Knowledge that Transforms

The level as well as fluency of capital supply on the interbank market is crucial for banking sector liquidity. However, the dominance of individual players on this market leads to liquidity imbalance and, thus, might increase the risk for other banks. We test how different bank exposures in interbank market translates into other bank liquidity risk and credit supply. To this end, we use 207 bank exits from interbank markets between 1997 and 2013 in 52 emerging and developed countries. We find that the withdrawal of a bank with high net exposure on interbank market leads to a statistically significant drop in the liquidity position of the remaining banks. The effect is also economically significant. Finally, we find that a liquidity imbalance adversely affects the bank credit supply. Our findings suggest that the consequences are more severe for banks heavily relying on the local interbank market, for emerging countries and surprisingly in pre-crisis periods.

This article reviews empirical studies on Islamic banking and concentrates on their main findings while highlighting future research directions. The earlier literature on Islamic banking built a foundation using normative judgment, descriptive analysis, theoretical development, and appraisal of country experiences. The paper discusses scholars’ concerns that have led to a paradigm shift in the system and highlight practitioners’ disquiet about recent practices. Subsequent research focuses on empirical investigations without extensive analytical and theoretical exploration in the area. Recent studies focus on the financial crisis, solvency, maqasid, disclosure and financial inclusion, and regulations. Even with the spillover effect on the Islamic banks after the crisis, a few pieces of evidence show that the system performs below its conventional counterpart. The paper discusses issues that are relevant to Islamic banking and identifies other avenues for future research.

This paper analyzes sovereign risk shift-contagion, i.e. positive and significant changes in the propagation mechanisms, using bond yield spreads for the major eurozone countries. By emphasizing the use of two econometric approaches based on quantile regressions (standard quantile regression and Bayesian quantile regression with heteroskedasticity) we find that the propagation of shocks in euro's bond yield spreads shows almost no presence of shift-contagion in the sample periods considered (2003–2006, Nov. 2008–Nov. 2011, Dec. 2011–Apr. 2013). Shock transmission is no different on days with big spread changes and small changes. This is the case even though a significant number of the countries in our sample have been extremely affected by their sovereign debt and fiscal situations. The risk spillover among these countries is not affected by the size or sign of the shock, implying that so far contagion has remained subdued. However, the US crisis does generate a change in the intensity of the propagation of shocks in the eurozone between the 2003–2006 pre-crisis period and the Nov. 2008–Nov. 2011 post-Lehman one, but the coefficients actually go down, not up! All the increases in correlation we have witnessed over the last years come from larger shocks and the heteroskedasticity in the data, not from similar shocks propagated with higher intensity across Europe. These surprising, but robust, results emerge because this is the first paper, to our knowledge, in which a Bayesian quantile regression approach allowing for heteroskedasticity is used to measure contagion. This methodology is particularly well-suited to deal with nonlinear and unstable transmission mechanisms especially when asymmetric responses to sign and size are suspected.

Whereas macroprudential policy has come to the fore since the Global Financial Crisis, with many regulators being given responsibility for such policy, the appropriate tools and the effectiveness of such tools remain open questions. We suggest that existing work on effectiveness of macroprudential policy may be vulnerable to bias due to omission of long run cointegration effects. This paper seeks to offer a fresh baseline for work in this area by adopting a cointegration framework which is robust to a variety of alternative techniques and compares favourably with non-cointegrated alternatives. We assess the impact of typical macroprudential policy interventions on house price and household credit growth in up to 19 OECD countries, using three datasets from the IMF and BIS, thus giving both a wider range of control variables and broader coverage of instruments than in most extant work. We find evidence that macroprudential polices remain effective in both short- and long-run at curbing house price and household credit growth even within a cointegration framework, albeit some tools are more effective than others. These include, in particular, taxes on financial institutions, general capital requirements, strict loan-to-value ratios and debt-to-income ratio limits.

Widespread bank losses during the financial crisis have raised concerns that equity-based compensation for bank CEOs causes excessive risk-taking. Debt-based compensation, so-called inside debt, aligns the interests of CEOs with those of external creditors. We examine whether inside debt induces CEOs to pursue less risky acquisitions. Consistent with this, we show that acquisitions announced by CEOs with high inside debt incentives are associated with a wealth transfer from equity to debt holders. After the completion of a deal, banks where acquiring CEOs have high inside debt incentives display lower market measures of risk and lower loss exposures for taxpayers.

Interbank funding markets are central to the functioning of the financial system and the transmission of monetary policy. Libor–OIS spreads have been widely-used indicators of conditions in these markets. We construct models that incorporate the long-run equilibrium relationship between term Libor and OIS rates and their regime-dependent dynamics. We find strong evidence for three regimes in the interbank funding market that resemble different pricing of risk and equilibrium outcomes. We provide point and interval estimates for stress thresholds that may serve as benchmarks for policy makers and market participants in assessing funding conditions. We provide evidence of asymmetric adjustment of rates toward long-run equilibrium, and shed light on the role of different policy measures in the adjustment process.

Most discussions of the Greek debt overhang have focussed on the implications for Greece. We show that when additional funds released to the debtor (Greece), via debt restructuring, are used efficiently in pursuit of a practicable business plan, then both debtor and creditor can benefit. We examine a dynamic two country model calibrated to Greek and German economies and support two-steady states, one with endogenous default and one without, depending on creditors’ expectations. In the default steady state, debt forgiveness lowers the volatility of both German and Greek consumption whereas demanding higher recovery rates has the opposite effect. In a second order approximation of the model, conditional welfare analysis shows that a policy of immediate leniency followed by harsher terms as the economy grows is beneficial to both creditors and debtors.

We analyze the interaction among market competition, capital regulation, fixed regulatory compliance costs, and the portfolio and monitoring decisions of banks. We examine how the interplay among the effects of changes in the degree of competition and capital requirements regulation influence optimal bank choices and market outcomes. Furthermore, we evaluate how ratcheting up the Basel regulatory regime is likely to influence both the competitive structure of banking markets and the overall quality of bank loans. Higher capital requirements and increased fixed costs reduce the degree of competition in banking markets. The weight of these changes can fall more heavily on banks that choose to expend resources to monitor their loans to address loan losses.

Multi-year forecasts of bank performance under stressful economic conditions determine large institution regulatory capital requirements and yet the accuracy of these forecasts is undocumented. I compare the accuracies of alternative stress test model forecasts using the financial crisis as the stress scenario. Models include specifications that mimic the Federal Reserve CLASS model and alternatives that use Lasso, the AIC and an abridged set of explanatory variables. A simple single-equation Lasso model has, by far, the best forecast accuracy. Large differences in model forecast accuracy are undetectable from estimation sample statistics. These findings highlight the need for new methods for validating bank stress test models.

This paper studies the effect of information disclosure on banks’ portfolio risk. We cast a simple banking system into a general equilibrium model with trading frictions. We find that the information disclosure lowers the expected risk-adjusted profits for a non-negligible fraction of banks. The magnitude of this effect depends on the structure of the banking system and, alarmingly, it is more pronounced for systemically important institutions. We connect these theoretical findings to the stress test procedure, where bank information is disclosed by the regulator. The 2011 and 2014 stress tests are used in an empirical study to further support our theoretical results.