Knowledge that Transforms

Building an unbalanced panel of United States (US) bank holding company (BHC) and commercial bank balance-sheet data from 1986 to 2008, we examine the relationship between short-term capital buffer and portfolio risk adjustments. Our estimations indicate that the relationship over the sample period is a positive two-way relationship. Moreover, we show that the management of such adjustments is dependent on the degree of bank capitalization. Further investigation through time-varying analysis reveals a cyclical pattern in the uncovered relationship: negative after the 1991/1992 crisis, and positive before 1991 and after 1997.

We investigate whether the introduction of fixed-price U.S. federal deposit insurance in 1933 increased the risk-taking of banks over the succeeding period. We examine 60 financial institutions and find that banks and trusts in general became more risky after the introduction of deposit insurance. However, a subset of well-performing banks appears to have reduced their risk. Deposit insurance also reduced the incentives of depositors to discriminate between ex ante weaker and stronger banks thus reducing depositor discipline in return for greater banking system stability.

This paper examines why some financial stress episodes lead to economic downturns. The paper identifies episodes of financial turmoil in advanced economies using a financial stress index (FSI), and proposes an analytical framework to assess the impact of financial stress – in particular banking distress – on the real economy. It concludes that financial turmoil characterized by banking distress is more likely to be associated with deeper and longer downturns than stress mainly in securities or foreign exchange markets. Economies with more arm's-length financial systems seem to be more exposed to contractions in activity following financial stress, due to the greater procyclicality of leverage in their banking systems.

We explore the inter-temporal effects of the pool externalities caused by imperfect screening in competitive credit markets. We find that imperfect screening may, depending on the parameters of the model, generate excessive screening, inefficient duplication of screening or screening cycles. Whenever screening cycles occur they are manifestations of either socially excessive or insufficient screening. We present a full equilibrium characterization and a welfare analysis. The implementation of socially optimal lending decisions requires communication across lenders (i.e. information sharing), which decentralized markets typically cannot achieve.

This paper examines the interaction between monetary policy and financial stability and provides an assessment of the implications of banks’ risk management practices for monetary policy. By considering the desire of the central bank to stabilize different types of the “basis” risk as a contribution to financial stability, we derive a set of plausible interest-rate rules characterized by either backward or forward interest-rate smoothing. The paper investigates the determinacy conditions of the rational expectations equilibria obtained under such rules. Contrary to what previously found in the literature, we find that the practice of smoothing interest rates backward does not in general alleviate problems of equilibrium indeterminacy. Moreover, basis risk stabilization may lead to policy rules embedding “forward” interest-rate smoothing, where a new kind of indeterminacy may arise following excessive concern for financial stability.

While the current capital adequacy framework, Basel II, aims to make banks’ capital requirements more sensitive to the underlying risk of the assets, it may also introduce an additional source of procyclicality in the banking sector. In this paper we assess the potential cyclicality of Basel II for the entire bank portfolio. This is in contrast to previous studies which have taken into account only parts of banks’ assets, and also neglected the potential cyclicality of bank capital. We apply a detailed data set covering a relatively long period to analyse the cyclicality of both bank capital and Basel II capital requirements. Moreover, we employ a more comprehensive system of models than applied in the existing literature. Consistent with previous evidence, we find a substantial increase in the calculated Basel II capital requirements at the same time as bank capital deteriorates in a recession scenario. However, we also find that the cyclicality of Basel II capital requirements may be effectively contained if risk weightings are based on a sufficiently long observation period which includes economic downturns.

The original Taylor rule establishes a simple linear relation between the interest rate, inflation and the output gap. An important extension to this rule is the assumption of a forward-looking behaviour of central banks. Now they are assumed to target expected inflation and output gap instead of current values of these variables. Using a forward-looking monetary policy reaction function, this paper analyses whether central banks’ monetary policy can indeed be described by a linear Taylor rule or, instead, by a nonlinear rule. It also analyses whether that rule can be augmented with a financial conditions index containing information from some asset prices and financial variables. The results indicate that the monetary behaviour of the European Central Bank and Bank of England is best described by a nonlinear rule, but the behaviour of the Federal Reserve of the United States can be well described by a linear Taylor rule. Our evidence also suggests that only the European Central Bank is reacting to financial conditions.

This paper studies whether compliance with the Basel Core Principles for effective banking supervision (BCPs) is associated with bank soundness. Using data for over 3000 banks in 86 countries, we find that neither the overall index of BCP compliance nor its individual components are robustly associated with bank risk measured by individual bank Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z-score.

In the context of the proposed EU financial supervisory reforms, this paper focuses on the governance of the network of national supervisory banking agencies and the newly established Community supervisor (European Banking Authority, EBA). We assess to what extent lack of governance convergence nationally and with EBA could undermine the incentives for cooperation among supervisors. Convergence should particularly focus on (i) the issue of the presence of politicians on decision-making bodies; (ii) the need for clearly defining dismissal procedures of heads of supervision; (iii) autonomy from government in regulatory matters; (iv) supervisory autonomy in matters of licensing and withdrawing licenses; (iv) mechanisms for judicial accountability; (v) legal protection for supervisors handling in good faith. In the absence of full centralization of prudential supervision, early harmonization of national governance arrangements towards best practice would better align supervisors’ incentive structures and, hence, be beneficial for the effectiveness of European supervision.