Knowledge that Transforms

One way systemic risk can crystallise is through fire sales of commonly held assets. This paper examines fire sale vulnerabilities across different types of financial institution, including non-banks. We undertake an in-depth empirical analysis of the interconnections between European open-ended investment funds and UK regulated banks and insurance companies through their common asset holdings. This research is the first to combine regulatory holding-level asset data for banks and insurers with private data for open-ended investment funds. Our results show the existence of a significant overlap between the equity and debt portfolios of different types of financial institution. We characterise financial institutions of different types in terms of their concentration profile, portfolio similarity and vulnerability to fire sales, providing evidence for the existence of a price-mediated channel of contagion between banks, insurance companies and investments funds.

We examine the relationship between bank bailouts and sovereign risk in 35 countries and 19 bailouts from 2005 to 2015. Bailouts negatively affect sovereign ratings, with rating agencies consistently perceiving higher risk when a country’s banking system has been rescued (risk-increasing effect). The increase in public debt as a result of the bank bailouts is the main mechanism through which the risk-increasing effect occurs. Moreover, financial soundness and banking market structure shape the impact of bailouts on sovereign risk. In particular, proactiveness in undertaking public bailouts for banking systems that are largely distressed – that is, risky and low profitable – and highly concentrated seems to lead to smaller increases in sovereign risk. However, the strength of the connection between the public sector and the banking system neither moderates nor magnifies the impact of bailouts. Furthermore, rating dynamics (duration, momentum, and timing) reinforce the importance and duration of the effect of bailouts on sovereign ratings. The results are robust to endogeneity concerns, sample selection bias and several robustness tests.

US credit unions have been subject to a strict regulation of their commercial lending which included both requirements for enhanced organizational practices and a cap on the proportion of business loans relative to assets (imposed in 1998 by US Congress). Since 2003, however, these limitations have been steadily relaxed, a process which has resulted in an increase in credit union business lending activity. Using data from the universe of US credit unions we provide comprehensive evidence that expansion of the business loan portfolio increases the risk of the asset side of the credit union. This is the case even for credit unions which benefit from partnership with the SBA, for which we observe an initial increase in the risk of non-SBA backed loans (an overconfidence effect) which reverses over time (a learning effect). Our results suggest, furthermore, that the risk of business loans is exacerbated for credit unions which initiate their business loan activity and which do so rapidly. In the second part of our analysis we provide descriptive and quasi-experimental evidence that expansions of credit union activity into business loans are associated with lower subsequent growth rates of deposits. This result is similar to the reaction to risk indicators found in the banking literature and might give an ex-ante incentive for the CU that could work as a market-based stabilization mechanism complementary to that of explicit regulation.

We find that the movement of urban house prices in the U.S. has become more synchronized since the early 2000s. The elevated comovement is substantial, widespread, occurring for the majority of city-pairs, and continued even after the housing market turned to bust in 2007. We investigate whether and to what extent the comovement increase can be explained by banking integration following deregulations in the banking industry. Utilizing novel measures of city-level banking integration based on bank deposit data, we find that an increase in banking integration leads to an increase in the comovement of urban house prices. City-pairs that are more connected through national banking system had experienced a greater increase in comovement, after controlling for a variety of explanatory variables. Our findings can be interpreted as spillover effect, rather than substitution effect, of banking integration at work.

We develop a model for defaultable bonds incorporating both uncertainty about corporate earnings and uncertainty due to climate-related risks, which determine downward jumps in the firm value. In particular, we study how bond pricing is affected by transition risks, such as those coming from an abrupt change of climate policies. We show how the issuer’s credit quality changes as a result of its engagement in projects funded by green bonds and study the impact of green bonds on investors’ portfolio allocation. The way ‘green’ bonds may contribute to financial stability is also discussed.

We formulate the “High Liquidity Creation Hypothesis” (HLCH) that a proliferation in the core activity of bank liquidity creation increases failure probability. We test the HLCH in the context of Russian banking, where many failures occurred albeit not triggered by swings in business cycles or an exogenous shock such as a crisis. Using Berger and Bouwman (2009) liquidity creation measures, we find that high liquidity creation is associated with greater probability of bank failure and this finding survives multiple robustness checks. Our results suggest that regulatory authorities can mitigate systemic distress and reduce the costs to society from bank failures through early identification of high liquidity creators.

We examine the influence of both organizational and geographical religiosity, as important ethical parameters moderating a bank’s decision to securitize their assets. The study employs a unique database of banks located within countries marked by high (low) religious adherence. Our results provide evidence that different measures of religiosity affect a bank’s decision to securitize their assets: Banks located in countries with high religious adherence are less likely to engage with securitization compared to banks in countries with lower religiosity, while Islamic banks have a higher likelihood of embarking on a highly monitored model of asset securitization in contrast to conventional banks. When examining the motives underlying a bank’s decision to securitize assets, there is strong evidence that Islamic banks securitize their assets to improve their portfolio diversification, financial performance, and regulatory compliance. This study highlights the importance of considering informal ethical mechanisms, such as religiosity, at both the country and firm levels, when studying bank risk-taking and trading decisions, especially in countries with dual banking systems.

In this paper we document empirical evidence regarding the unintended consequences of financial regulatory changes on market liquidity of Mexican sovereign debt. We find mixed impacts: in the context of Basel 2.5, Basel III and the Liquidity Coverage Ratio, we find negative effects, while in the case of the Dodd-Frank Act and the Volcker Rule we find positive effects. The difference in results can be explained by the fact that some of the regulatory changes mainly imposed additional constraints on government debt holdings, while others were designed to enhance transparency and thus reduce uncertainty as well as information asymmetries. Moreover, our estimates suggest that the aggregate effect of the regulatory changes decreased the weekly turnover ratio of Mexican sovereign debt securities by 18 percent. Our results hold under different liquidity measures and different econometric specifications.

Applying a machine-learning algorithm to a large sample of U.S. public firms, we document that more than 30% of the firms substantially alter debt structures in a year, even when leverage ratio is stable, when short-term debt is trivial, and when little cash outlay is required for operations. The instability of debt structure reveals new costs of financial constraints: compared to high-credit-quality firms, low-credit-quality firms have to change debt structure more frequently to accommodate their financing needs, even with increased borrowing costs; low-credit-quality firms lack the opportunity available to high-credit-quality firms to reduce borrowing costs through switching debt instruments.

The coronavirus (COVID-19) pandemic halted economic activity worldwide, hurting firms and pushing many of them toward bankruptcy. This paper discusses four central issues that have emerged in the academic and policy debates related to firm financing during the downturn. First, the economic crisis triggered by the pandemic is radically different from past crises, with important consequences for optimal policy responses. Second, it is important to preserve firms’ relationships with key stakeholders (e.g., workers, suppliers, customers, and creditors) to avoid inefficient bankruptcies and long-term detrimental economic effects. Third, firms can benefit from “hibernation,” incurring the minimum bare expenses necessary to withstand the pandemic while using credit to remain alive until the crisis subdues. Fourth, the existing legal and regulatory infrastructure is ill-equipped to deal with an exogenous systemic shock like a pandemic. Financial sector policies can help channel credit to firms, but they are hard to implement and entail different trade-offs.