Ever wondered how to understand what a bank is really saying about its condition in quarterly earnings reports? A new paper from the federal insurer of bank deposits’ research arm takes a stab at deciphering the code.
In “Breaking the Word Bank: Effects of Verbal Uncertainty on Bank Behavior,” author Paul Soto of the Federal Deposit Insurance Corp. (FDIC, which sponsored the paper through its Center for Financial Research) notes that banks differ from non-financial firms because they must communicate to both regulators and shareholders. Further, he said, banks possess opaque and complex balance sheets and serve as main providers of credit to the real economy.
“In this paper, I propose a new index to detect the idiosyncratic uncertainty banks face at the bank-quarter level by applying natural language processing techniques to earnings conference call transcripts,” Soto wrote. “The index reveals which banks at a given quarter signal more uncertainty about their balance sheets.”
In the abstract to the paper, Soto stated that higher uncertainty is associated with lower lending and higher trading the next quarter, suggesting active management of uncertainty. “The active management of uncertainty is more pronounced during periods of high aggregate volatility and for banks with more skin in the game,” he wrote. “Using loan level data and firm fixed effects, I control for demand-side factors and find that higher bank level uncertainty is associated with lower loan issuances the following quarter.”
In his conclusion, Soto suggests that the new index he proposes can be used to track the flow of credit to the real economy by identifying banks most likely to cut back credit during the business cycle and deviate to more liquid assets such as trading. “The new bank level measure could provide another layer of transparency to an otherwise opaque financial industry,” he wrote.