This paper analyses the evolution of the safety and soundness of the European banking sector during the various stages of the Basel process of capital regulation. We document the evolution of various measures of systemic risk as the Basel process unfolds. Most strikingly we find that the exposure to systemic risk as measured by SRISK has been steeply rising for the highest quintile, moderately rising for the second quintile, and remaining roughly stationary for the remaining three quintiles of listed European banks. This observation suggests that during the Basel process, systemic risk has been contained for the majority of European banks, but not for the largest and riskiest institutions. When analyzing the sources of systemic risk we find compelling evidence that the increase in exposure to systemic risk (SRISK) is tied to the implementation of internal models for determining credit risk, as well as market risk. Based on this evidence, the sub-prime crisis found especially the largest and more systemic banks ill-prepared and lacking resiliency. This condition has been aggravated during the European sovereign crisis. The Banking Union has not restored aggregate resiliency to pre-crisis levels. Finally, low-interest rates considerably affect the contribution to systemic risk, particularly for the riskier banks

We examine the impact of bank liquidity creation on systemic risk and its heterogeneous impact over the network connectedness. We find that excessive liquidity creation increases the systemic risk with a “U shape” relationship, while internal and external liquidity creation drives systemic risk in a different way. Network connectedness of banks strengthens the relationship between liquidity creation and systemic risk. Our results provide supporting evidence on regulating bank liquidity creation to enhance the financial stability

This study examines the interplay between political influence and regulatory decision-making. Political influence is captured based on whether a bank is headquartered in a state where an elected official holds a chair position on a congressional committee related to the banking and financial services industry. Using data of US commercial banks over the period 2000–2015, we show that our measure of political influence reduces a bank's probability of receiving a formal regulatory enforcement action. Results are robust to the use of alternative model specifications and the sample restrictions. However, we find that various bank and environmental characteristics are important conditional factors

In this paper, we examine the role of political connections in mitigating the detrimental impact of policy uncertainty on banks. Our estimates show that banks are more cautious when facing policy uncertainty, but that the effect is partially alleviated when banks are politically connected. For an increase of one standard deviation in policy uncertainty, connected banks maintain a loss provision to loan volume ratio that is almost seven percent lower compared to their unconnected peers. These findings are robust to a geographical regression discontinuity setting, as well as to a placebo test. Lastly, the mitigating role of political connections is driven mainly by smaller banks and periods of stricter banking regulations

Stability of the banking system and macroprudential regulation are essential for healthy economic growth. In this paper we study the European bank network and its vulnerability to stressing different bank assets. The importance of macroprudential policy is emphasized by the inherent vulnerability of the financial system, high level of leverage, interconnectivity of system's entities, similar risk exposure of financial institutions, and susceptibility for systemic crisis propagation through the system. Current stress tests conducted by the European Banking Authority do not take in consideration the connectivity of the banks and the potential of one bank vulnerability spilling over to the rest of the system. We create a bipartite network with bank nodes on one hand and asset nodes on the other with weighted links between the two layers based on the level of different countries’ sovereign debt holdings by each bank. We propose a model for systemic risk propagation based on common bank exposures to specific asset classes. We introduce the similarity in asset distribution among the banks as a measure of bank closeness. We link the closeness of asset distributions to the likelihood that banks will experience a similar level and type of distress in a given adverse scenario. We analyze the dynamics of tier 1 capital ratio after stressing the bank network and find that while the system is able to withstand shocks for a wide range of parameters, we identify a critical threshold for both asset risk and bank response to a shock beyond which the system transitions from stable to unstable

Using the Prudential Instruments Database (Cerutti et al., 2017b) and a unique confidential database on balance sheet items of euro area financial institutions, we analyse cross-border spillovers from prudential regulation for 248 banks from 16 euro-area countries over the period 2007Q3–2014Q4. We find that foreign branches increase lending following the tightening of sector-specific capital buffers, loan-to-value (LTV) limits or reserve requirements on deposits in local currencies in the countries where their parent banks reside. We also find that cross-border spillovers through lending of branches are stronger than through subsidiaries, possibly because it is easier for branches to reallocate lending across different jurisdictions, as they do not need to meet prudential requirements at a solo level. Finally, we find that also euro-area domestic banks increase lending, in particular to the real sector, when LTV limits are tightened abroad

Using a novel cross-European dataset on bank internationalization, the paper accounts for organizational and geographic complexity and evaluates its impact on systemic risk and how both the 2008–09 global financial crisis and the 2010–11 European sovereign debt crisis might have modified such an impact. Ahead of the crisis (2005–07), results suggest that bank complexity materially reduces systemic risk and enhances stability, as it encourages banks to take on more diversified risks. While such a relation is inverted during the crisis (2008–11) and after the crisis (2012–13), consistent with the view that, during distress times, international banks have less ability to monitor cross-border risks. Further evidence show that, regardless of the period, the effect of complexity on systemic risk is accentuated for ‘too-big-too-fail’ banks and banks with strong activity diversity. Conversely, complex banks with merger-acquisition history and banks operating networks of foreign branches mitigate systemic risk during the acute crisis and the later stage of the crisis, respectively. The results are robust to the use of alternative measures of systemic risk and complexity, and numerous additional tests. Findings bear critical policy implications for financial regulations

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

Is the asset management sector a source of financial instability? This paper develops a macroprudential stress test model which enables the quantification of systemic vulnerabilities due to fire sales in this sector. The model incorporates the flow-performance relationship as an additional funding shock in the model of Greenwood et al. (2015). Using data on US equity mutual funds for the period 2003–14, we quantify both fund-specific and system-wide (aggregate) vulnerabilities to fire sales over time. Our main finding is that the aggregate vulnerability, according to this propagation mechanism, is relatively small in comparison with values reported for banks. However, during periods of low market liquidity, the vulnerability of the system can become significant. Our paper also contributes to the ongoing discussion on the SIFI designation of Non-Bank Non-Insurer entities. For this purpose, we explore the determinants of individual funds’ vulnerability to systemic asset liquidations, highlighting the importance of size and portfolio illiquidity. Therefore, regulators should monitor structural vulnerabilities in the fund sector arising through liquidity transformation

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