Knowledge that Transforms

We present a pricing model of bank bailout insurance guarantees against tail risk and empirical evidence that provides a rational explanation why big bank equities “underperform” relative to small banks during normal times while they “overperform” during crises. A new measure accounting for left-tail risk protection against losses conditional on a crisis explains the “underperformance” of large banks during normal periods. Over the long-term spanning several economic cycles, bank assets are fairly priced regardless of size. Our empirical evidence supports our model’s predicted pattern of excess bank return reversals across economic cycles following Too-Big-To-Fail (TBTF) bailout policy in 1984.

Stability of the banking system and macroprudential regulation are essential for healthy economic growth. In this paper we study the European bank network and its vulnerability to stressing different bank assets. The importance of macroprudential policy is emphasized by the inherent vulnerability of the financial system, high level of leverage, interconnectivity of system's entities, similar risk exposure of financial institutions, and susceptibility for systemic crisis propagation through the system. Current stress tests conducted by the European Banking Authority do not take in consideration the connectivity of the banks and the potential of one bank vulnerability spilling over to the rest of the system. We create a bipartite network with bank nodes on one hand and asset nodes on the other with weighted links between the two layers based on the level of different countries’ sovereign debt holdings by each bank. We propose a model for systemic risk propagation based on common bank exposures to specific asset classes. We introduce the similarity in asset distribution among the banks as a measure of bank closeness. We link the closeness of asset distributions to the likelihood that banks will experience a similar level and type of distress in a given adverse scenario. We analyze the dynamics of tier 1 capital ratio after stressing the bank network and find that while the system is able to withstand shocks for a wide range of parameters, we identify a critical threshold for both asset risk and bank response to a shock beyond which the system transitions from stable to unstable.

Using a sample of publicly listed banks from 62 countries over the 1991–2017 period, we investigate the impact of capital on banks’ cost of equity. Consistent with the theoretical prediction that more equity in the capital mix leads to a fall in firms’ costs of equity, we find that better capitalized banks enjoy lower equity costs. Our baseline estimations indicate that a 1 percentage point increase in a bank’s equity-to-assets ratio lowers its cost of equity by about 18 basis points. Our results also suggest that the form of capital that investors value the most is sheer equity capital; other forms of capital, such as Tier 2 regulatory capital, are less (or not at all) valued by investors. Additionally, our main finding that capital has a negative effect on banks’ cost of equity holds in both developed and developing countries. The results of this paper provide the missing evidence in the debate on the effects of higher capital requirements on banks’ funding costs.

Using account level data from a credit bureau, we study the role that social capital plays in consumer default decisions. We find that borrowers in communities with greater social capital are significantly less likely to default on loans, even after adjusting for different levels of income and other characteristics such as credit scores. The results are strongest for potentially strategic defaults on mortgages; a one standard deviation increase in social capital reduces such defaults by 12.4 %. These results can be generalized to any mortgage default. Our results also indicate that the effect of social capital is most prominent among more creditworthy borrowers, suggesting that when given a choice, the social cost of defaulting is an important factor affecting default decisions. We find a similar impact of social capital on consumer defaults in other datasets with more detailed information on borrowers as well. Our results are robust to modeling and methodology choices, as well as controlling for other drivers of default such as wealth, income and amenities from homeownership. Our results suggest that increasing social capital via measures to build community cohesion such as promotion of owner-occupied home ownership may be one avenue to deter consumer default.

Lack of coordination for prudential regulation hurts developing economies but benefits advanced economies. We consider a two-country macro model in which countries have limited ability to issue state-contingent contracts in international markets, and equilibrium is constrained inefficient. Both countries have incentives to stabilize their economy by using prudential limits, but the emerging economy depends on the advanced economy to bear global risk. Intermediating global risk requires bearing systemic risk, which financially developed economies are unwilling to bear, preferring financial stability over credit flows. Advanced economies prefer tighter prudential limits than would occur with coordination, to the harm of emerging economies.

This paper assesses the sensitivity of solvency stress testing results to the choice of credit risk variable and level of data aggregation at which the stress test is conducted. In practice, both choices are often determined by technical considerations, such as data availability. Using data for the Belgian banking system, we find that the impact of a stress test on banks’ Tier 1 ratios can differ substantially depending on the credit risk variable considered, but much less so on the level of aggregation. If solvency stress tests are going to be used as a supervisory tool or to set regulatory capital requirements, there is a need to further harmonise their execution across institutions and supervisors in order to enhance comparability. This is certainly relevant in the context of the EU-wide stress tests, where institutions often use different credit risk variables (and levels of data aggregation) to estimate the impact of the common methodology and macroeconomic scenario on their capital level and supervisors rely on different models to quality assure and validate banks’ results. More generally, there is also a need to improve the availability and quality of the data to be used for stress testing purposes.

We study the effects of technological change on financial intermediation, distinguishing between innovations in information (data collection and processing) and communication (relationships and distribution). Both follow historical trends towards an increased use of hard information and less in-person interaction, which are accelerating rapidly. We evaluate more recent innovations, such as the combination of data abundance and artificial intelligence, and the rise of digital platforms. We argue that the rise of new communication channels can lead to the vertical and horizontal disintegration of the traditional bank business model. Specialized providers of financial services can chip away activities that do not rely on access to balance sheets, while platforms can interject themselves between banks and customers. We discuss limitations to these challenges to the traditional bank business model, and the resulting policy implications.

This paper investigates whether the takeover market has been affected by heightened macroeconomic uncertainty, following President Trump’s Election, both in the US and globally. We have based our analysis on a four-year period around the 2016 US elections, and as such we have observed an increase in M&A deals and associated valuations, after the election; this was especially true for cross-border deals acquiring U.S. targets, consistent with a tariff-jumping hypothesis. The high target valuations are also the product of the implementation of a lower corporate tax rate, which reveals positive externalities for U.S. targets, stemming from the protectionist and lower corporate tax initiatives of the regime.

We introduce this special issue on Economic Policy Uncertainty (EPU) with a focus on how EPU affects allocative efficiency. We observe that EPU affects the market value of firms in about 37% of Fama–French 30 industries, but leads to lower investments in 90% of them. Allocation decisions in a market economy rely on signals from the capital market, which EPU distorts. This may cause increasing conflicts of interest between managers and investors. We highlight key studies in the EPU literature and then describe each paper in this special issue. We also provide suggestions for future research.

Central banks and supervisory authorities regularly conduct stress tests of banks. As losses accumulate in stress scenarios, banks’ equity position worsens, and they must pay higher interest rates to retain funding. I explore how variations of Merton-type models can be used to measure bank risk, and then examine the link between various risk measures and funding costs. Finally, I outline a method for incorporating funding cost increases into top-down stress tests.