul raes are compued as a percenage of ne loan balances, so ha d l = D l /B l where D l represens oal defauls of loan ype l during ime period, and B l represens average balances of loan ype l during ime period. Anicipaed credi losses are compued as d* l = d* l-1 + λ l (d l d* l-1 ). The user cos rae for asses, for example, is hen uc l = r l r ref d* l. The parameers λ l can be loan-specific, bu are fixed over ime. They can be esimaed, for example, by finding he bes one-period-ahead predicion. I use he adapive expecaions model because i is a simple mehod for smoohing defauls ha has a long hisory in economics. 15 I do no derive my applicaion of his model from micro foundaions, bu i may be easily jusified. One appeal is ha loans wih long mauriies canno be re-priced, and geomerically declining weighed averages approximae balances of loans by ime of issue. In addiion, adjusmen coss may induce firms o se prices or raes as geomerically declining weighed averages of pas saes. Finally, a one-period-ahead predicion for defaul raes is generally irrelevan o banks; hey wish o know defaul raes over he life of he loan. A weighed average presens a rade-off in he informaion conained in he curren and pas raes beween shor-run flucuaions (noise) and long-run averages (signal) ha may be experienced over fuure loans mauriies. An alernaive o smoohing wih he adapive expecaions model would be o use a more sophisicaed model. 16 The adapive model is preferred o a more sophisicaed model because here is a preceden of using he adapive model in he accouns, in he non-life insurance indusry. Thus, i is implemened by saisical agencies around he world. The benefis of specifying a sophisicaed model of defaul expecaions would no ouweigh he advanage of compuaional simpliciy offered by he adapive model. Such models are difficul o esimae, and i would require subsanial effor o map saisical defaul predicions ino changes in defaul margins ha is 14 Federal Reserve Board of Governors (2010), Federal Reserve Saisical Release: Charge-off and Delinquency Raes on Loans and Leases a Commercial Banks, accessed a hp:// May 6, The macroeconomics lieraure on adapive versus raional expecaions is large. Evans and Ramey (2006) provide an excellen review. Adapive expecaions were developed by Cagan (1956) and Friedman (1957). Lucas (1972) argued ha he parameers of he adapive model were no invarian o changes in oher model parameers (in paricular, policy parameers), so ha adapive models were unusable for policy analysis. This led o a period of ime in which he adapive model fell largely ou of use. This disadvanage does no apply o banking because here is lile ineracion beween policy and he expecaion being generaed. 16 Researchers have developed saisical ools for predicing fuure defaul raes. Some have incorporaed macroeconomic condiions ino hese predicions. Examples include Wilson (1997a, 1997b); Hamerle e al. (2004); Virolainen (2004); and Hoggarh e al. (2005). 12

