Are bank shareholders enemies of regulators or a potential source of market discipline?

In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer – that is, maximize put option value – by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between Tobin’s q and an ex ante measure of the failure probability, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts outweighing charter value. From these estimates, we infer the prevalence of moral hazard. Examining publicly held bank holding companies (BHC) during the tumultuous 1986–1992 period, we find that shareholders’ risk-taking incentives were confined to a small fraction of highly risky institutions. Furthermore, our analysis shows that the inflection point at which banks begin to tilt in favor of moral hazard increased substantially in 1993–2005. These findings are encouraging to bank regulators and legislators because they indicate that tighter capital rules and more rigorous supervision introduced by several legislative initiatives in the 1990s have helped squeeze a lot of the moral hazard incentives out of the banking system.     

Deposit insurance, bank regulation, and financial system risks

Empirical evidence is presented to show that in modern times banks can hedge liquidity shocks but could not do so prior to FDIC insurance. However, the government's limitations in properly pricing FDIC insurance are leading to many current examples of moral hazard. A model is presented to show that if insurance premiums are set to be “actuarially fair,” incentives for banks to take excessive systematic risks remain. Motivated by empirical evidence that money market mutual funds also can hedge liquidity shocks, I consider an alternative government insurance system that mitigates distortions to risk-taking yet preserves liquidity hedging and information synergies.     

Aggregate Investment Externalities and Macroprudential Regulation

Evidence suggests that banks tend to lend a lot during booms and very little during recessions. We propose a simple explanation for this phenomenon. We show that instead of dampening productivity shocks, the banking sector tends to exacerbate them, leading to excessive fluctuations of bank credit, output, and asset prices. Our explanation relies on three ingredients that are characteristic of modern banks’ activities: moral hazard, high exposure to aggregate shocks, and the ease with which capital can be reallocated to its most productive use. At the competitive equilibrium, banks offer privately optimal contracts to their investors, but these contracts are not socially optimal: banks reallocate capital excessively upon aggregate shocks. This is because banks do not internalize the impact of their decisions on asset prices. We examine the efficacy of possible policy responses to these properties of credit markets, and derive a rationale for macroprudential regulation in the spirit of a Net Stable Funding Ratio.     

The impacts of Net Stable Funding Ratio requirement on Banks’ choices of debt maturity

In this paper, we study the impacts of the Net Stable Funding Ratio (NSFR) requirement on banks’ choices of debt maturity and asset structures, with consequences for banks’ profitability and social welfare. We develop a model in which the manager of a bank determines both debt maturity structure (short-term vs. long-term debt) and asset composition (cash vs. risky assets). To address the incongruence of goals between the bank manager and the bank stakeholders, in our model we assume that the manager receives only a proportion of the bank’s profit in her pay schedule. We demonstrate that the optimal choices of the manager regarding debt maturity and asset structure lead to socially inefficient (second-best) outcomes because the manager internalizes only part of the social benefit. We then study the implications of the NSFR requirement on the manager’s choices and demonstrate that the NSFR requirement can enhance social welfare and reach an efficient (first-best) outcome, if a sufficiently low weight of short-term debt as available stable funding is required by regulation. Further, we find that under the same conditions the NSFR requirement reduces banks’ use of short-term financing and thus increases the probability of banks’ survival and profits from the ex ante point of view, while it decreases banks’ profits from the ex post point of view, since it reduces the threshold for banks’ survival. Our main results have some interesting empirical implications: under certain conditions, the NSFR requirement may reduce both bank failures and banks’ observed profits.     

Optimal student loans and graduate tax under moral hazard and adverse selection

We characterize the set of second‐best “menus” of student‐loan contracts in an economy with risky labor‐market outcomes, adverse selection, moral hazard, and risk aversion. We combine student loans with optimal income taxation. Second‐best optima provide incomplete insurance because of moral hazard. Optimal repayments must be income contingent, or the income tax must comprise a graduate tax. Individuals are ex ante unequal because of differing probabilities of success, and ex post unequal, because taxation trades off incentives and redistribution. In addition, second‐best optima exhibit an interim equalization property: the poststudy but prework expected utilities of newly graduated student types must be equal.     

The Roles of Corporate Governance in Bank Failures during the Recent Financial Crisis

We analyze the roles of bank ownership, management, and compensation structures in bank failures during the recent financial crisis. Our results suggest that failures are strongly influenced by ownership structure: high shareholdings of lower‐level management and non‐chief executive officer (non‐CEO) higher‐level management increase failure risk significantly. In contrast, shareholdings of banks’ CEOs do not have a direct impact on bank failure. These findings suggest that high stakes in the bank induce non‐CEO managers to take high risks due to moral hazard incentives, which may result in bank failure. We identify tail risk in noninterest income as a primary risk‐taking channel of lower‐level managers.     

