Knowledge that Transforms

Abundant references to threats to financial stability likely posed by systemic risk-taking in the euro area investment fund industry in an era of persistent low interest rates have not been accompanied by robust supportive empirical evidence. This is the first study that assesses the effects of euro area conventional and unconventional monetary policy shocks on coherent systemic risk measures applied to the investment fund industry. This research finds evidence of systemic risk-taking notably in the forms of contagion and increased vulnerability. It seems more material following conventional than unconventional monetary policy shocks. There is heterogeneity in the results, as the investment focus is important for assessing investment funds’ contribution to systemic risk. Fund types most affected by significant systemic risk-taking are bond funds, mixed funds and real estate funds. Some evidence of heightened vulnerability in equity funds is also present. Increase in leverage is part of the risk-taking mechanism. A key policy implication is that persistently accommodative monetary policy geared toward preserving price stability may face an intertemporal trade-off with financial stability, making it necessary to coordinate monetary and macroprudential policies.

We consider predicting systemic financial crises one to five years ahead using recurrent neural networks. We evaluate the prediction performance with the Jórda-Schularick-Taylor dataset, which includes the crisis dates and annual macroeconomic series of 17 countries over the period 1870−2016. Previous literature has found that simple neural net architectures are useful and outperform the traditional logistic regression model in predicting systemic financial crises. We show that such predictions can be significantly improved by making use of the Long-Short Term Memory (RNN-LSTM) and the Gated Recurrent Unit (RNN-GRU) neural nets. Behind the success is the recurrent networks’ ability to make more robust predictions from the time series data. The results remain robust after extensive sensitivity analysis.

European banks are exposed to a substantial amount of risky sovereign debt. “Missing capital” in the banking system resulting from the zero-risk weight exemption for European sovereign debt amplifies the co-movement between sovereign CDS spreads and facilitates cross-border crisis spillovers. Risks spill over from risky peripheral sovereigns to safer core countries, but not in the opposite direction nor for exposures to countries not exempted from risk-weighting. Unfunded non-domestic sovereign bond exposures primarily affect CDS spreads of non-GIIPS banks, while domestic sovereign-to-bank linkages are particularly important for GIIPS banks. Spillovers are attenuated when banks fund their sovereign bond exposures with capital.

We survey 149 leading academic researchers on bank capital regulation. The median (average) respondent prefers a 10% (15%) minimum non-risk-weighted equity-to-assets ratio, which is considerably higher than the current requirement. North Americans prefer a significantly higher equity-to-assets ratio than Europeans. We find substantial support for the new forms of regulation introduced in Basel III, such as liquidity requirements. Views are most dispersed regarding the use of hybrid assets and bail-inable debt in capital regulation. 70% of experts would support an additional market-based capital requirement. When investigating factors driving capital requirement preferences, we find that the typical expert believes a five percentage points increase in capital requirements would “probably decrease” both the likelihood and social cost of a crisis with “minimal to no change” to loan volumes and economic activity. The best predictor of capital requirement preference is how strongly an expert believes that higher capital requirements would increase the cost of bank lending.

We propose a theory of corporate liquidity management in which signaling through illiquidity is cheaper than signaling through “skin in the game.” This causes ex post liquidation of worthy projects even when there are enough aggregate resources available for their continuation. We examine the policy remedies for this distortion and consider their consequences for the supply of liquidity, interest rate policy, and subsidies.

We examine the portfolio choice of banks in a micro-founded model of runs. To insure risk-averse investors against liquidity risk, competitive banks offer demand deposits. We use global games to link the probability of a run to the bank's portfolio management. Based upon interim information about risky investment, banks liquidate investments to hold a safe asset. This partial hedge against investment risk reduces the withdrawal incentives of investors for a given deposit rate. As a result, (i) banks provide more liquidity ex ante (so banks offer a higher deposit rate) and (ii) the welfare of investors increases. Our results highlight the management of both sides of a bank's balance sheet and a complementarity in the two forms of insurance that banks provide to investors.

Our paper examines whether investor opinions expressed in social media predicted stock returns of financial firms during the 2007–2009 global financial crisis. We conduct a textual analysis of the articles published on the stock market insight website Seeking Alpha before the crisis and find that banks that were described in articles with a higher fraction of negative words experienced (1) sharper drops in stock prices, (2) larger increases in expected default probability, and (3) greater surges in nonperforming loans during the crisis. Our evidence suggests that wisdom of crowds provides valuable information on how banks weather a forthcoming crisis.

We study retail deposit withdrawals from commercial banks that were differentially exposed to distress during the 2007–2009 financial crisis. We show that the propensity of clients to withdraw deposits increases with the severity of bank distress. However, an exclusive pre-crisis bank-client relationship eliminates withdrawal risk. The mechanism through which strong bank-client relationships mitigate withdrawal risk relates to the transaction costs of switching accounts rather than informational rents or differentiated services. Our findings provide empirical support to the Basel III liquidity regulations that emphasize the role of well-established client relationships for the stability of bank funding.

Time-varying depreciation rates are estimated for research and development of the United States aggregate economy and innovation-intensive industries. Mean annual R&D depreciation rates are 31.5% for software, 41% for pharmaceuticals, 42% for semiconductors, and 30.4% for aggregate economy during 1978–2014. R&D depreciation rates vary across industries. R&D investment demand has separate elasticities in time-varying depreciation, interest rate and price growth, allowing for different rates of technology shifts across industries. Software R&D investment has the same magnitude of elasticities to depreciation, interest rate and price, supporting a user cost to apply. For pharmaceuticals and semiconductors, depreciation leads to more R&D investment that implies the effect of scale. For aggregate economy, depreciation reduces R&D investment more than interest rate, indicating obsolescence. Forecasting of R&D investment is improved at both industry and aggregate level. Forecastable time-varying depreciation, interest rate and price growth predict R&D investment based on the estimated demand function. The in-sample forecast comparison for 2015–2019 confirms the superiority to the alternative methods. Out-of-sample forecasts of R&D investment are carried out through 2025, and R&D capital stocks are constructed across industries and aggregate U.S. economy.

In this paper, we examine the effect of labor unions on bank performance during the recent financial crisis. Empirical evidence from the 314 largest global banks indicates that the stock returns and profitability of unionized banks are higher, and the default probabilities are lower than non-unionized banks. Moreover, unionized banks have lower tail risk in their stock returns, more tangible equity, more liquid assets, and better quality lending before the crisis than non-unionized banks. These finding show that unionized banks operate more conservatively and engage in less risk-taking. Our results imply that union preferences can shape the risk culture of banks.