Full text of Research Update : Third Quarter 2004

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hird Quarter 2004

Federal Reserve Bank of New York

Update
Research and Statistics Group

www.newyorkfed.org/research

Jiang Wang Is Named Research Group’s
First Resident Scholar
he Research Group has recently
established a Program for Resident
Scholars, designed to attract outstanding researchers to the Bank for a stay
of at least one year. The resident scholars
will participate fully in the Group’s work,
contributing to policy discussions and providing intellectual leadership by advising
and collaborating with our economists.

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The Group is pleased to announce that
Jiang Wang, the Nanyang Technological
University Professor of Finance at MIT’s
Sloan School of Management, has been
appointed the first resident scholar. Jiang,
the recipient of the Leo Melamed Prize in
1997 and the Batterymarch Fellowship in

1995, has published in the Journal of Finance,
the Journal of Financial Economics, the
Journal of Political Economy, the Quarterly
Journal of Economics, the Review of Economic
Studies, and the Review of Financial Studies.
In addition, Jiang is a research associate
at the National Bureau of Economic
Research. He also serves as an editor of
Quantitative Finance and as an associate
editor of the Journal of Financial Markets
and several other journals, and is a former
associate editor of the Review of Financial
Studies. Jiang’s current research focuses on
asset pricing and management under market imperfections, trading volume, and
market liquidity.

Ne w R e s e a r c h : J u l y - S e p t e m b e r 2 0 0 4

Economic Policy Review focuses
on Pillar 3 of Basel II Accord
Why did two key economic measures diverge
so sharply in 2001?
New Staff Reports
Papers recently published by Research Group staff
Papers presented at conferences

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The Program for Resident
Scholars complements our
Visiting Scholars Program, in
which economists from
major research institutions
visit the Bank to present their
work and discuss our economists’ research.

Research Update

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Third Quarter 2004

Academics and Central Bankers Explore
Third Pillar of Basel II Accord
f the three pillars supporting the
emerging, international bank capital regulation known as the Basel II
Accord, the third—increased disclosure
and market discipline of banks—is probably the least considered. The new issue of
the Bank’s Economic Policy Review (vol. 10,
no. 2) sheds light on this topic by publishing the many papers and discussions from
the conference “Beyond Pillar 3 in
International
Banking
Regulation:
Disclosure and Market Discipline of
Financial Firms,” co-organized by the
Bank and Columbia Business School’s
Chazen Institute of International Business.

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The first two pillars of Basel II—adequate bank capital and supervisory review
of bank capital—have received much
attention from researchers and the press.
Accordingly, the conference organizers
instead sought to focus on the less-known
pillar: specifically, disclosure of information about prospects and risks by banks to
investors and the discipline that investors
apply in response.

The papers and their discussions, by
academics and central bank researchers,
addressed a range of questions, from the
theoretical (If the rationale for regulating
banks is, or was, some market failure, can we
expect more efficient market monitoring of
banks now?) to the practical (Disclosure of
what information, by which market, and
how?). On a larger scale, the presenters also
considered whether market discipline is a
credible concept at all, and if the
globalization of financial firms makes
discipline less credible, or more imperative.
Although the papers differed in technique and focus, several made a similar
point: The strength of investor discipline
depends on supervisory discipline, and vice
versa. If investors can expect supervisors to
take prompt corrective action against troubled banks, supervisors can rely on
investors, via signals from bank bond and
stock prices, to help identify those banks.

Pu b l i c a t i o n s a n d P a p e r s
The Research and Statistics Group produces a wide range of publications:
●

The Economic Policy Review—a policy-oriented journal focusing on economic
and financial market issues.

●

EPR Executive Summaries—online versions of selected Economic Policy Review
articles, in abridged form.

●

Current Issues in Economics and Finance—concise studies of topical economic
and financial issues.

Second District Highlights—a regional supplement to Current Issues.
● Staff Reports—technical papers intended for publication in leading economic
and finance journals, available only online.
●

●

Publications and Other Research—an annual catalogue of our research output.

Federal Reserve Bank of New York

www.newyorkfed.org/research

Two Similar Economic
Measures Diverge;
Is One Flawed?
he 2001 recession saw a sharp divergence between two key economic
indicators: the manufacturing production component of industrial production and the goods output component of
GDP. The deviation was peculiar because
manufacturing production and goods output, as their names suggest, appear to track
the same types of activity. This phenomenon could suggest that one measure is
flawed, casting doubt on the reliability of
overall GDP or industrial production.

