Knowledge that Transforms

Using data on publicly traded banks in 61 countries, we examine how the institutional environment affects the relationship between bank capital and system-wide fragility. Consistent with prior studies, we find that bank capital is associated with a reduction in the systemic risk contribution of individual banks. This effect is more pronounced for banks located in countries with less efficient public and private monitoring of financial institutions and in countries with lower levels of information availability. Overall, our findings suggest that capital can act as a substitute for a weak institutional environment in reducing systemic risk.

An extensive review of the evidence related to the 2007–09 crisis reveals that it was an insolvency risk crisis, not a liquidity crisis. The appropriate post-crisis regulatory reform should therefore focus on increasing capital requirements. The Basel III liquidity requirements do not serve a useful economic purpose in dealing with the root causes of the stresses that led to the 2007–09 crisis, and unnecessarily constrain the asset transformation and liquidity creation roles of banks to the detriment of economic growth.

We use European Banking Authority (EBA) 2014 stress test data to study the use of the internal ratings based approach (IRB) and the risk weights of European banks. A simple inspection of data at country level reveals significant differences in the use of the IRB approach by banks and in risk weighted asset (RWA) densities. Empirical analysis of these differences is conducted at both the level of bank group and country of exposure. A clearly negative relation is found between use of the IRB approach and RWA densities, even after controlling for portfolio and bank characteristics. The jurisdiction in which a credit exposure is located affects both the use of IRB and risk density. Portfolio variables (default rate, weight of corporate exposures), and bank characteristics (book equity ratio, liquidity measures) are also significantly related to risk weights. The analysis of the dataset also provides some evidence of a relation between RWA density and IRB utilization, and portfolio composition, bank size, and market risk measures (stock return volatility, CDS spreads).

We consider the effectiveness of unit root exuberance tests in predicting banking crises. Using a sample of 15 EU countries over the past three decades, our crisis dating follows the scheme of the European Systemic Risk Board. The exuberance indicators slightly outperform benchmark signaling and logit models. Variables based on credit- and debt-service are identified as better predictors than housing market variables, which in turn outperform stock market variables. The results corroborate the existing literature, which says financial crises are typically preceded by leveraged bubbles, and more specifically, that initial bubble signals from explosive growth in credit and asset prices are followed by a lift-off in debt-servicing costs as a financial crisis nears. The risk of financial crisis peaks just after the bubble bursts. Our results indicate that exuberance tests, which can be used in crisis prediction in a manner similar to conventional early warning models, may be readily incorporated into the toolkit of financial stability supervisors.

European banks hold 10% of their total assets in portfolios that give rise to unrealised gains and losses which, under Basel III, may no longer be removed from banks’ regulatory capital. Using a sample of European banks, and taking advantage of the different regulatory treatment afforded, under Basel II, to such gains and losses across jurisdictions and instruments and over time, we find evidence that: a) the inclusion of unrealised gains and losses in regulatory capital ratios increases their volatility; b) the total or partial inclusion in regulatory capital of unrealised gains and losses on fixed-income securities reduces the volume of debt at fair value, thus potentially affecting the demand for liquid long-term securities (most of which are currently government bonds); and c) the higher the proportion of gains on debt instruments allowed in regulatory capital, the higher the regulatory Tier 1 capital ratio, thus affecting banks’ capital buffer strategy.

This paper contrasts the empirical features of financial and business cycles of 13 European Union countries, and discusses candidate theoretical mechanisms which could explain these differences. Relative to their business cycle counterparts, we show that financial cycles have a higher amplitude, a longer duration and exhibit far greater symmetry. Mostly owing to this difference in symmetry, we find that financial and business cycles synchronise on average only two-thirds of the time, exhibiting weaker concordance in countries having experienced very persistent financial downturns. We then relate our empirical results to the literature by reviewing five model mechanisms that could potentially underlie these facts. Overall, our results suggest that macroeconomic stabilization and financial stability objectives can, at times, be in conflict.

We propose a contingent clawback bond (COCLA) as an alternative source of contingent convertible capital (CoCo). We develop a utility maximization model in which a bank manager faces the following two trade-offs: one trade-off is between the private benefits of control and costs of financial distress when loans under-perform, and the other is between the costs and benefits of screening loan credit quality (effort). In our model, the supply of loans, amount of junior debt issued, level of effort exerted by a manager, and manager's decision to exercise the clawback option are endogenously determined in the maximization of the manager's utility function. We find that the manager optimally exercises the clawback following a low realization of cash flows, thereby solving the trigger problem presented in CoCos. In the model, the debt to equity conversion from the COCLA is an endogenous decision, the regulatory capital adequacy ratio (CAR) is satisfied, and the bank does not face distress costs. From a practical perspective, the conversion rate for the COCLA that jointly maximizes the manager's expected utility and stock holders’ pay offs is around 25%, a rate close to the typical percentage (30%–35%) that is often found in initial public offering clawback (IPOC) contracts used in the corporate world.

I develop a theory of multiple maturity segments on the interbank market based on the persistence of liquidity shocks and banks’ liquidity management. The developed framework is embedded in a micro-founded network model, which features interbank funding as an over-the-counter phenomenon and replicates financial system phenomena of network formation, monetary policy transmission, and endogenous money creation. This setup is used to shed light on the interbank market's role for allocation and stability in the financial system. I show that the amount of interbank funding depends on the persistence and magnitude of liquidity shocks, as well as banks’ liquidity requirement. Optimal monetary policy experiments show that while interbank funding allows for considerably higher loan provision to the real economy, its term segment, by increasing the size of the interbank market, reduces that effect. Furthermore, the central bank's interest rate policy can effectively mitigate systemic risk and allow for higher sustainable loan supply of the real economy in regimes with lenient capital requirements. However, it is less effective in stimulating loan provision in more restrictive regulatory regimes.

We examine the effect of ex-post information contagion on the ex-ante level of systemic risk defined as the probability of joint bank default. Because of counterparty risk or common exposures, bad news about one bank reveals valuable information about another bank, triggering information contagion. When banks are subject to common exposures, information contagion induces small adjustments to bank portfolios and therefore increases overall systemic risk. When banks are subject to counterparty risk, by contrast, information contagion induces a large shift toward more prudential portfolios, thereby reducing systemic risk.