Knowledge that Transforms

In this paper, we explore whether economic uncertainty differently affects the default risk of Islamic and conventional banks. Using a sample of 568 banks from 20 countries between 2009 and 2018, we use the World Uncertainty Index (WUI) by Ahir et al. (2018) to conduct a study based on a comparable measure across countries. Our findings indicate that economic uncertainty increases the default risk of conventional banks but does not affect Islamic banks’ default risk. To understand why, we explore the influence of religiosity, institutional factors, and bank-level heterogeneity. We observe that Islamic banks’ default risk is not significantly affected by uncertainty in all types of countries, but such a difference with conventional banks mainly holds for banks with higher income diversification, larger size, and that are publicly traded. Moreover, our findings show that conventional banks suffer more from uncertainty in terms of stability in countries with higher religiosity and with a higher share of profit-loss sharing (PLS) contracts. Our results are robust to alternative estimation techniques to deal with endogeneity and to alternative variable measurements.

In this paper, we examine the role of political connections in mitigating the detrimental impact of policy uncertainty on banks. Our estimates show that banks are more cautious when facing policy uncertainty, but that the effect is partially alleviated when banks are politically connected. For an increase of one standard deviation in policy uncertainty, connected banks maintain a loss provision to loan volume ratio that is almost seven percent lower compared to their unconnected peers. These findings are robust to a geographical regression discontinuity setting, as well as to a placebo test. Lastly, the mitigating role of political connections is driven mainly by smaller banks and periods of stricter banking regulations.

This paper analyses the evolution of the safety and soundness of the European banking sector during the various stages of the Basel process of capital regulation. We document the evolution of various measures of systemic risk as the Basel process unfolds. Most strikingly we find that the exposure to systemic risk as measured by SRISK has been steeply rising for the highest quintile, moderately rising for the second quintile, and remaining roughly stationary for the remaining three quintiles of listed European banks. This observation suggests that during the Basel process, systemic risk has been contained for the majority of European banks, but not for the largest and riskiest institutions. When analyzing the sources of systemic risk we find compelling evidence that the increase in exposure to systemic risk (SRISK) is tied to the implementation of internal models for determining credit risk, as well as market risk. Based on this evidence, the sub-prime crisis found especially the largest and more systemic banks ill-prepared and lacking resiliency. This condition has been aggravated during the European sovereign crisis. The Banking Union has not restored aggregate resiliency to pre-crisis levels. Finally, low-interest rates considerably affect the contribution to systemic risk, particularly for the riskier banks.

Climate change has been recently recognised as a new source of risk for the financial system. Over the last years, several central banks and financial supervisors have recommended investors and financial institutions to assess their exposure to climate-related financial risks. Central banks and financial supervisors have also started to design scenarios for climate stress tests - to- assess how vulnerable the financial system is to climate change. Nevertheless, the financial community falls short of methodologies that allow the successful analysis of the risks that climate change poses to financial stability. Indeed, the characteristics of climate risks (i.e., deep uncertainty, non-linearity and endogeneity) challenge traditional approaches to macroeconomic and financial risk analysis. Embedding climate change in macroeconomic and financial analysis using innovative perspectives is fundamental for a comprehensive understanding of the macrofinancial relevance of climate change. This Special Issue is devoted to the relation between climate risks and financial stability and represents the first comprehensive attempt to fill methodological gaps in this area and to shed light on the financial implications of climate change. It includes original contributions that use a range of methodologies – such as network modelling, dynamic evolutionary macroeconomic modelling and financial econometrics – to analyse climate-related financial risks and the implications of financial policies and instruments aiming at the low-carbon transition. The research insights of these contributions can inform the decisions of central banks and financial supervisors about the integration of climate change considerations into their policies and financial risk assessment.

