Knowledge that Transforms

Until recently, the lack of appropriate harmonized micro data covering both income and wealth has been the major obstacle in analyzing financial vulnerability of the household sector in the euro area. This data problem has been partially circumvented by the dissemination of the Household Finance and Consumption Survey (HFCS). Based on this unique data set, we put forward a stress testing method of household balance sheets in a consistent manner across euro area countries. To this end, we put forward a metric of distress which takes into account both the solvency and liquidity position of the household and demonstrate that this metric outperforms the most common metrics used in the literature, which do not take into account the households’ asset holdings. We calibrate this metric using the country level data on non-performing loan ratios and estimate stress-test elasticities in response to an interest rate shock, an income shock and a house price shock. We find that, albeit euro-area households are relatively resilient as a whole, there are large discrepancies in the impact of macroeconomic shocks across countries. Finally, we demonstrate that our framework could be used to assess some measures mitigating losses to the banks, such as engaging in the restructurings of loans that are at risk of defaulting.

This paper evaluates the model risk of models used for forecasting systemic and market risk. Model risk, which is the potential for different models to provide inconsistent outcomes, is shown to be increasing with market uncertainty. During calm periods, the underlying risk forecast models produce similar risk readings; hence, model risk is typically negligible. However, the disagreement between the various candidate models increases significantly during market distress, further frustrating the reliability of risk readings. Finally, particular conclusions on the underlying reasons for the high model risk and the implications for practitioners and policy makers are discussed.

Banks are typically exposed to spirals between liquidity scarcity and solvency risk. We build a network model of optimizing banks featuring contagion on both sides of balance sheets: runs on short term liabilities and banks’ liquidity hoarding induce liquidity freezes; fire sale externalities and interconnected debt defaults produce asset risk. We use the model, which is calibrated to European data via simulated method of moments, to study the effects of phase-in increases of liquidity coverage ratios. Interestingly we find that the systemic risk profile of the system is not improved and might even deteriorate. Based on those insights we propose an alternative approach: differential (across banks) application of coverage ratios based on a systemic importance ranking help to mitigate the externalities and deliver a much more stable system.

This study evaluates the efficiency of the cyclically-adjusted budget balance (CABB) as the central gauge in the reinforced European fiscal framework for evaluating fiscal discipline. We do this by means of a simulation experiment. We use an estimated DSGE model to simulate all the macroeconomic data needed to assess the CABB according to the official EC methodology. Additionally, the model contains an expenditure fiscal rule that accounts for non-automatic variation in the budget, which allows us to observe the true discretionary measures of fiscal policy. Our results indicate that the EC methodology frequently fails to identify the true fiscal policy stance and also frequently fails to correctly signal potential violations of the SGP limit on structural deficit. In the latter case triggering corrective fiscal contractions to comply with the SGP results in increased macroeconomic instability. In addition, we show that allowing for a bigger role for stability-oriented discretionary policy and thus relaxing the SGP limit on structural deficit could enhance the stabilization efficiency of fiscal policy without reducing the degree of compliance with the Maastricht Treaty. These conclusions apply to small countries in a monetary union as well as large countries with independent monetary policy.

We examine the impact of foreign bank presence on a host countries’ business regulatory environment. We employ a panel dataset of 87 developing economies for the 1995–2013 period and measure the efficiency of business regulations using the indices from the Heritage and the Fraser datasets. Our results show that foreign bank presence exerts a positive impact on the efficiency of business regulations; however, we find no evidence in favor of a more pronounced positive effect when foreign banks originate from countries that have a more efficient business regulatory environment. Moreover, host countries’ administrative requirements and, particularly, bureaucracy costs benefit from a foreign bank presence; however, cost and time procedures to start a business do not.

Around the world, investors, practitioners, regulators and policy makers seek to understand whether, when and why recently listed stocks, initial public offerings (IPOs) are delisted rather than continue trading (survive). Using data on 7,627 IPOs issued during 2000–2008 across 32 countries, we explore the impact of the legal system on IPO survival. We find that IPOs in countries with better investor protections remain listed for longer. This suggests that better legal systems increase the net benefits companies derive from staying listed. We also provide evidence that better legal systems increase the effectiveness of IPO certification by venture capitalists, underwriters and auditors.

We propose a framework for estimating time-varying systemic risk contributions that is applicable to a high-dimensional and interconnected financial system. Tail risk dependencies and systemic risk contributions are estimated using a penalized two-stage fixed-effects quantile approach, which explicitly links time-varying interconnectedness to systemic risk contributions. For the purposes of surveillance and regulation of financial systems, network dependencies in extreme risks are more relevant than simple (mean) correlations. Thus, the framework provides a tool for supervisors, reflecting the market's view of tail dependences and systemic risk contributions. The model is applied to a system of 51 large European banks and 17 sovereigns during the period from 2006 through 2013, utilizing both equity and CDS prices. We provide new evidence on how banking sector fragmentation and sovereign-bank linkages evolved over the European sovereign debt crisis, and how they are reflected in estimated network statistics and systemic risk measures. Finally, our evidence provides an indication that the fragmentation of the European financial system has peaked.

This paper examines the effects of bank business models on performance and risk for a sample of 505 banks from 30 European countries over the period from 1998 to 2013. We document that business models in the European banking sector are characterized by a continuum, rather than a discrete set, of possible strategies. Using factor analysis to identify business models, we can account for this continuity. To estimate the impact of business models on performance, we use a methodology that is able to separate short-run effects from the longer-term impact of business model choices. Our findings show that retail-oriented banks perform better in terms of both profitability and stability and that diversification is associated with higher profitability. We report substantial variation of business model effects over different bank types. Our results lend support to the new capital regulations proposed in the Basel III framework, but we also argue that business model considerations should be more fundamentally integrated in the post-crisis regulatory and supervisory practice.

In this paper, we use the DCC MIDAS approach to assess the validity of the wake-up call hypothesis for developed and emerging markets during the global financial crisis (GFC). We use this approach to decompose the total correlations into short- (daily) and long-run (quarterly) correlations for the period from 1999 to 2011. We then examine the transmission mechanisms by regressing the quarterly economic, financial, and behavioral variables on the quarterly DCC–MIDAS correlations. We find that country specific factors are crisis contingent transmission mechanisms for the co-movements of emerging country pairs and mixed pairs of advanced and emerging countries during the global financial crisis. However, we do not observe wake-up calls in the transmission of the crisis among advanced country pairs. The classification of the transmission mechanisms for crisis and non-crisis periods with the different country pairs has important implications for crisis management as well as for portfolio investment strategies. Thus, our findings contribute to the discussion on the role and effectiveness of the international financial architecture.

Using option pricing based models, we compute the actuarially fair deposit insurance premium and the market value of assets and asset volatility for Japanese banks as implied by their stock prices. The findings based on these variables suggest that banks shift risks to the deposit insurer who charges them risk insensitive premiums. Well-designed regulatory policies in response to the crisis, however, effectively restrain banks’ risk-shifting. Not only did the introduction of the prompt corrective action discipline insured banks, but large-scale public capital infusions successfully deleveraged banks whose assets are risky. This effectively mitigated banks’ risk-shifting.