14 convincingly more accurae han oher mehods. Complicaed mehods also reduce he accessibiliy of he daa and ease of replicaion. Adapive defauls provide a mid-poin beween acual and long-run average defaul raes, and can be made o nes boh. Figure 3 suggess ha average defaul raes do no appropriaely adjus for changes in ineres rae margins. Using a consan defaul rae risks oversaing oupu during recessions (when margins are increasing) and undersaing oupu during booms (when margins are decreasing). Acual defaul raes, however, are no a good proxy for he defaul margin because of he delay beween increases in defaul and changes in margins. Usually, banks canno change margins on exising balances, and so have o wai unil hose balances come due; an adapive margin capures he approximaely geomerically declining imporance of pas loans in banks porfolios. Alernaives for Incorporaing Defauls ino he NIPAs Since ineres income ha is inended o cover anicipaed losses of principle from defauls is no available o cover he coss of providing borrower services, implicily-priced borrower services should be calculaed by muliplying he loan balance by he currenly employed user-cos margin (B l )(r l - r ref ) and hen deducing anicipaed defauls D* l =(d* l )(B l ). Deducing anicipaed defauls from he definiion of borrower FISIM implies he need o adjus eiher he oal amoun of ineres income ha banks repor before FISIM is aken ino consideraion, or he amoun of pure ineres income ha banks are shown as receiving afer borrower and deposior FISIM have been subraced from he ineres income ha hey repor (ermed SNA ineres in he SNA, 6.164). The place where his flow is incorporaed ino he accouns has he poenial o affec income, saving, and ne borrowing and lending of he affeced paries. The SNA does no currenly conain a recommendaion of wha o do wih his flow. The SNA does, however, have a recommendaion for acual defaul, saing ha [u]nilaeral repudiaion of deb is no a ransacion and hus mus be relegaed o a non-ransacion flow (10.211). Thus, defauls are currenly placed in oher flows. 17 Neverheless, because defauls are large, predicable, and economically relevan, such a reamen has he poenial o disor measures of saving, ne lending/borrowing, and profi. Thus, several alernaive reamens of defaul are considered. One mus find a place for he following wo flows: (1) The porion of ineres paid by he borrower o offse anicipaed credi losses (he defaul margin ) and (2) acual defauls. Five reamens for hese wo flows are considered. In he firs four, he defaul margin is placed in ineres income; in he las, he defaul margin is a curren ransfer. Acual defauls are decomposed ino anicipaed defauls and excess defauls. Anicipaed defauls are reaed as an oher flow, a capial ransfer, or a curren ransfer. Excess defauls are reaed as an oher flow or a capial ransfer. The reamens are presened in an order ha brings heir impac up he sequence of accouns. 17 Oher flows refers o flows in he oher changes in asses accouns in he SNA (12.1). These are furher classified as oher changes in he volume of asses or holding gains/losses. Because volumes and prices for hese asses are no easily disinguished, i is no clear which flow credi losses represen. The NIPAs are no a complee sysem of accouns ha includes revaluaion accouns and oher changes in asses accouns. Excess defauls could be repored as a below-he-line adjusmen, similar o how naural disasers appear in insurance oupu. 13

15 No maer how hese flows are incorporaed ino he accouns, removing defauls from he bank oupu measure will reduce measures of boh final consumpion of FISIM and inermediae consumpion of bank oupu. This reduces measured bank value added and oupu, reduces measured bank operaing surplus, increases value added of oher businesses, and increases he operaing surplus of oher businesses. This can be seen in he producion accoun and generaion of income accouns in all five reamens. Appendix B conains a se of 5 ables. Each able follows he effecs of one of he five reamens hrough he sequence accouns for U.S. daa in I may be beneficial o he reader o refer o hese ables when reading he descripions of he reamens ha follow. Treamen 1: The defaul margin is ineres and acual defauls are oher flows. The reamen ha mos closely follows he logic of he 2008 SNA couns he defaul margin as a pure ineres paymen (par of SNA ineres ) raher han as par of borrower FISIM and reas acual defauls as oher flows (for example, as an oher change in he volume of asses ). In he language of he 2008 SNA, he reference rae muliplied by he loan balance is defined as SNA ineres (6.164). In he firs reamen, he defaul rae can be added o he reference rae, which when muliplied by he loan balance may be used o generae a new measure of SNA ineres. Now insead of in SNA l = (B l )(r ref ), SNA ineres is defined as in SNA l = (B l )(r ref + d* l ) where d* l is he defaul margin for loan l and r ref is he reference rae of ineres. SNA ineres is reaed as propery income o he bank, so ha he new reamen affecs measured bank value added, oupu, and operaing surplus, bu no profis (ha is, enrepreneurial income). As noed above, official BEA mehodology excludes defaul from calculaions of profis, so his reamen would no violae ha rule, leaving profis unaffeced. This reamen would reduce personal consumpion and personal income by an idenical amoun. Household and business borrowers would consume a smaller amoun of implicily-priced banking services, bu would ransfer a larger amoun o he bank in he form of pure ineres paymens. For his reason, he measure of heir saving would be unchanged. Because measured saving would be unchanged and he reamen does no inroduce any capial ransfers, measured ne borrowing and lending would be unchanged. Wheher measured saving should be affeced by defaul could be debaed, bu no including defaul in measures of saving by he borrowers a leas has he advanage of consisency wih SNA definiions of saving. Since he defaul margin would no longer be used in he oupu impuaion, measured bank oupu and value added would be reduced, improving he esimaes of hose wo conceps. In addiion, his reamen would improve esimaes of he value added of he indusries ha consume implicily-priced inermediaion services. However, because he defaul margin would be booked as a pure ineres income bu acual defauls would be below he line, measured profis would remain he same as under he approach currenly used in he NIPAs. Treamen 2: The defaul margin is ineres and acual defauls are capial ransfers. Treamen 2 places acual defauls in capial ransfers raher han in oher flows. This reamen hus has he same effec on 14

