Knowledge that Transforms

Using account level credit-card data from six major commercial banks from January 2009 to December 2013, we apply machine-learning techniques to combined consumer-tradeline, credit-bureau, and macroeconomic variables to predict delinquency. In addition to providing accurate measures of loss probabilities and credit risk, our models can also be used to analyze and compare risk management practices and the drivers of delinquency across the banks. We find substantial heterogeneity in risk factors, sensitivities, and predictability of delinquency across banks, implying that no single model applies to all six institutions. We measure the efficacy of a bank's risk-management process by the percentage of delinquent accounts that a bank manages effectively, and find that efficacy also varies widely across institutions. These results suggest the need for a more customized approached to the supervision and regulation of financial institutions, in which capital ratios, loss reserves, and other parameters are specified individually for each institution according to its credit-risk model exposures and forecasts.

The CLASS model is a top-down capital stress testing framework that uses public data, simple econometric models and auxiliary assumptions to project the effect of macroeconomic scenarios on U.S. banking firms. Through the lens of the model, we find that the total banking system capital shortfall under stressful macroeconomic conditions began to rise 4years before the financial crisis, peaking in the fourth quarter of 2008. The capital gap has since fallen sharply, and is now significantly below pre-crisis levels. In the cross-section, banking firms estimated to be most sensitive to macroeconomic conditions also have higher capital ratios, consistent with a “precautionary” view of bank capital, though this behavior is evident only since the crisis. We interpret our results as evidence that the resiliency of the U.S. banking system has improved since the financial crisis, and also as an illustration of the value of stress testing as a macroprudential policy tool.

Earnings press releases, as a timely vehicle for communicating a firm’s performance to third parties, can be used by managers to influence the perception of the firm’s achievements. Taking the stock price reaction to the tone of earnings press releases at earnings announcements into account, we argue that equity-based incentives induce managers to inflate the tone. We further posit that the impact of tone on the abnormal stock returns at the earnings announcements depends on the magnitude of the equity-based incentives. Based on over 26,000 earnings press releases of S&P1500 firms between 2004Q4 and 2012Q4, we find that the tone of earnings press releases tends to be more positive when the managerial portfolio value is more closely tied to the firm’s stock price. We also find that investors react proportionally less to the tone as managers’ equity incentives increase.

Based on data from 32 countries over the period 1996–2010, this paper is the first to assess the relationship between financial innovation, on the one hand, and bank growth and fragility, as well as economic growth, on the other hand. We find that different measures of financial innovation, capturing both a broad concept and specific innovations, are associated with faster bank growth, but also higher bank fragility and worse bank performance during the recent crisis. These effects are stronger in countries with larger securities markets and more restrictive regulatory frameworks. In spite of these seemingly ambiguous findings, our evidence points to a positive net effect of financial innovation on economic growth: financial innovation is associated with higher growth in countries and industries with better growth opportunities.

We investigate whether and how firms manage their rollover risk by having a dispersed bond maturity structure (granularity). Granularity can be achieved or maintained by frequently issuing sets of bonds with different maturities. We find that firms with higher granularity have higher availability of financing, lower cost of financing, lower financial constraints and lower stock return volatility. The effects are stronger for firms that face higher rollover risk. The evidence suggests that spreading out bond maturities is an effective corporate policy to manage rollover risk.

We propose a novel risk measure that relates to subsequent negative conditional stock market returns. Our risk measure considers both the fragility and stress of the market. Fragility is measured by the Fragility Index developed by Berger and Pukthuanthong (2012) and market stress is based on several economic variables. Results show that incorporating both market stress and fragility improves the information content of a risk measure. Our risk measure relates to poor subsequent monthly market returns. We show the risk measure contains predictive information in a purely ex-ante specification.

Supranational resolution of insolvent banks does not necessarily improve welfare. Supranational regulators are more inclined to bail-out banks indebted towards international creditors because they take into account cross-border contagion. When banks’ creditors are more likely to be bailed out, market discipline decreases and risk-taking by indebted banks increases. Depending on the trade-off between giving the right incentives ex ante and limiting contagion ex post, both a national and a supranational resolution framework can be optimal. In particular, if market discipline is low under both national and supranational resolution mechanisms, supranational resolution improves welfare as it stimulates interbank trade.

Activist shareholders have an incentive to communicate and cooperate with other major shareholders. However, the impact of their activity on information flow surrounding targeted firms is largely unknown. We explore this aspect using a prolific proponent: labor unions. Following the mailing of proxies containing union-sponsored shareholder proposals, trading volume increases significantly and at-issue bond yield spreads of targeted firms are lower compared to matched firms. Subsequent difference-in-differences analyses show that stock prices of targeted firms become more informative as a result of activism, affirming the intuition that activism results in a reduction of differential information between outside investors.

We use a sample of banks from 24 European countries to investigate whether the adoption of the Basel II Capital Accord in 2008 affects the market valuation of discretionary loan loss provisions (DLLPs). Although Basel II lowers the incentives of internal ratings-based (IRB) banks to recognize income-increasing DLLPs in an opportunistic manner, it has no such impact on the remaining banks, which adopt the Standardized methodology. We use this setup in a difference-in-difference (DiD) design, where Standardized banks act as a control group. Our evidence supports the three hypotheses that, for IRB relative to Standardized banks, Basel II is associated with (i) less income-increasing DLLPs and (ii) less income-smoothing via DLLPs, which enhances the informational content of DLLPs about future loan losses and leads to (iii) higher market valuation of DLLPs. Our findings are timely and have policy implications for future regulatory developments in the banking industry.

This paper investigates the response of the shadow economy to banking crises. Our empirical analysis, based on a large sample of countries, suggests that the informal sector is a powerful buffer, which expands at times of banking crises and absorbs a large proportion of the fall in official output. To rationalise our evidence, we build a dynamic stochastic general equilibrium model which accounts for financial and labour market frictions and for nominal rigidities. In line with the empirical literature on the shadow economy, we assume that in the informal sector access to external finance is limited, and the production technology is relatively more labour intensive. Following a banking shock in the official sector, the model predicts a large negative transmission to the unofficial economy that substantially dampens the overall effect of the shock.