Bank risk and real estate: An asset pricing perspective

While a number of papers have investigated the time-series behavior ofex post bank stock returns and real estate returns, no study has comprehensively studied the relationship betweenex ante risk premiums on both assetsand the time-varying nature of such premiums in relationship to economic and real estate market conditions. In this study, we investigate how the changing nature of bank risk taking, especially in the real estate market, has affected theex ante pricing of risk in the market for bank stocks. We find that the time variation in bank risk premiums are partly determined by interest rate and real estate market conditions. We also discover that the real estate factor has been important for banks in the 1980s.     

Subordinated Debt,Market Discipline,and Bank Risk

This paper demonstrates that subordinated debt (subdebt thereafter) regulation can be an effective mechanism for disciplining banks. By reducing the chance that managers of distressed banks can take value‐destroying actions to benefit themselves, subdebt regulation may encourage banks to lower asset risk. Moreover, subdebt regulation and bank capital requirements can be complements for alleviating the banks’ moral hazard problems. To make subdebt regulation effective, regulators may need impose ceilings on the interest rates of subdebt, prohibit collusion between banks and subdebt investors, and require subdebt to convert into the issuing bank's equity when the government provides assistance to the bank.     

How useful is the Marginal Expected Shortfall for the measurement of systemic exposure? A practical assessment

We explore the practical relevance from a supervisor’s perspective of a popular market-based indicator of the exposure of a financial institution to systemic risk, the Marginal Expected Shortfall (MES). The MES of an institution can be defined as its expected equity loss when the market itself is in its left tail. We estimate the dynamic MES recently proposed by Brownlees and Engle (2012) for a panel of 68 large US banks over the last decade and a half. Running panel regressions of the MES on bank characteristics, we first find that the MES can be roughly rationalized in terms of standard balance-sheet indicators of bank financial soundness and systemic importance. We then ask whether the cross section of the MES can help to identify ex ante, i.e. before a crisis unfolds, which institutions are more likely to suffer the most severe losses ex post, i.e. once it has unfolded. Unfortunately, using the 2007–2009 crisis as a natural experiment, we find that some standard balance-sheet ratios are better able than the MES to predict large equity losses conditionally to a true crisis.     

Securitization,competition and monitoring

We analyze the impact of loan securitization on competition in the loan market. Using a dynamic loan market competition model where borrowers face both exogenous and endogenous costs to switch between banks, we uncover a competition softening effect of securitization that allows banks to extract rents in the primary loan market. By reducing monitoring incentives, securitization mitigates winner’s curse effects in future stages of competition thereby decreasing ex ante competition for initial market share. Due to this competition softening effect, securitization can adversely affect loan market efficiency while leading to higher equilibrium profits for banks. This effect is driven by primary loan market competition, not by the exploitation of informational asymmetries in the secondary market for loans. We also argue that banks can use securitization as a strategic response to an increase in competition, as a tool to signal a reduction in monitoring intensity for the sole purpose of softening ex ante competition. Our result suggests that securitization reforms focusing exclusively on informational asymmetries in markets for securitized products may overlook competitive conditions in the primary market.     

Bank Mergers and Diversification: Implications for Competition Policy

This paper analyses competition and mergers among risk averse banks. We show that the correlation between the shocks to the demand for loans and the shocks to the supply of deposits induces a strategic interdependence between the two sides of the market. We characterise the role of diversification as a motive for bank mergers and analyse the consequences of mergers on loan and deposit rates. When the value of diversification is sufficiently strong, bank mergers generate an increase in the welfare of borrowers and depositors. If depositors have more correlated shocks than borrowers, bank mergers are relatively worse for depositors than for borrowers.     

Evidence on the role of accounting conservatism in monitoring managers’ investment decisions

Watts (2003), among others, argues that conservatism helps in corporate governance by mitigating agency problems associated with managers’ investment decisions. We hypothesize that if conservatism reduces managers’ex ante incentives to take on negative net present value projects and improves the ex post monitoring of investments, firms with more conservative accounting ought to have higher future profitability and lower likelihood (and magnitude) of future special items charges. Consistent with this expectation, we find that firms with more conservative accounting have (i) higher future cash flows and gross margins and (ii) lower likelihood and magnitude of special items charges than firms with less conservative accounting.     

The formation of financial networks

Modern banking systems are highly interconnected. Despite various benefits, linkages between banks carry the risk of contagion. In this article, I investigate whether banks can commit ex ante to mutually insure each other, when there is contagion risk in the financial system. I model banks' decisions to share this risk through bilateral agreements. A financial network that allows losses to be shared among various counterparties arises endogenously. I characterize the probability of systemic risk, defined as the event that contagion occurs conditional on one bank failing, in equilibrium interbank networks. I show that there exist equilibria in which contagion does not occur.     

Bank failures and bank fundamentals: A comparative analysis of Latin America and East Asia during the nineties using bank-level data

This paper uses bank-level data from recent banking crises in East Asia and Latin America to address the following two questions: (1) To what extent did individual bank conditions explain the failures? (2) In terms of their fundamentals, was it mainly the weak banks ex ante that failed in the crisis countries? The results show that for the two regions, bank-level fundamentals significantly affect the likelihood of collapse for these banks. Systemic shocks (both macroeconomic and liquidity) that triggered the crises mainly destabilized the weak banks ex ante, particularly in East Asia, which raises questions about the role that regional differences play for the degree of banking sector resilience to systemic shocks in the financial and macroeconomic environment.     

