Knowledge that Transforms

We develop a simple model of banking regulation with two policy instruments: minimum capital requirements and the supervision of domestic banks. The regulator faces a trade-off: high capital requirements cause a drop in the banks’ profitability, whereas strict supervision reduces the scope of intermediation and is costly for taxpayers. We show that a mix of both instruments minimises the costs of preventing the collapse of financial intermediation. Once we allow for cross-border banking, the optimal policy is not feasible. If domestic supervisory effort is not observable, our model predicts a race to the bottom in capital requirement regulation. Therefore, countries are better off by harmonising regulation on an international standard.

Cumulative prospect theory (CPT) is widely considered to be the most successful descriptive theory for decision making under risk and uncertainty. Sophisticated methods have been developed to reliably elicit CPT parameters on an individual basis. The aim of this paper is to analyze whether such methods are suited to be applied in real world situations, particularly in the context of investment counseling for retail investors. Specifically, we examine whether CPT parameters elicited via standardized computer tools are successful in predicting an individual’s preference for different structured financial products. Surprisingly, we find only low predictive power of the elicited CPT parameters on the WTP. Using a second set of experiments, we examine possible explanations for the low prediction quality. Overall, we have to conclude that it is too much of a leap to draw conclusions about the attractiveness of complex financial products from CPT parameters elicited via simple lotteries.

The primary role of a bank branch is evolving from a service provider towards a sales channel. Previous branch-level studies of sales efficiency consider a static setting of a single time period, ignoring the stochastic nature of sales outcomes. In this paper, we examine efficiency and performance of sales teams in a bank branch network over time, taking into account the changing demand and operational conditions, as well as random disturbances. The intertemporal sales frontier is estimated from the panel of monthly data over the years 2007–2010 using the stochastic semi-nonparametric envelopment of data (StoNED) method. The efficiency scores of sales teams and the trajectories of performance over time allow managers and the sales force to learn from past events and to develop the managerial and work practices across the network. While this study focuses on the case of a specific bank, some of the innovative features of our approach are applicable to sales efficiency assessment in other banks and financial institutions, as well as other network-based sales organizations.

This paper examines the impact of the individual dimensions of social performance (SP) on firm risk (total and idiosyncratic) using 16,599 firm-year observations over the period 1991–2007. We find that firm risk for S&P500 members is positively affected by Employee, Diversity, and Corporate Governance concerns. On the other hand, Community (Diversity) strengths negatively (positively) affect their risk. As to non-S&P500 members, firm risk is positively affected by Employee concerns and Diversity strengths. However, firm risk of non-S&P500 members is negatively affected by Environment strengths. The direction of causation between firm risk and SP depends on the dimension examined.

Stress tests with handpicked scenarios might misrepresent risks either because dangerous scenarios are not considered or because the scenarios considered are too implausible. To overcome these two pitfalls we propose a systematic search for the worst case within a relative entropy ball of sufficiently plausible scenarios. For this purpose we use mixed scenarios, which are risk factor distributions rather than realisations. A Maximum Loss theorem explicitly gives the worst case distribution. The method is illustrated in a number of example applications: linear and quadratic portfolios, stressed default probabilities, stressed correlations, macroeconomic stress tests.

This paper presents new evidence on the relationship between competition and innovation by extending previous literature from manufacturing to financial services. We introduce a new measure of overall innovation by estimating and enveloping annual minimum cost frontiers to create a global frontier. The distance to the global frontier constitutes each bank’s technology gap, which decreases if the bank manages to innovate. Our innovation measure enables us to derive and estimate the model of Aghion et al. (2005b) at the firm level for the US banking industry. Based on individual bank Call Report data for the period 1984–2004, consistent with theoretical and empirical work by Aghion et al., we find evidence of an inverted-U relationship between competition and innovation that is robust over several different specifications. Further evidence on major structural changes in the US banking industry indicates that banks moved beyond their optimal innovation level and that interstate banking deregulation resulted in lower bank innovation. Policy implications to financial reform and prudential regulation are discussed also.