Knowledge that Transforms

Financial innovation and greater information availability have increased the tradability of bank assets and have reduced banks’ dependence on individual bank managers. We show that this can have two opposing consequences for banking stability. First, the hold-up problem between bank managers and shareholders becomes less severe. Consequently, banks’ capital structure needs to be less concerned with disciplining the management. Deposits – the most effective disciplining device – can be reduced, increasing banks’ resilience to adverse return shocks. However, limiting the hold-up problem also diminishes bank managers’ rents, reducing their incentives to properly monitor and screen borrowers, with adverse implications for asset quality. Thus, the default risk of banks does not necessarily decline. We argue that this delivers a novel explanation for the origin of the recent subprime crisis.

We estimate the impact of macroeconomic news on composite stock returns in three emerging European Union financial markets (the Budapest BUX, Prague PX-50, and Warsaw WIG-20), using intraday data and macroeconomic announcements. Our contribution is twofold. We employ a larger set of macroeconomic data releases than used in previous studies and also use intraday data, an excess impact approach, and foreign news to provide more reliable inferences. Composite stock returns are computed based on 5-min intervals (ticks) and macroeconomic news are measured based on the deviations of the actual announcement values from their expectations. Overall, we find that all three new EU stock markets are subject to significant spillovers directly via the composite index returns from the EU, the U.S. and neighboring markets; Budapest exhibits the strongest spillover effect, followed by Warsaw and Prague. The Czech and Hungarian markets are also subject to spillovers indirectly through the transmission of macroeconomic news. The impact of EU-wide announcements is evidenced more in the case of Hungary, while the Czech market is more impacted by U.S. news. The Polish market is marginally affected by EU news. In addition, after decomposing pooled announcements, we show that the impact of multiple announcements is stronger than that of single news. Our results suggest that the impact of foreign macroeconomic announcements goes beyond the impact of the foreign stock markets on Central and Eastern European indices. We also discuss the implications of the findings for financial stability in the three emerging European markets.

We examine the effects of structural change in the U.S. banking industry, as well as key regulatory changes, including recently enacted deposit insurance reform legislation, on the resiliency of the FDIC-administered bank insurance fund (BIF) by estimating and comparing the probability of BIF insolvency over time. We do this using a Markov-switching model that relies on historical patterns of BIF disbursements to define the probability of switching among three “states” of the banking industry's financial health. Monte Carlo simulations are then performed to project the financial condition of the BIF over a 50-year period. Our results indicate that the insolvency risk to the bank insurance fund has increased significantly due to industry consolidation, and is mainly due to the concentration of deposits in the 10 largest U.S. banking companies. We also find that recent deposit insurance reforms will cause only a marginal reduction in the risk of BIF insolvency. The increased risk associated with a more concentrated industry structure simply dominates the reform effect.

The paper investigates the nexus between labor and financial markets, focusing on how labor union’s attitude in the wage-setting process and the firm’s investment strategy affect asset returns. We assume that the labor union’s relative preferences between wage and employment depend on selected measures of firm’s financial performance. The paper shows that if the labor union ties its preference for wage to the firm’s dividends (or to any other quantity measuring available liquidity), then the volatility of the firm’s returns increases. Consequently, equities have to grant high expected returns in order to remunerate the increased volatility. This mechanism offers an explanation for the “equity premium” (that is the difference between the equity return rate and the risk free rate). It is a welcome result that the simulated excess return is about the empirical estimate and that it is obtained with a plausibly low parameterization of the shareholders’ risk aversion.

Systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank’s failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk. Regulatory mechanisms such as bank closure policy and capital adequacy requirements that are commonly based only on a bank’s own risk fail to mitigate aggregate risk-shifting incentives, and can, in fact, accentuate systemic risk. Prudential regulation is shown to operate at a collective level, regulating each bank as a function of both its joint (correlated) risk with other banks as well as its individual (bank-specific) risk.

This paper analyzes the role and effects of public policy when inefficient financing can result from coordination problems among multiple lenders. Developing a financing game with both fundamental and strategic uncertainty, we first show that inefficient liquidation of a fundamentally solvent project can arise in equilibrium as a result of coordination failure among lenders. We then investigate the effects of two types of public policies: an information policy and a public guarantee program. The analysis shows that the inefficiencies caused by coordination problems among lenders can be effectively and efficiently removed only when both policies are simultaneously designed and implemented in an appropriate combination. We also address the potential cost of public intervention, focusing particularly on the negative influence on the ex ante effort incentives of borrowers.

We review key characteristics of the hedge fund industry, and identify conditions under which this sector can pose a threat to financial stability. Direct regulation of hedge funds that increases transparency does not appear feasible, may create a moral-hazard problem, and may reduce market liquidity. Indirect regulation by prime brokers and market discipline by creditors, counterparties, and investors have been effective in limiting the risks from the hedge fund sector. To reduce systemic risks, more regulation of prime brokers is warranted to avoid competitive dynamics from undermining counterparty risk management practices.

This paper analyzes the existence of flights from stocks to bonds and vice versa. We propose a definition and a test for flight-to-quality, flight-from-quality and cross-asset contagion and examine their characteristics and effects for the financial system. The empirical analysis for eight developed countries including the US, the UK, Germany and Japan shows that flights exist and are a common feature in many crises episodes. Our findings also reveal that flights are not merely country-specific events but occur simultaneously across countries. This indicates that there is a link between the occurrence of flights and cross-country contagion. Moreover, we show that flights enhance the resiliency of the financial markets by providing diversification benefits in times when they are needed most.

The recent credit crisis and the increased internationalization of the European banks have given the debate about the role of national regulators a renewed urgency. We therefore investigate the determinants of bondholders’ abnormal returns for both domestic and cross-border bank merger announcements that involve European acquirers for the period 1998–2002. We find that bondholders’ abnormal returns are higher for Domestic Mergers than cross-border mergers, in direct contrast to evidence from equity prices where no difference is found. Further investigations in which we control for the changes in market power for example suggest this result may be indicative of investors perceiving Domestic Mergers as increasing the probability of a government bailout in case of distress. Banks’ bondholders also experience higher abnormal returns when the country of the partner bank has stricter rules in relation to forbearance of prudential regulations than the own country, and when functional diversification between lending and fee/trading activities increases.

This paper links banking with asset prices in a dynamic macroeconomic model, to provide a simple characterization of financial instability. In contrast with historical bank runs, recent banking crises were driven by deteriorating bank assets. Hence, in contrast with bank run models, this paper focuses on the interaction of falling asset prices, bank losses, credit contraction and bankruptcies. This interaction can explain credit crunches, financial instability, and banking crises, either as fundamental or as self-fulfilling outcomes. The model distinguishes between macroeconomic and financial stability. Its simplicity helps understand balance sheet effects and delivers closed-form solutions without resorting to linearization. For instance, the critical threshold beyond which an asset price decline triggers financial instability can be related explicitly to the structural parameters of the economy.