16 measures of value added, oupu, operaing surplus, profis, income, and saving as he firs reamen does because hese values are unaffeced by boh oher flows and capial ransfers. This reamen does, however, increase measured ne lending of households and oher business and decrease ne lending of banks. I brings acual defauls above he line, so hey show up as a ransacion in he capial accoun. The balancing iem of he capial accoun, ne lending/borrowing, is hus affeced. The case for never considering unilaeral repudiaion of deb o be a ransfer is less clear-cu han he forcefulness of he language of he 2008 SNA would sugges. Unilaeral repudiaion of deb frequenly resuls from bankrupcy. Cancellaion of deb via bankrupcy is a legal righ under cerain circumsances. Banks realize ha hey are going o be obligaed o accep some deb cancellaion when hey make loan decisions. Because he laws surrounding deb cancellaion are he resul of he policy-making process and because banks likely rea some cancellaion of deb as normal, i does no seem unreasonable o rea his flow as a ransacion. The SNA defines a capial ransfer as a change in he ownership of an asse, redisribuing wealh bu leaving saving unaffeced (3.60); i is disinguished from a curren ransfer in ha is value is no wholly available for final consumpion in he curren period. Relinquishing a financial claim is specifically included in capial ransfers (8.10). Deb cancellaion is anamoun o relinquishing a financial claim. The inuiion is ha ne lending and borrowing should include principal repaymens. Banks charge he defaul margin o cover he principal paymens of defaulers. By including defauls in capial ransfers, measured ne borrowing and lending will reflec banks relinquishing of claims on he incomes of oher businesses and households, much of which was anicipaed in he aggregae and for which he bank is indemnified hough he defaul margin. A consequence of his reamen is ha measured ne borrowing and lending will conain boh anicipaed and excess credi losses (ha is, acual credi losses in excess of anicipaed credi losses). The argumen o consider credi losses o be capial ransfers relies on he fac ha banks charge a margin o cover he anicipaed principal paymens of defaulers. Ye acual credi losses in excess of anicipaed losses, have no place in capial ransfers. The hird reamen addresses his issue. Treamen 3: The defaul margin is ineres and anicipaed defauls are capial ransfers. In reamen hree, only anicipaed defauls are included in capial ransfers. Excess credi losses are placed in oher flows. 18 The effecs of his reamen on he accouns are much he same as he effecs of he previous reamen. However, measured ne lending and borrowing are affeced by anicipaed credi losses raher han acual credi losses. This ensures he porion of defauls ha is noisy boh o banks and o borrowers does no ener measures of ne lending. In reamens 4 and 5 below, excess defauls are included in oher flows, as well. 18 The idea of breaking up an ineres rae ino pieces and reaing differen pieces as differen ypes of flows is presen in he 1993 SNA. Vanoli (1999) discusses a lengh he reamen of ineres in a high-inflaion environmen. This reamen suggess ha a porion of nominal ineres offses he loss in he value of principal. In his case, Vanoli (1999) recommends ha a porion of ineres be couned as a revaluaion gain o he lender (loss o he borrower), offseing he loss o he lender due o he reducion of he value of principal from price changes. This reamen appears in he 1993 SNA (Chaper XIX, Annex B). 15