In financial stability, it is essential to know the determinants of interest rates in interbank markets because they are important vehicles for liquidity allocation among banks and are relevant for monetary policy transmission. Recent research indicates that banks with excess liquidity exercise their market power by rationing liquidity during periods of financial stress. This confirms the value of knowing the banks connections and identifying liquidity spreaders in such markets to manage contagion risk, liquidity hoarding and to preserve financial stability. In addition to well studied bank features such as size, liquidity and credit risk, we study which network metrics relate to interest rates during different periods. Using transaction level data on unsecured and secured lending, we apply an approach that employs network theory, econometric models and machine learning to analyze the structural properties of the secured and unsecured interbank markets in Mexico. Our findings support the “too-interconnected-to-fail” hypothesis. In the secured interbank market, PageRank shows a relationship with interest rates, while metrics associated with the notion of influence and systemic risk (Katz and DebtRank) are relevant in the unsecured interbank market. In general, a bank with high centrality lends at higher rates and gets funding at lower rates.

Economic policy uncertainty (EPU) increases the cost of raising equity capital, especially when the economy is weak. A one standard deviation increase in the EPU index developed by Baker, Bloom, and Davis (2016) is associated with a 43 basis point increase in the price discount of seasoned equity offerings (SEOs) during the 2000−2014 period. The cross-sectional analysis shows that the EPU effect on SEO discounts is stronger for firms with greater dependence on government spending, less informative stock price, or a smaller EPU beta. Moreover, there are fewer SEO activities in periods when there is a high degree of policy uncertainty.

Which policies can increase the resilience of the financial system to climate risks? Recent evidence on the significant impacts of climate change and natural disasters on firms, banks and other financial institutions call for a prompt policy response. In this paper, we employ a macro-financial agent-based model to study the interaction between climate change, credit and economic dynamics and test a mix of policy interventions. We first show that financial constraints exacerbate the impact of climate shocks on the economy while, at the same time, climate damages to firms make the banking sector more prone to crises. We find that credit provision can both increase firms’ productivity and their financial fragility, with such a trade-off being exacerbated by the effects of climate change. We then test a set of “green” finance policies addressing these risks, while fostering climate change mitigation: i) green Basel-type capital requirements, ii) green public guarantees to credit, and iii) carbon-risk adjustment in credit ratings. All the policies reduce carbon emissions and the resulting climate impacts, though moderately. However, their effects on financial and real dynamics is not straightforwardly positive. Some combinations of policies fuel credit booms, exacerbating financial instability and increasing public debt. We show that the combination of the three policies leads to a virtuous cycle of (mild) emission reductions, stable financial sector and high economic growth. Additional tools would be needed to fully adapt to climate change. Hence, our results point to the need to complement financial policies cooling down climate-related risks with mitigation policies curbing emissions from real economic activities.

This paper investigates the risk of failure of loans guaranteed by public credit guarantee schemes. We analyse the determinants of the time to default of approximately 15,000 loans guaranteed by the Italian Central Guarantee Fund between 2007 and 2009. Using the Cox proportional hazards model, we test the role of the financial intermediary that requests the guarantee on a firm’s behalf, while distinguishing between banks and mutual guarantee institutions (MGIs) and controlling for a set of variables that characterise each guaranteed loan. The findings confirm that loans are more likely to default when a bank—rather than an MGI—is involved in the guarantee process. Considering some elements (e.g. age, size and sector) that affect opacity among small- and medium-sized enterprises (SMEs), banks seem to perform better than MGIs in screening and monitoring loans requested by firms in the manufacturing sector.

Using data for 6740 U.S. banks from 1996 to 2016, we consider whether mortgage loan demand is a key determinant of banks’ cost efficiency and management quality. We estimate mortgage loan demand from loan-level applications at individual banks, and we estimate bank efficiency and management quality score from banks’ structural models. In line with theoretical considerations around economies of scale, our results show that loan amount demand improves cost efficiency, but the number of loan applications reduces cost efficiency. In contrast, mortgage loan demand has an economically less significant effect on management quality score. We also find that loan demand is an important factor in shaping banks’ loan quality, above and beyond operational efficiency.