In order to incentivize stronger issuer due diligence effort, European and U.S. authorities are amending securitization-related regulations to force issuers to retain an economic interest in the securitization products they issue. This paper contributes to the process by exploring the economics of equity and mezzanine tranche retention in the context of systemic risk, moral hazard, accounting frictions and funding distortions. It shows that loan screening activity is maximized when the loan originating bank retains the equity tranche. However, in case capital structure irrelevance does not hold a profit maximizing bank is likely to favor retention of the less risky mezzanine tranche. From a regulator's perspective this is a problem because the implied loan screening activity is substantially lower in this case. Policy attention is even more warranted if performing due diligence is costly, the economic outlook is positive or loan profitability is high

The recent crisis has spurred the use of bank stress tests as a crisis management and early warning tool. However, a weakness is that current stress tests are based on consolidated balance sheets, and thus omit potential risks embedded in banking groups’ geographical structures by assuming that capital and liquidity are available wherever they are needed within the group. This study presents a framework to integrate ring fencing and regulatory differences (e.g., minimum capital requirements) into cross-border bank stress tests. Case studies show how some forms of ring fencing—home or host regulators limiting flows of capital and income within a group—could significantly increase banks’ capital needs

Intervention has taken different forms in different countries and periods of time. Moreover, recent episodes showed that in front of an imminent crisis, the promise of no interventions made by governments is barely credible. In this paper we address the problem of resolving banking crises from the government perspective, taking into account the fact that preventing banking crises is crucial for the government. In addition, we introduce the moral hazard problem, inherent in the banking system, and consider the interaction between regulation, policy measures and banks’ behavior. To the best of our knowledge, this is the first paper that compares different policy plans to resolve banking crises in an environment where insufficiently capitalized banks have incentives to take risk, and the government has to decide whether to provide public services or impede crises. We show that when individuals highly value public services then the best policy in terms of welfare is to apply the tax on early withdrawals, as the government can transfer those taxes to the whole population by investing in public services (although at some cost). Conversely, when individuals assign a low value to consuming public services, recapitalization is the dominant policy. Finally, when the probability of a crisis is sufficiently high, capital requirements should be used

The paper presents a simple dynamic macroeconomic model of a bank-dominated financial system that captures some of the key credit market imperfections commonly found in middle-income countries. The model is used to analyze the interactions between monetary and macroprudential policies, involving, in the latter case, changes in reserve requirements. In addition to a qualitative analysis, a calibrated version is used to study numerically the transitional dynamics and steady-state effects of an increase in the reserve requirement ratio, under alternative parameter values. The analysis shows that understanding how these tools operate is essential because they may alter, possibly in substantial ways, the monetary transmission mechanism

Using data for more than 160 countries in the period 1997–2010, we explore the impact of large-scale natural disasters on the distance-to-default of commercial banks. The financial consequences of natural catastrophes may stress and threaten the existence of a bank by adversely affecting their solvency. After extensive testing for the sensitivity of the results, our main findings suggest that natural disasters increase the likelihood of a banks’ default. More precisely, we conclude that geophysical and meteorological disasters reduce the distance-to-default the most due to their widespread damage caused. In addition, the impact of a natural disaster depends on the size and scope of the catastrophe, the rigorousness of financial regulation and supervision, and the level of financial and economic development of a particular country

We examine the international transmission of liquidity shocks from multinational bank holding companies to their subsidiaries during the financial crisis of 2008. Our results demonstrate that a subsidiary's reduction in lending is strongly related to its parent bank's lending via the interbank market. While subsidiaries that were dependent on interbank financing increased their credit supply prior to the crisis, they reduced their lending activities during the crisis. Additionally, we observe that interbank-dependent subsidiaries tried to change their funding strategy when they were unable to increase their deposit growth significantly during the crisis. During the crisis, subsidiaries could not rely on their parent banks’ support via the interbank market and encountered problems in attracting new depositors, which could explain the significant decline in lending during the financial crisis. These findings highlight the need to regulate and monitor multinational funding strategies, especially in the interbank market

The excessive increase of leverage, i.e. the abuse of debt financing, is considered one of the primary factors in the default of financial institutions since it amplifies potential investment losses. On the other side, portfolio diversification acts to mitigate these losses. Systemic risk results from correlations between individual default probabilities that cannot be considered independent. Based on the structural framework by Merton (1974), we propose a model in which these correlations arise from overlaps in banks’ portfolios. Our main result is the finding of a critical level of diversification that separates two regimes: (i) a safe regime in which a properly chosen diversification strategy offsets the higher systemic risk engendered by increased leverage and (ii) a risky regime in which an inadequate diversification strategy and/or adverse market conditions, such as market size, market volatility and time horizon, cannot compensate the same increase in leverage. Our results are of relevance for financial regulators especially because the critical level of diversification may not coincide with the one that is individually optimal