Monetary Policy,Bank Lending,and the Risk‐Pricing Channel

This paper identifies a monetary policy channel through the risk pricing of bank debt in the market for jumbo certificates of deposit (jumbo CDs). Adverse policy shocks increase debt holder perceptions of bank default, increasing the risk premia for some banks, thereby decreasing their external funding of loans. The results show that contractionary policy increases the sensitivity of jumbo‐CD spreads to leverage and asset risk for small banks, and to leverage for large banks. The results also show a distributional and aggregate effect on banking system jumbo CDs and total loans, producing a risk‐pricing (or market discipline) channel. This channel has implications for monetary and regulatory policies, and financial stability.     

Bank size and risk-taking under Basel II

We analyze the relationship between bank size and risk-taking under the Basel II Capital Accord. Using a model with imperfect competition and moral hazard, we show that the introduction of an internal ratings based (IRB) approach improves upon flat capital requirements if the approach is applied uniformly across banks and if the costs of implementation are not too high. However, the banks’ right to choose between the standardized and the IRB approaches under Basel II gives larger banks a competitive advantage and, due to fiercer competition, pushes smaller banks to take higher risks. This may even lead to higher aggregate risk-taking.     

Rediscounting under Aggregate Risk with Moral Hazard

Freeman (1999) proposes a model in which discount window lending and open‐market operations have different effects. This is important because in most of the literature these policies are indistinguishable. However, Freeman's argument that the central bank should absorb losses associated with default to provide risk sharing stands in stark contrast to the concern that central banks should limit their exposure to credit risk. We extend Freeman's model by introducing moral hazard. With moral hazard, the central bank should avoid absorbing losses and Freeman's argument breaks down. However, we show that policies resembling discount window lending and open‐market operations can still be distinguished in this new framework. The optimal policy is for the central bank to make a restricted number of creditors compete for funds. By restricting the number of agents, the central bank can limit the moral hazard problem. By making them compete with each other, the central bank can exploit market information that reveals the state of the economy.     

Bank resilience to systemic shocks and the stability of banking systems: Small is beautiful

Utilising a novel empirical approach and an extensive sample of listed European banks, we identify which bank characteristics offer a shelter from systemic shocks and compare the relative effects of several hypothetical prudential rules on a bank’s risk exposure. While the results show that restrictions on a bank’s leverage ratio and the imposition of liquidity requirements, as in the Basel III Accord, may improve the resilience of a bank to systemic events, they also demonstrate that bank size, the share of non-interest income and asset growth (none of which are at the centre of the new regulatory landscape) are key determinants of a bank’s risk exposure. In particular, the introduction of a cap on bank absolute size appears the most effective tool, ceteris paribus, to reduce the default risk of a bank given systemic events. Furthermore, in spite of the integration process of the financial industry in Europe, the analysis presented here shows that such a cap should be country-specific with smaller economies requiring smaller banks. Finally, we show that the strengthening of individual bank stability obtained via size restrictions is accompanied by a reduction of the contribution to systemic risk for banks which are relatively large compared to the domestic economy.     

Bank systemic risk and corporate investment: Evidence from the US

In this paper, we develop a simple two-period model in which a bank’s investment (e.g., loans) is influenced by short-term financing and a probability of a financial crisis. When banks ex ante expect to be bailed out during financial crises, they do not necessarily internalize the cost of financial crises and invest more. We argue that the level of systemic risk in the banking sector is largely driven by (1) the way in which banks finance their investment (e.g., loans) using more short-term debt and/or (2) the increase in asset commonality amongst banks. We use three measures that arguably capture two dimensions of “bank systemic risk”, namely, (1) bank funding maturity and (2) bank asset commonality, to empirically test whether bank systemic risk has a positive effect on corporate investment. We document that in a sample of publicly listed firms in the United States over the period 1991–2013, bank systemic risk is positively associated with the firm-level investment ratio after controlling for a large set of country- and firm-level variables. In addition, we show that a firm's leverage strengthens the positive effect of bank systemic risk on corporate investment, suggesting that more financially constrained firms experience a larger effect of bank systemic risk on corporate investment than less financially constrained firms.     

The Risk‐Taking Channel of Monetary Policy: Exploring All Avenues

The literature on the risk‐taking channel of monetary policy grew quickly, leading to scattered evidence. We examine this channel through different angles, exploring detailed information on loan origination and performance. Ex ante riskier borrowers receive more funding at the extensive margin when interest rates are lower. Ex post performance is independent of the level of interest rates at origination. Still, loans granted in periods of very low and stable interest rates show higher default rates once interest rates start to increase. Risk‐taking is stronger among banks with lower capital ratios, suggesting that this channel may be linked to managerial incentives for risk‐shifting.