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A recent analysis, however, finds no evidence of error (“The Relationship between
Manufacturing Production and Goods
Output,” Current Issues in Economics and
Finance, vol. 10, no. 9). Rather, author
Charles Steindel concludes that the divergence is largely consistent with long-run
trends, and that it was accentuated by the
strength of spending on consumer—relative to capital—goods as well as the growth
of merchandising services in the sale of
consumer goods.
According to Steindel, manufacturing
production fell roughly 6 3/4 percent from
June 2000 through December 2001. In the
subsequent year and a half, production
grew very little. By comparison, goods output saw only a small drop in the period,
and it has experienced substantial growth
since then.

This different behavior between
arguably similar measures has caused some
to question the accuracy of the indicators.
However, Steindel explains that manufacturing production is in fact a different
measure than goods output. Broadly
speaking, goods output comprises the sales
of U.S. manufacturers, plus a large amount
of activity associated with the sale of all
goods in the nation—most notably, the
merchandising services used in the sale of
imported and domestically manufactured
consumer goods. Manufacturing production is a more limited measure, covering
the output of U.S. factories. Thus, Steindel
does not attribute the deviation to an error
in one of two “similar” indicators. He suggests instead that the discrepancy during
the 2001 slowdown is largely consistent
with the long-run tendency of goods output to grow more strongly than manufacturing production.
The author adds that the deviation was
accentuated by the strength in consumer
spending relative to capital spending as
well as the growing importance of merchandising services in the sale of consumer
goods. “Since the output of service sector
workers who bring consumer goods to
market is counted in goods output but not
in manufacturing production,” Steindel
observes, “these trends very likely helped
buoy the goods output figure during the
recession and beyond.”

Research and Statistics Group

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Research Update

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Third Quarter 2004

New Titles in the Staff
Reports Series
The following new Staff Reports are available at
www.newyorkfed.org/research/staff_reports.

Microeconomics
No. 191, July 2004

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Why Use Debit Instead of Credit? Consumer
Choice in a Trillion-Dollar Market
Jonathan Zinman
Debit cards are overtaking credit cards as the
most prevalent form of electronic payment at
the point of sale, yet the determinants of such
consumer choice have received relatively little
scrutiny. Several stylized facts suggest that
debit-card use is driven by behavioral factors.
The popular view is that debit-card use presents a puzzle for canonical economic models.
However, cost-based motives for using debit
cards should not be overlooked. Zinman documents robust effects of credit-card use on
debit-card use and shows that such effects are
consistent with a canonical model of consumer
choice. Yet he also shows that it is difficult to
distinguish between canonical and behavioral
motives for debit-card use in public data. More
generally, Zinman develops analytical frameworks for testing competing canonical and
behavioral models, and finds important roles
for both pecuniary and psychological motives.
No. 192, August 2004

The Incentive Effects of Higher Education
Subsidies on Student Effort
Ay egül ahin
The author analyzes the disincentive effects of
low-tuition policies on student effort. Her
game-theoretic model of parent and student
responses to tuition subsidies is calibrated
using information from the National
Longitudinal Survey of Youth 1979 and the
High School and Beyond Sophomore Cohort:
1980-92. She finds that although subsidizing
tuition increases enrollment rates, it reduces
student effort. This follows from the fact that a

Federal Reserve Bank of New York

high-subsidy, low-tuition policy causes an
increase in the percentage of less able and
less highly motivated college graduates.
Additionally—and potentially more important—all students, even the more highly motivated ones, respond to lower tuition levels by
decreasing their effort levels. This study adds
to the literature by demonstrating how highsubsidy, low-tuition policies have disincentive
effects on students’ study time and adverse
effects on human capital accumulation.
No. 194, September 2004

Why Did the Average Duration of
Unemployment Become So Much Longer?
Toshihiko Mukoyama and Ay egül ahin
This paper examines the causes of the observed
increase in the average duration of unemployment over the past thirty years. It first analyzes
whether changes in the demographic composition of the U.S. labor force, particularly the
age and gender composition, can explain this
increase. The authors then consider the contribution of institutional changes, such as the
change in the generosity and coverage of
unemployment insurance. They find that
changes in the composition of the labor force
and institutional changes can only partially
account for the longer duration of unemployment. A job search model is constructed and
calibrated to U.S. data. The results indicate
that more than 70 percent of the increase in
the duration of unemployment over the past
thirty years can be attributed to an increase in
within-group wage inequality.