17 Treamen 4: The defaul margin is ineres and anicipaed defauls are curren ransfers. Hicks (1939) suggess ha flows ha are predicable be included in income, whereas flows ha are unpredicable should no. From he perspecive of he bank, he amoun received from borrowers o cover anicipaed credi losses is no available o be disribued o workers, suppliers, or providers of capial or funds. Insead, i mus be used o cover credi losses, especially over ime. However, if credi losses are placed in he capial accouns or in oher flows, measured bank income will appear o be higher han wha hey are able o disribue o oher paries by precisely he level of acual defauls. A more accurae picure of he income ha is a he banks disposal is achieved by placing defauls in curren ransfers. If anicipaed credi losses are couned as a curren ransfer, his ransfer will increase he measured disposable income of oher businesses and of households, while reducing he measured disposable income of banks. This will increase measured saving by oher businesses and households, while reducing saving by banks. Such a siuaion avoids a hiding a large drain on banks balance shees ha is o some degree regular and predicable, if only from he bank s perspecive. Taking he perspecive of he bank in his maer is lile differen from aking he perspecive of he insurance company in he case of non-life insurance losses. From he perspecive of he insurance company, losses are regular and o a large degree predicable. From he perspecive of he insured, losses are highly irregular and unpredicable. The SNA has decided o consider insurance losses o be curren ransfers, aking he perspecive of he insurance company. The defaul margin in he banking indusry may be hough of as being parallel o he porion of gross premiums se aside o cover insured losses in he insurance indusry. Anicipaed defaul is analogous o normal losses (expeced claims) and acual credi losses are analogous o claims. Treamen 5: The defaul margin and anicipaed defauls are curren ransfers. The posiives of he above reamens nowihsanding, hey all exclude credi losses from measured enrepreneurial income, which is mean o be analogous o business profis. I would probably be impossible o convince a banker ha exclusion of credi losses from measured profis is correc, in an economic sense or oherwise. Bankers probably worry more abou defaul han anyhing else, and have developed a sysem of underwriing, screening, and monioring o proec hemselves from i. As noed above, credi card defaul raes may be larger han credi card oupu. Disorions in profiabiliy numbers will be even larger. Thus, he above mehods do no produce esimaes of bank profis ha accord wih he percepions of bankers. By couning he defaul margin as a curren ransfer raher han an ineres paymen, he margin is removed from he measure of banks and oher businesses enrepreneurial income, so ha measured enrepreneurial income of banks decreases and measured enrepreneurial income of oher business decreases. In addiion, because curren ransfers are no primary incomes, he measured balance of primary incomes of banks decreases, while he measured balance of primary incomes of oher businesses and of households increases. The SNA defines primary incomes as incomes ha accrue o insiuional unis as a resul of heir paricipaion in producion or of ownership of asses ha may be needed in producion (7.2). The par ha resuls from ownership propery income includes ineres. However, he porion of ineres ha is used o cover credi 16

18 losses can hardly be described as propery income arising from making funds available o borrowers. Irrespecive of wha is done wih acual or anicipaed credi losses, classifying he defaul margin as a curren ransfer o borrowers may mos accuraely reflec is rue purpose. VII. Resuls For he purposes of illusraion a sabilizaion parameer of 0.20 has been chosen for smoohing he chargeoff raes. Similar conclusions would be implied by parameers varying from 0.1 o 0.3. (Higher values for λ resul in less loss of informaion and less ime-shifing of he smoohed series, bu a he cos of leaving more volailiy in he smoohed series.) Figure 4 shows acual, anicipaed, and excess charge-offs. Acual and Adjused Charge-offs $M Year Adjused Charge-offs Acual Charge-offs Excess Defaul Figure 4: Acual, Adjused, and Excess Charge-offs. Source: Federal Reserve Board of Governors calculaions from call repor daa, auhor's calculaions. 17

19 Table 1 shows he sandard deviaions of log differences in oupu, by reamen of charge-offs (ne vs. gross) and by reference rae (no sabilized vs. sabilized). Rae sabilizaion is discussed in appendix A, and is done because of he effec of removing charge-offs on he variance of oupu growh. Unadjused quarerly asse and liabiliy oupu growh raes have sandard deviaions of 12.3% and 21.8%, respecively; adjusing for charge-offs increases he asse oupu growh sandard deviaion o 26.9%. Using a sabilized reference rae largely erases he effec of neing ou anicipaed charge-offs. Table 1: Sandard Deviaions of Log Differences of Oupu Measures Oupu Caegory Loss Adjused Reference Rae* S. Dev. Asse yes sabilized Liabiliy Asse no sabilized Liabiliy Asse no sabilized Liabiliy Asse no sabilized Liabiliy * Reference rae sabilizaion is discussed in appendix A. The magniude of he effec of removing anicipaed charge-offs from oupu is quie subsanial. The charge-off expense is on average equal o 38.5% of ineres earned. 18

