Knowledge that Transforms

A sovereign debt crisis can have significant knock-on effects in the financial markets and put financial stability at risk. This paper focuses on the transmission of sovereign risk to insurance companies as some of the largest institutional investors in the sovereign bond market. We use a firm level panel dataset that covers large insurance companies, banks and non-financial firms from nine countries over the time period from 1 January 2008–1 May 2013. We find significant and robust transmission effects from sovereign risk to domestic insurers. The impact on insurers is not significantly different from that on banks but larger than for non-financial firms. We find that systemically important insurers are more closely linked to the domestic sovereign. Based on European data, we show that risks in sovereign bond portfolios are an important driver of insurer risk, which is not reflected in current insurance regulation (incl. Solvency II in Europe).

We examine the impact of the financial crisis on the stock market valuation of large and systemic U.S. bank holding companies (BHCs). Using the Bertsatos and Sakellaris (2016) model of fundamental valuation of bank equity, we provide evidence that the financial crisis has not altered investors’ attitudes towards bank characteristics. In particular, before, during, and after the crisis, investors in large and systemic U.S. BHCs seemed to penalize leverage, albeit temporarily. Both before and after the crisis, they reward size in the short run. This pattern is appearing only briefly during the crisis. We also show that bank opacity plays no role in market valuation either in the short run or in the long run. Last but not least, we find evidence that stress testing has been informative to the market and that those BHCs that failed at the post-crisis stress tests were not subsequently valued differently by the market.

A majority of U.S. banks between 1973 and 2012 held equity capital significantly beyond the required minimum. We study the risk-return tradeoff in connection with a bank’s capital structure, and identify several new significant market factors that drive the level of equity capital in banks. During normal growth periods, bank leverage is negatively related to a level of competition and loan portfolio diversification, while high bank leverage is associated with low past liquidity. During recessions and expansions, the roles of those factors change following distortions in risk-return tradeoff. In distress, when banks approach regulatory capital requirements, market determinants of book leverage lose their significance; however, leverage does not decrease until a bank is within 1% of the minimal capital threshold.

In an approach analogous to Rajan and Zingales (1998), we examine how the ability to access long-term debt affects firm-level growth volatility. We find that firms in industries with stronger preference to use long-term finance relative to short-term finance experience lower growth volatility in countries with better-developed financial systems, as these firms may benefit from reduced refinancing risk. Institutions that facilitate the availability of credit information and contract enforcement mitigate refinancing risk and therefore growth volatility associated with short-term financing. Increased availability of long-term finance reduces growth volatility in crisis as well as non-crisis periods.

In January 2006, federal regulators issued guidance requiring banks with specific high concentrations of commercial real estate (CRE) loans to tighten managerial controls. This paper shows that banks with concentrations in excess of the thresholds set in the guidance subsequently experienced slower growth in their CRE portfolios than can be explained by changes in bank or economic conditions. Moreover, banks above the CRE thresholds tended to have slower commercial and industrial loan growth but faster household loan growth following issuance of the guidance. The results highlight the potentially broad influence that portfolio-based macroprudential regulation might have on bank behavior.

Using a large sample of firms with single-name credit default swap (CDS) contracts in 30 countries, we document the evidence that political uncertainty, proxied by national election dummy, is positively related to firm-level credit risk. Specifically, this positive relation is more pronounced for the firms that have no political connection or poor international diversification, and in the countries with higher political uncertainty and lower investor protections. Further, by using a difference-in-differences approach, we find evidence to support idiosyncratic volatility and debt rollover channels through which political uncertainty affects the credit risk of individual firm.

I discuss changes to bank supervision and regulation since the financial crisis. Microprudential supervision promotes the safety and soundness of individual institutions, while macroprudential supervision focuses on emerging risks to financial system stability. I highlight tools for implementing this macroprudential approach to promoting financial stability, and discuss the interactions and proper relationship between monetary policy and financial stability. While macroprudential tools should be the first line of defense against emerging financial imbalances, in cases where those tools proved to be inadequate to limit risks to financial stability, monetary policy should be considered as a possible defense.

In this paper we show in a thought experiment that in an economy where i) investors hold rational expectations, ii) output is generated by a linear homogeneous production function, and iii) real investment is allocated across sectors according to the CAPM, a fractional reserve banking system is not Pareto efficient and amplifies the business cycle. In developing these results we show that these three well known propositions in economics also imply a new view of the business cycle, one where the business cycle is described in terms of the dispersion of an ex-ante probability distribution. The policy implication of this analysis is that bank regulation should go further than the Volcker rule or the Vickers commission proposal by restricting bank investments to currency and deposit accounts on the central bank. Nonbank financial institutions should then carry out the financial intermediation function now carried out by banks. The paper proposes that post office banking perhaps augmented with blockchain technology sometime in the future is one way to implement the transition from fractional reserve banking to full reserve banking. While little academic work has been done on full reserve banking in the aftermath of the Great Crisis, it is interesting to note that it is part of banking reform proposals now (July 2016) before the parliament in Iceland and a special national referendum in Switzerland.

This paper contributes to prior literature and to the current debate concerning recent revisions of the regulatory approach to measuring bank exposure to interest rate risk in the banking book by focusing on assessment of the appropriate amount of capital banks should set aside against this specific risk. We first discuss how banks might develop internal measurement systems to model changes in interest rates and measure their exposure to interest rate risk that are more refined and effective than are regulatory methodologies. We then develop a backtesting framework to test the consistency of methodology results with actual bank risk exposure. Using a representative sample of Italian banks between 2006 and 2013, our empirical analysis supports the need to improve the standardized shock currently enforced by the Basel Committee on Banking Supervision. It also provides useful insights for properly measuring the amount of capital to cover interest rate risk that is sufficient to ensure both financial system functioning and banking stability.

There is a current controversy concerning the appropriate size of banks’ capital requirements, and the trade-off between the costs and benefits of implementing higher capital requirements. We quantify the size of capital buffers required to reduce system-wide losses using confidential regulatory data for Australian banks from 2002 to 2014 and annual public accounts from 1978 to 2014. We find that a moderate increase in bank capital buffers is sufficient to maintain financial system resilience, even after taking economic downturns into consideration. Furthermore, while banks benefit from paying a lower cost of debt when they have a higher capital buffer, lending volumes are lower indicating that credit supply may be hampered if bank capital levels are too high within a financial system.