Banking and Finance
No. 190, July 2004

Estimating Probabilities of Default
Til Schuermann and Samuel Hanson
The authors conduct a systematic comparison
of confidence intervals around estimated probabilities of default (PD) using several approaches
from large-sample theory as well as bootstrapping. They do so for two PD estimation methods—cohort and duration (intensity)—using

www.newyorkfed.org/research

twenty-two years of credit ratings data. The
authors find that the bootstrapped intervals for
the duration-based estimates are surprisingly
tight compared with the more commonly used
(asymptotic) Wald interval. They also find that
despite the relatively tight confidence intervals,
it is impossible to distinguish notch-level PDs
for investment-grade ratings. However, once
the speculative-grade barrier is crossed, notchlevel PDs can be distinguished quite cleanly.
Conditioning on the state of the business cycle
helps; it is easier to distinguish adjacent PDs in
recessions than in expansions.
No. 193, September 2004

Learning about Beta: A New Look
at CAPM Tests
Tobias Adrian and Francesco Franzoni
When risk-factor loadings are time-varying
and unobservable, investors are forced to form
beliefs about the levels of their loadings. The

learning process involved in forming these
beliefs has normative implications for assetpricing tests. This paper develops an equilibrium
model of learning about time-varying beta. In
it, the capital asset pricing model (CAPM)
works for investors’ probability distribution.
However, mispricing can be observed if econometricians estimate betas without accounting
for the investors’ learning process. The empirical implication for asset-pricing tests is that the
factor loadings must be estimated as latent
variables. The authors provide an empirical
application of this methodology to the cross
section of returns on ten book-to-market and
ten size-sorted portfolios. For these assets, the
data do not reject a learning-augmented version of CAPM. This model performs better
than other common empirical specifications,
including the Fama-French three-factor model.

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Recently Published
Nicola Cetorelli. 2004. “Real Effects of Bank
Competition.” Journal of Money, Credit,
and Banking 36, no. 3, part 2 (June): 543-58.
Arturo Estrella. 2004. “The Cyclical Behavior
of Optimal Bank Capital.” Journal of Banking
and Finance 28, no. 6 (June): 1469-98.
Andrew Haughwout. 2004. “Land Taxation in
New York: A General Equilibrium Perspective.” In Amy Ellen Schwartz, ed., City Taxes,
City Spending: Essays in Honor of Dick
Netzer, 73-94. Northampton, Mass.:
Edward Elgar.

Til Schuermann. 2004. “Modeling Regional
Interdependencies Using a Global Vector
Error-Correcting Macroeconometric Model,”
with M. Hashem Pesaran and Scott Weiner
(with discussions and a rejoinder). Journal of
Business and Economic Statistics 22, no. 2
(April): 129-62; 175-81.
Til Schuermann. 2004. “The New Basel Capital Accord and Questions for Research,” with
Marc Saidenberg. In Benton E. Gup, ed., The
New Basel Capital Accord, 97-124. Cincinnati,
OH: South-Western Educational Publishing.
Til Schuermann. 2004. “What Do We Know
about Loss Given Default?” In David Shimko,
ed., Credit Risk Models and Management,
249-74. London: Risk Publications.

Research and Statistics Group

Research Update

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■

Third Quarter 2004

Papers Presented
by Economists in
the Research and
Statistics Group

“Do Drug Prices Vary across Rich and Poor
Countries?” Rebecca Hellerstein. International
AIDS Economics Network Preconference
Meeting for the Fifteenth International AIDS
Conference, Bangkok, Thailand, July 9.

“Inference, Arbitrage, and Asset Price Volatility,”
Tobias Adrian. Thirty-First Annual Meeting of
the European Finance Association, Maastricht,
the Netherlands, August 21.

“Unraveling the U.S. Supply Chain,” Bart
Hobijn and Margaret McConnell. Global Economic Modeling Network and International
Input-Output Association Conference, Free
University of Brussels, Brussels, Belgium,
September 4. With Bess Rabin.

“Why Emergency Lending Facilities Go
Unused,” Leonardo Bartolini. Society for Economic Dynamics Annual Meeting, Florence,
Italy, July 2. Also presented at the European
Economic Association and Econometric
Society Annual Meeting, Madrid, Spain,
August 21.