20 Table 2: Borrower Services Adjused for Defaul, Borrower Services (curren mehod) Plus: Adjusmen for defaul Plus: Adjusmen for rae sabilizaion Equals: Borrower Services (proposed mehod) Percen impac on revenue Source: NIPA able 7.11, Ineres Paid and Received by Secor and Legal Form of Organizaion 2. See appendix A Table 2 illusraes he effec of hese wo adjusmens on annual borrower services, from Noe ha borrower services peak in 2007 insead of 2006, which is a resul of he rae sabilizaion. Alhough he effec of he rae sabilizaion is negaive during , in he long run i is jus as likely negaive as i is posiive unless a rend is pushing i in one direcion or anoher. Table 3: Illusraive Impac of Charge-off Adjusmen on PCE of Borrower Services Illusraive impac on PCE (Personal Loans and Credi Cards) PCE of Borrower Services: Original PCE of Borrower Services: Charge off Adjusmen Growh in PCE, Original 9.5% 3.1% 12.5% 6.7% 5.2% Growh in PCE, wih Proposed Charge off Adjusmen 8.3% 0.9% 39.2% 9.5% 11.1% Table 3 illusraes he impac of a charge-off adjusmen on consumpion of borrower services. This does no include he reference rae adjusmen, and assumes credi card and personal loan services are no used as inermediae inpus. The 38.2% growh in may be worrying; however, noe ha (a) we are working from a smaller base and (b) 2006 saw record profis on credi cards. This increase in nominal expendiures reflecs a reducion in charge-off raes and an increase in he realized rae of reurn. Togeher, hese consiue a surge in he price of credi card services which in 2005 were relaively cheap. Figure 5 shows a graph of quarerly log loan deposior services from he firs quarer of 1985 o he second quarer of 2009, under hree assumpions: No credi loss adjusmen, he adapive credi loss adjusmen, and a 19

21 consan credi loss adjusmen. In his case, he adapive credi loss model shows a clearer downurn in he banking indusry in and These downurns are no apparen in eiher of he oher wo series. Figure 6 shows a graph of quarerly deposior services for all asses and liabiliies, during he same ime period. Under he proposed mehodology, mos of he quarerly variaion in he oupu of commercial banks resuls from variaion in deposior services. Log Loan Borrower Services and Credi Loss Adjusmens Millions of curren $ (log scale) Q1 1985Q4 1986Q3 1987Q2 1988Q1 1988Q4 1989Q3 1990Q2 1991Q1 1991Q4 1992Q3 1993Q2 1994Q1 1994Q4 1995Q3 1996Q2 1997Q1 1997Q4 Time 1998Q3 1999Q2 2000Q1 2000Q4 2001Q3 2002Q2 2003Q1 2003Q4 2004Q3 2005Q2 2006Q1 2006Q4 2007Q3 2008Q2 2009Q1 Log Borrower Services - Adapive Defaul Log Borrower Services - Consan Defaul Log Borrower Services - No Adjusmen Figure 5: Log loan services wih credi loss adjusmens: No credi loss adjusmen, adapive credi loss adjusmen, and consan rae credi loss adjusmen. Source: Federal Reserve Board of Governors calculaions from Call Repor daa, auhor s calculaions. 20

22 Borrower and Deposior Services, Proposed Curren $ (M) Q2 1986Q1 1986Q4 1987Q3 1988Q2 1989Q1 1989Q4 1990Q3 1991Q2 1992Q1 1992Q4 1993Q3 1994Q2 1995Q1 1995Q4 1996Q3 1997Q2 Quarer Borrower Services IGO, Ne 1998Q1 1998Q4 1999Q3 2000Q2 2001Q1 2001Q4 2002Q3 Deposior Service IGO 2003Q2 2004Q1 2004Q4 2005Q3 2006Q2 2007Q1 2007Q4 2008Q3 2009Q2 Figure 6: Service flows consumed by borrowers and deposiors, ne of anicipaed defaul and using sabilized reference rae. Includes service flows from all asses. Source: Federal Reserve Board of Governors abulaions of Call Repor daa, auhor's calculaions. 21

