Knowledge that Transforms

We study the impact of national politics on default risk of eurozone banks as measured by the stock market-based Distance to Default. We find that national electoral cycles, the power of the government as well as the government’s party ideological alignment significantly affect the stability of banks in the eurozone member countries. Moreover, we show that the impact of national politics on bank default risk is more pronounced for large as well as weakly capitalized banks.

This paper assesses the interrelationship between financial openness, bank risk and bank profit efficiency using a cross-country sample of 2007 commercial banks covering 140 countries over the period 1999–2011. To establish whether the impact of financial openness on both bank risk and profit efficiency occurs directly or through each one of the two bank characteristics (efficiency and risk, respectively), we begin our analysis by investigating the potential reverse Granger causality between profit efficiency and risk using a dynamic simultaneous model via system GMM estimation. We then account explicitly for the role of bank risk in the estimation of bank profit efficiency using stochastic frontier analysis, allowing for the influence of different measures of financial openness and risk alongside other control variables. Our results indicate that financial openness reduces bank profit efficiency directly, not through changes in bank risk. We also find that financial openness increases bank risk indirectly, through the decreased bank profit efficiency channel.

We investigate a simple dynamical model for the systemic risk caused by the use of Value-at-Risk, as mandated by Basel II. The model consists of a bank with a leverage target and an unleveraged fundamentalist investor subject to exogenous noise with clustered volatility. The parameter space has three regions: (i) a stable region, where the system has a fixed point equilibrium; (ii) a locally unstable region, characterized by cycles with chaotic behavior; and (iii) a globally unstable region. A calibration of parameters to data puts the model in region (ii). In this region there is a slowly building price bubble, resembling the period prior to the Global Financial Crisis, followed by a crash resembling the crisis, with a period of approximately 10–15 years. We dub this the Basel leverage cycle. To search for an optimal leverage control policy we propose a criterion based on the ability to minimize risk for a given average leverage. Our model allows us to vary from the procyclical policies of Basel II or III, in which leverage decreases when volatility increases, to countercyclical policies in which leverage increases when volatility increases. We find the best policy depends on the market impact of the bank. Basel II is optimal when the exogenous noise is high, the bank is small and leverage is low; in the opposite limit where the bank is large and leverage is high the optimal policy is closer to constant leverage. In the latter regime systemic risk can be dramatically decreased by lowering the leverage target adjustment speed of the banks. While our model does not show that the financial crisis and the period leading up to it were due to VaR risk management policies, it does suggest that it could have been caused by VaR risk management, and that the housing bubble may have just been the spark that triggered the crisis.

This paper provides an overview of visual analytics—the science of analytical reasoning enhanced by interactive visualizations tightly coupled with data analytics software—and discusses its potential benefits in monitoring systemic financial stability. The core strength of visual analytics is to combine visualization's high-bandwidth information channel to the human analyst with the flexibility and power of rapid-iteration analytics. This combination is especially valuable in the context of macroprudential supervision, which is increasingly dominated by large volumes of dynamic and heterogeneous data. Our contribution is to describe and categorize the analytical challenges faced by macroprudential supervisors, and to indicate where and how visual analytics can increase supervisors’ comprehension of the data stream, helping to transform it into actionable knowledge to support informed decision- and policy-making. The paper concludes with suggestions for a research agenda.

There seems to be a consensus among regulators and scholars that in order to improve the functioning of a banking system it is necessary to raise the level of bank information disclosure. However, its influence on bank competition – which is an important factor affecting the efficiency and stability of the banking system – is left out of consideration. To test whether greater bank information disclosure is associated with both lower market power and lower concentration in the banking markets, we use country-level data covering the years 1998, 2001, 2005 and 2010. Our findings show that countries with higher levels of bank transparency have lower levels of bank concentration, while the link between transparency and market power is less pronounced. We also show that the reduction of competition due to stricter disclosure requirements depends on bank credit risks and the relationship is U-shaped.

We study the macroprudential roles of bank capital regulation and monetary policy in a borrowing cost channel model with endogenous financial frictions, driven by credit risk, bank losses and bank capital costs. These frictions induce financial accelerator mechanisms and motivate the examination of a macroprudential toolkit. Following credit shocks, countercyclical regulation is more effective than monetary policy in promoting price, financial and macroeconomic stability. For supply shocks, combining macroprudential regulation with a stronger anti-inflationary policy stance is optimal. The findings emphasize the importance of the Basel III accords in alleviating the output-inflation trade-off faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of financial distress.

This paper empirically investigates if insurers exhibited a flight home or flight to quality during the European sovereign debt crisis and other stages of the financial crisis. Our dataset consists of over sixty insurance companies, for which we separately observe trading behaviour and portfolio revaluations at a quarterly frequency during 2006–2013. When explaining insurers’ trading behaviour we explicitly control for country risk and momentum strategies. The results show that insurers exhibited a flight to quality during the European sovereign debt crisis, while we find no evidence of a flight home. The flight to quality was not present before the European sovereign debt crisis and disappeared after ECB chairman Draghi's speech mid-2012. Interestingly, supervisory data suggests that the observed flight to quality was not driven by regulatory solvency constraints.

In this paper, we aim to investigate (a) the dynamic adjustment of investment-to-GDP ratio and bank credit-to-GDP ratio following banking crisis episodes; (b) whether the adjustment of investment and bank credit ratios varies with several country and crisis characteristics. Based on a sample of 79 developed and emerging countries over the 1973–2010 period, our results suggest that in the aftermath of banking crises, investment ratio declines but swiftly recovers to its pre-crisis level within two to three years. Bank credit declines significantly and remains stagnated even in the medium run. In terms of country characteristics, we find that investment and bank credit ratios decline significantly more in advanced countries and countries with higher level of capital openness. In addition, investment ratio declines significantly more in countries with higher level of financial development. Finally, we split the banking crises episodes into two categories: those preceded by a domestic credit boom or a surge in net capital inflows, and those that were not preceded by such booms. We find that dynamic adjustment of investment and bank credit ratios differs substantially across the two groups. Existence of a credit boom or a surge in capital inflow in the run-up to the crisis intensifies the length and depth of the decline in investment and bank credit ratios. In fact, we find no statistically significant decline in investment following banking crises that were not preceded by a credit boom or a surge in capital inflows. These results imply that deleveraging is costly to the economy.

We assess the relative effect of securitization activity on banks’ lending rates employing a uniquely detailed dataset from the euro-denominated syndicated loan market. We find that in the run-up to the 2007–2009 crisis banks more active at originating asset-backed securities did not price their loans more aggressively (i.e. with narrower lending spreads) than non-active banks. We show that also within the set of loans that were previously securitized, the relative level of securitization activity by the originating bank is not related to narrower lending spreads. Our findings, which are limited to the cross-sectional impact of securitization, suggest that the effect of securitization on the cost of corporate funding appears to be quite limited.

This paper empirically investigates the incidence of regulatory forbearance during the financial crisis. Using an option pricing technique in concert with valuation data gathered from failed bank sales, I find that failed banks consistently underreported the level of impairment in loan portfolios during the financial crisis period of 2008–2010, helping these market value insolvent banks to report adequate capital for regulatory purposes. Impairment-adjusted capital ratios provide evidence of regulatory forbearance for up to 18 months prior to seizure. Analyses of bank coverage ratios reveal that coverage ratios are negatively and significantly related to impairment levels and are significantly lower for banks with critically low levels of capital.