“Current Accounts and Global Rebalancing in
a Multi-Country Simulation Model,” Paolo
Pesenti. NBER Preconference on G-7 Current
Account Imbalances, Cambridge, Massachusetts,
July 12. With Hamid Faruqee, Douglas Laxton,
and Dirk Muir.

“Simulating Fedwire Security Service,” Morten
Bech. Bank of Finland conference, Helsinki,
Finland, August 26. With Kurt Johnson and
Kimmo Soramäki.
“Exchange Rate Pass-Through into Developing
Countries,” Linda Goldberg. NBER International Finance and Macroeconomics Summer
Institute, Cambridge, Massachusetts, July 14.
“The United States in the Global Economy,”
Linda Goldberg. Fordham University Graduate
School of Business seminar, New York City,
July 29.
“Overview of the International Wage Flexibility Project,” Erica Groshen. European Central
Bank conference, Frankfurt, Germany, July 7.
With William Dickens, Julian Messina, Jarkko
Turunen, and Melanie Ward.

Federal Reserve Bank of New York

“Stabilization, Competitiveness, and RiskSharing: A Model of Monetary Interdependence,” Paolo Pesenti and Cédric Tille. NBER
International Finance and Macroeconomics
Summer Institute, Cambridge, Massachusetts,
July 16. Also presented at Cornell University,
Ithaca, New York, September 22, and the
European Central Bank, Frankfurt, Germany,
September 27.
“Money and Modern Bank Runs,” David
Skeie. Society for Economic Dynamics Annual
Meeting, Florence, Italy, July 3.
“Place of Work and Place of Residence: Informal
Hiring Networks and Labor Market Outcomes,” Giorgio Topa. Stanford Institute for
Theoretical Economics seminar, Stanford
University, Palo Alto, California, July 8.

www.newyorkfed.org/research

Research and
Statistics Group
Publications and Papers:
July-September 2004
Publications are available at www.newyorkfed.org/
research/publication_annuals/index.html.

Economic Policy Review, vol. 10, no. 2
“Beyond Pillar 3 in International Banking
Regulation: Disclosure and Market Discipline
of Financial Firms,” papers from a conference
cosponsored by the Federal Reserve Bank of
New York and the Jerome A. Chazen Institute
of International Business at Columbia
Business School, October 2-3, 2003.
Contents include:
Conference Overview and Summary of Papers
Donald P. Morgan and Frederic S. Mishkin
Rebalancing the Three Pillars of Basel II
Jean-Charles Rochet
Disclosure, Volatility, and Transparency:
An Empirical Investigation into the Value
of Bank Disclosure
Ursel Baumann and Erlend Nier
Market Indicators, Bank Fragility,
and Indirect Market Discipline
Reint Gropp, Jukka Vesala, and Giuseppe Vulpes
A Reconsideration of the Risk Sensitivity
of U.S. Banking Organization Subordinated
Debt Spreads: A Sample Selection Approach
Daniel M. Covitz, Diana Hancock,
and Myron L. Kwast
Risk and Return of Publicly Held versus
Privately Owned Banks
Simon H. Kwan

Current Issues in Economics
and Finance, vol. 10
No. 8, July 2004

The Evolution of U.S. Bank Branch
Networks: Growth, Consolidation,
and Strategy
Beverly Hirtle and Christopher Metli
No. 9, August 2004

The Relationship between Manufacturing
Production and Goods Output
Charles Steindel
No. 10, September/October 2004

Reserve Accumulation: Implications for
Global Capital Flows and Financial Markets
Matthew Higgins and Thomas Klitgaard

Staff Reports
Available only online.
No. 190, July 2004

Estimating Probabilities of Default
Til Schuermann and Samuel Hanson
No. 191, July 2004

Why Use Debit Instead of Credit? Consumer
Choice in a Trillion-Dollar Market
Jonathan Zinman
No. 192, August 2004

The Incentive Effects of Higher Education
Subsidies on Student Effort
Ay egül ahin
No. 193, September 2004

Learning about Beta: A New Look
at CAPM Tests
Tobias Adrian and Francesco Franzoni
No. 194, September 2004

Why Did the Average Duration of
Unemployment Become So Much Longer?
Toshihiko Mukoyama and Ay egül ahin

The views expressed in the publications and papers summarized in Research Update are those
of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York
or the Federal Reserve System.
Research and Statistics Group

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