Research on bank efficiency has developed in two separate streams: econometric studies and Data Envelopment Analysis, a linear programming technique. These two branches of literature have developed quickly, but separately; in this paper these two approaches have been tested on a common panel of 270 Italian banks, and this has suggested the following: (i) econometric and linear programming results do not differ dramatically, when based on the same data and conceptual framework; (ii) when differences arise, they can be explained by going back to the intrinsic features of the models. Moreover, some findings on Italian banks may be of interest also to the international reader: (i) efficiency scores show a high variance; (ii) the banking system is split in two, between northern and southern banks; (iii) there is a direct (rather than inverse) relationship between productive efficiency and asset quality; (iv) the efficiency of Italian banks did not increase over the period 1988–1992.

The Basel Committee designed a system of risk weights (“standardised approach”) to measure the riskiness of banks' loan portfolios. We investigate its ability to adequately reflect risk through an analysis of the economic capital implied in corporate bond spreads. This is based on a dataset of issuance spreads, ratings and other relevant bond variables including 7232 eurobonds issued by an internationally-diversified sample during 1991–2003. Three main results emerge: the spread/rating relationship is strongly significant; the estimated spreads per rating class indicate a steeper risk/rating relationship than the one approved by the Basel Committee; no significant difference appears in the spread/rating relation of banks and non-financial firms issuers.

The new rules on bank liquidity set by the Basel Committee require banks to hold high-quality liquid assets (HQLAs) against future cash outflows in periods of market stress. Domestic government bonds are considered to be HQLAs. To assess the appropriateness of this rule, we investigate the liquidity of European government bonds in ordinary times and in periods of market turmoil. We find that the effect of adverse market conditions on liquidity strongly depends on individual bond’s characteristics. Our evidence argues for rules on HQLAs that should constrain the eligibility of government bonds depending on their characteristics (primarily, duration and rating).

We investigate how the credit cycle affects the link between bond spreads and credit ratings. Using a simple model of the credit assessment process, we show that when the debt market is more opaque, the information content of ratings deteriorates, creating an incentive for investors to increase the amount spent on private information. We test this hypothesis empirically. Results show that when market opaqueness (proxied by the spread between Aaa- and Baa-rated bonds) increases, the explanatory power of ratings and other control variables deteriorates as investors increasingly price in non-public information.

Supervisory stress tests assess the impact of an adverse macroeconomic scenario on the profitability and capitalisation of a large number of banks. The results of such stress test exercises have recently been disclosed to the public in an attempt to restore confidence and to curb bank opaqueness by helping investors distinguish between sound and fragile institutions. In an unprecedented effort for transparency, the 2011 European Union stress test lead to the release of some 3400 data points for each of the 90 participating banks. This makes it an ideal setting to investigate a number of hypotheses on the information role of the stress tests. In this paper we examine the 2011 European stress test exercise to assess whether and how it affected bank stock prices. Our event study analysis shows that the test’s results were considered relevant by investors. The market did not simply look at the detailed historical data which was released after the tests, but also attached considerable importance to variables measuring each bank’s vulnerability to the simulated downturn scenario. The latter include proxies for liquidity risk and model risk. Information on sovereign debt holdings, while affecting market reaction on a univariate basis, is not statistically significant in a multivariate setting. We also find that the market is not able to anticipate the test results and this is consistent with the idea of greater bank opaqueness prior to the disclosure of the stress test results. Overall, our analysis shows that stress tests produce valuable information for market participants and can play a role in mitigating bank opacity.

In designing credit rating systems under the new Basel Accord, considerable effort has been devoted to rating assignment and quantification, while the choice of the optimal bucket structure has received less attention. To fill this gap, we propose two “bucketing” strategies based on constrained optimisation, paying attention to the implications of rating buckets for loan-pricing and adverse selection phenomena. We compare them with some more naïve approaches, based on a sample of about 100,000 European companies. We also analyse the persistence of our performance measures over time, as well as the effect of large exposures being associated with low-PD obligors.