Knowledge that Transforms

This paper analyzes the cyclical effects of bank capital requirements in a simple model with credit market imperfections. Lending rates are set as a premium over the cost of borrowing from the central bank, with the premium itself depending on collateral. Basel I- and Basel II-type regulatory regimes are defined and a capital channel is introduced through a signaling effect of capital buffers. The macroeconomic effects of a negative supply shock are analyzed, under both binding and nonbinding capital requirements. Factors affecting the procyclicality of each regime (defined in terms of the behavior of the risk premium) are also identified.

This article provides empirical evidence of behavioural responses by banks in the recent crisis. Using firm-specific balance sheet data, we construct aggregate indicators of systemic risk. Measures of size and herding show that balance sheet adjustments have been pro-cyclical in the crisis, while responses became increasingly dependent across banks and concentrated on certain market segments. Banks reacted less according to a pecking order, as an indication of reduced flexibility in their risk management opportunities. The behavioural indicators are useful tools for monetary and macro prudential analyses and can contribute to the micro foundations of financial stability models.

This paper examines blanket guarantee, deposit insurance and restructuring decisions with respect to a multinational bank (MNB) using Nash bargaining when the threat of a bank panic motivates countries to make decisions quickly. Failure of the bank would unevenly distribute externalities across countries, influencing the restructuring incentives. In equilibrium, the bank is either liquidated or one of the countries – or both – recapitalizes it. A partition of the recapitalization costs is sensitive to the country-specific benefits and costs from recapitalization, panic and liquidation. The home regulator benefits from the advantage that it is the only entity that can legally liquidate the MNB. Rational expectations regarding the bargaining result affect the incentives to declare a blanket guarantee.

This article is a review of a 531 page book that in turn is a review and evaluation of the 2319 page Dodd–Frank Wall Street Reform and Consumer Protection Act passed by Congress on July 16, 2010. The overriding theme of the book is to pose two approaches to attaining financial stability in the future. One approach is to establish a council of wise men and women supported by an army of highly skilled professional financial economists to formulate and implement regulations designed to prevent future financial crises that wreak havoc on the real economy and require financial support from taxpayers. This is the approach of the Dodd–Frank Act. The second approach proposed by the authors of this book is to design a taxing system that taxes systemically important financial institutions on the basis of their contribution to systemic risk. Borrowing ideas from the literature on the taxation of negative externalities their view is that financial institutions that create crises should pay for the clean-up. They also argue that requiring the financial polluters to pay for the creation of systemic risk will reduce the supply of systemic risk. The reader is invited to decide which approach is best.

This paper proposes a model to conduct macro stress test of credit risk for the banking sector based on scenario analysis. We employ an original bank-level data set that splits bank credit portfolios in 21 granular categories, covering household and corporate loans. The results corroborate the presence of a strong procyclical behavior of credit quality, and show a robust negative relationship between the logistic transformation of non-performing loans (NPLs) and GDP growth, with a lag response of up to three quarters. The results also indicate that the procyclical behavior of loan quality varies across credit types. This is novel in the literature and suggests that banks with larger exposures to highly procyclical credit types and economic sectors would tend to undergo sharper deterioration in the quality of their credit portfolios during an economic downturn. Lack of sufficient portfolio granularity in macro stress testing fails to capture these effects and thus introduces a source of bias that tends to underestimate the tail losses stemming from the riskier banks in a system.

We employ a new data set comprised of disaggregate figures on clearing house loan certificate issues in New York City to document how the dominant national banks were crucial providers of temporary liquidity during the Panic of 1907. Clearing house loan certificates were extensions of credit by the New York Clearing House to its members. These certificates were transferable to other clearing house members as a form of final payment for settlement of interbank payments. The certificate issues allowed borrowing banks to maintain (and increase) loans, fulfill cash payment upon depositor withdrawal demands, and enabled gold imports, which took two to three weeks to arrive. The large, New York City national banks acted as private liquidity providers by requesting (and the New York Clearing House issuing) a volume of clearing house loan certificates in excess of their own immediate liquidity needs, in accord with their role as central reserve city banks in the national banking system.

This paper introduces two methods of hiding loan losses and analyzes how they affect a bank's loan interest income, payments on deposits, liquidity and moral hazard. The analysis reveals that a hiding method represents a Ponzi scheme. Contrary to classic theory, e.g. Diamond (1984), moral hazard may arise even though a bank's loan portfolio is diversified. Alternative instruments to eliminate hiding are investigated. Under specific circumstances, a Ponzi scheme may provide a socially optimal method to create liquidity and prevent a failure of a solvent but illiquid bank.

This paper develops a partial equilibrium model of a banking firm to analyze how provisioning rules influence loan market fluctuations. We show that a backward-looking provisioning system amplifies the pro-cyclicality of loan market fluctuations. We demonstrate that, in a forward-looking provisioning system where statistical provisions are used to smooth the evolution of total loan loss provisions, the issue of pro-cyclicality of loan market fluctuations does not exist. Our results support the recent call of the Basel Committee for the implementation of a forward-looking provisioning system to address procyclicality.

I examine the relationship between bank efficiency and market power to test the quiet life hypothesis for a sample of 419 Latin American commercial banks between 1985 and 2010. A two-stage least squares model with instrumental variables controls for the simultaneous relationship between efficiency and market power. Citing developments in efficiency modelling, efficiencies are drawn from the random parameters stochastic frontier function model that treats unobserved heterogeneity, whilst conventional Lerner indices and the efficiency adjusted Lerner index proxy market power. The quiet life hypothesis is firmly rejected after various robustness checks. To test if bank restructuring and governance changes affect efficiency and market power, I use a difference-in-differences approach to determine the impact of bank privatisation and foreign acquisition of local banks on efficiency and market power. Privatisation is preferred over foreign acquisition though its impact is concentrated on efficiency rather than market power. The evidence suggests that bank restructuring has promoted competition at the expense of market power and yielded efficiency gains at banks under conditions of monopolistic competition.

We explore the dynamics of default cascades in a network of credit interlink-ages in which each agent is at the same time a borrower and a lender. When some counterparties of an agent default, the loss she experiences amounts to her total exposure to those counterparties. A possible conjecture in this context is that individual risk diversification across more numerous counterparties should make also systemic defaults less likely. We show that this view is not always true. In particular, the diversification of credit risk across many borrowers has ambiguous effects on systemic risk in the presence of mechanisms of loss amplifications such as in the presence of potential runs among the short-term lenders of the agents in the network.