23 Assessing he Esimaes To assess he performance of he alernaive mehods, he correlaions beween real GDP growh and growh raes of hese esimaes (adjused for growh in prices) are compared. Table 4 repors hese correlaions, as well as he variances of he differen mehods for compuing bank oupu. Borrower services compued wih he proposed mehod exhibis a correlaion wih GDP of 34.6% and a variance of 6.9%. This may be compared wih 5.1% and 12.4% respecively for borrower services compued wih he curren mehod. Thus, he new mehod produces a greaer co-variaion beween bank oupu and GDP, and also lower volailiy overall. This is rue for boh borrower and deposior services. Neiher removing charge-offs from oupu no sabilizing he rae alone can have such an impac. Table 4: Correlaions of real GDP growh wih real borrower and deposior services growh compued using various mehods. Real borrower and deposior services are deflaed wih a GDP deflaor. Correlaion wih GDP Growh Variance Borrower Services IGO Curren Mehod 5.1% 12.4% Sabilized Reference Rae Only 1 6.6% 3.5% Remove Charge offs Only 3.3% 88.7% Ref rae sabilized and charge offs removed 34.6% 6.9% Deposior Services IGO Curren Mehod 4.7% 8.7% Ref rae sabilized and charge offs removed 10.9% 4.9% 1. See appendix A. VIII. Discussion The inclusion of expeced credi losses in he measure of implicily-priced borrower services resuls in an oversaemen of bank oupu. A porion of oupu ha is impued is derived from a margin ha banks charge o indemnify hemselves agains expeced losses in heir loan porfolio due o borrower defaul. This paper proposes a mehodology for esimaing expeced credi losses by loan ype, and hen removes hese losses from impued oupu of banks. Over he enire ime series, he defaul margin appears o accoun for more han a hird of ineres receips, suggesing ha bank oupu is being subsanially oversaed. 22

24 In addiion, banks appear o increase margins in imes of high defaul, suggesing ha measures will oversae bank oupu growh during downurns. A measure of adapive defaul is shown o correc his problem. The adapive model is simple o implemen, has good properies, and enjoys preceden in naional accouning. Oupu growh from each of hese mehods may be compared wih real GDP growh. Such an exercise shows ha adjusmen for charge-offs and reference rae sabilizaion produces he larges posiive correlaion wih real GDP growh. Unless here is compelling evidence ha implici bank oupu should be counercyclical, his may be aken as evidence of he validiy of his approach. In addiion, I have included a discussion of he ways in which defauls and defaul margins may be incorporaed ino he SNA, as ineres income, curren ransfers, capial ransfers, or oher changes in he volume of asses. I have highlighed he advanages and disadvanages of each of hese mehods. The reamen of hese flows deermines how he new mehodology affecs measured business and household primary income, disposable income, saving, ne lending, and profis. Which is preferable is a maer for furher debae. References Adams, William, Liran Einav, and Jonahan Levin (2009), Liquidiy Consrains and Imperfec Informaion in Subprime Lending, American Economic Review, Vol. 99, No. 1, pp Ausubel, Lawrence M. (1991), The Failure of Compeiion in he Credi Card Marke, American Economic Review, Vol. 81, No. 1, pp Barne, William (1978), The User Cos of Money, Economic Leers, Vol. 2, pp Basu, Susano Rober Inklaar and J. Chrisina Wang (2008), The Value of Risk: Measuring he Service Oupu of Commercial Banks, Federal Reserve Bank of Boson Working Paper Chen, Baoline and Dennis Fixler (2003), Measuring he Services of Propery-Casualy Insurance in he NIPAs, Survey of Curren Business, Vol. 83, No. 10 (Oc.), pp Colangelo, Anonio and Reimund Mink (2009), Bank Services: Some Reflecions on he Treamen of Defaul Risk and he Term Premium, presened a he 16 h Annual Session of he Inernaional Saisical Insiue, Aug., 2009, Durban, Souh Africa. Downloaded a hp:// on 6/23/2010. Diewer, Erwin (1974), Ineremporal Consumer Theory and he Demand for Durables, Economerica, Vol. 42, pp Donovan, D. (1978), Modeling he Demand for Liquid Asses: An Applicaion o Canada, IMF Saff Papers, Vol. 25, pp Eurosa, IMF, OECD, UN and World Bank (1993), Sysem of Naional Accoun Eurosa, IMF, OECD, UN and World Bank (2008), Sysem of Naional Accoun BEA (2002), Corporae Profis: Profis before Tax, Profis Tax Liabiliy, and Dividends, BEA Mehodology Paper. 23