Implications of bank regulation for loan supply and bank stability: a dynamic perspective

ABSTRACT

We show that internal funds play a particular role in the regulation of bank capital, which has not received much attention, yet. A bank's decision on loan supply and capital structure determines its immediate bankruptcy risk as well as the future availability of internal funds. These internal funds in turn determine a bank's future costs of external finance and its future vulnerability to bankruptcy risks. Using a partial equilibrium model, we study how internal funds affect these intra- and intertemporal links. Moreover, our positive analysis identifies the effects of risk-weighted capital-to-asset ratios, liquidity coverage ratios and regulatory margin calls on the dynamics of internal funds and thus loan supply and bank stability. Only regulatory margin calls or large liquidity coverage ratios achieve bank stability for all risk levels, but for large risks a bank will stop credit intermediation.     

Firm-level risk of climate change: Evidence from climate disasters

While climate change impacts most regions, a company's physical location and geographic diversification could determine how it is affected by the risks associated with climate change. We explore information from extreme climate events to study whether and how they affect firm-level risks. The results indicate a positive association between a firm's exposure to catastrophic climate events, measured by headquarters and affiliation's locations and systematic and idiosyncratic volatility, suggesting that this risk is somewhat unpredictable and undiversifiable. Furthermore, geographic dispersion increases firms' exposure to extreme climate event risks. Our results also indicate that this effect is more pronounced in industries in which environmental issues are financially material and is mitigated by better environmental performance of the firm. In addition, the effect increases with investor awareness. Overall, our research contributes to a better understanding of businesses' exposure to the risks associated with climate change.     

Bank-level stability factors and consumer confidence – A comparative study of Islamic and conventional banks’ product mix

This study examines the behaviour of key bank-level stability factors of liquidity, capital, risk-taking and consumer confidence in Islamic and conventional banks that operate in the same market. Using fixed effect for a sample of 194 banks of Gulf Cooperation Countries between 2000 and 2007, we found that liquidity is not determined by the bank's product mix but rather attributed to systematic factors. However, non-performing assets (representing loans to sub-prime borrowers) have a positive and significant relationship with liquidity, implying that during the crisis Islamic banks tend to take stringent risk strategies compared to conventional banks. Furthermore, Islamic banks generally tend to provide higher consumer confidence levels as they were more capitalized than conventional banks, although conventional banks had carried higher averages of liquidity compared to Islamic banks. Consumer confidence levels or depositors’ discipline as proxied by deposits and customer funding over liabilities generally appear to be higher in Islamic banks than conventional banks.     

Information,sell-side research,and market making

The interaction between an investment bank's research and market making arms may have important implications for the trading of a firm's stock. We investigate the impact that research has on the liquidity provided by the bank's market maker. Utilizing a large sample of Nasdaq firms, we show that market makers whose banks also provide research coverage provide more liquidity and contribute more to price discovery than do market makers without such research coverage. Finally, we show that such “affiliated” market makers are less affected by uncertainty following earnings announcements. Our results provide new evidence on the sources of liquidity improvements for Nasdaq firms, and suggest that the information produced by banks in the sell-side research process is beneficial to their market makers.     

Modeling Foreign Exchange Risk Premium in Armenia

This paper applies stochastic discount factor methodology to modeling the foreign exchange risk premium in Armenia. We use weekly data on foreign and domestic currency deposits, which coexist in the Armenian banking system. This coexistence implies elimination of the cross-country risks and transaction costs, leaving the pure foreign exchange risk. It is shown that there exists a systematic time-varying risk premium that increases with maturity. Using two-currency affine term structure and generalized autoregressive conditional heteroskedasticity (GARCH)-in-mean models, we find that the central bank's foreign exchange market interventions and ratio-of-deposit volumes significantly affect public expectations about foreign exchange fluctuations. We also find that the foreign exchange risk premium accounts for the largest part of the interest differential. When accounting for economic and institutional differences, our results can be extended to other countries.     

Optimal allotment policy in central bank open market operations1

This article derives a central bank's optimal liquidity supply towards a money market with an unrestricted lending facility. We show that when the effect of liquidity on market rates is not too small, and the monetary authority is concerned with both interest rates and liquidity conditions, then the optimal allotment policy may entail a ‘discontinuous’ reaction to initial conditions. In particular, the model predicts a threshold level of liquidity below which the central bank will not bail out the banking system. An estimation of the liquidity effect for the euro area suggests that the discontinuity might have contributed to the Eurosystem's tight response to occurrences of underbidding during the period June 2000 through March 2004.     

Collateralization,leverage, and stressed expected loss

We describe a general equilibrium model with a banking system in which the deposit bank collects deposits from households and the merchant bank provides funds to firms. The merchant bank borrows collateralized short-term funds from the deposit bank. In an economic downturn, as the value of collateral decreases, the merchant bank must sell assets on short notice, reinforcing the crisis, and defaults if its cash buffer is insufficient. The deposit bank suffers from losses because of the depreciated assets. If the value of the deposit bank's assets is insufficient to cover deposits, it also defaults. Deposits are insured by the government, with a premium paid by the deposit bank equal to its expected loss on the deposits. We define the bank's capital shortfall in the crisis as the expected loss on deposits under stress. We calibrate the model on the U.S. economy and show how this measure of stressed expected loss behaves for different calibrations of the model. A 40% decline of the securities market would induce a loss of 12.5% in the ex-ante value of deposits.     

Information Acquisition in Rumor‐Based Bank Runs

We study information acquisition and dynamic withdrawal decisions when a spreading rumor exposes a solvent bank to a run. Uncertainty about the bank's liquidity and potential failure motivates depositors who hear the rumor to acquire additional noisy signals. Depositors with less informative signals may wait before gradually running on the bank, leading to an endogenous aggregate withdrawal speed and bank survival time. Private information acquisition about liquidity can subject solvent‐but‐illiquid banks to runs, and shorten the survival time of failing banks. Public provision of solvency information can mitigate runs by indirectly crowding‐out individual depositors' effort to acquire liquidity information.     

Climate reputation risk and abnormal returns in the stock markets: A focus on large emitters

Reputation risk is among the possible climate transition risks companies face, especially in emission-intensive industries. Failing to meet stakeholders' expectations about the contribution to climate goals might influence investors' strategies and produce financial damages. We look at the climate-related social media talk in a sample of highly polluting companies. For these companies, reputation risk materialises if their climate talk is perceived as not coherent with their action-taking. We then assess the impact of climate talk on short-term stock market performance, as measured by abnormal returns, and find a positive association between climate-related social media talks and abnormal returns. The strength of this association lowers during peak days of social media attention on climate-related topics.     

Measuring Liquidity Mismatch in the Banking Sector

This paper constructs a liquidity mismatch index (LMI) to gauge the mismatch between the market liquidity of assets and the funding liquidity of liabilities, for 2,882 bank holding companies over 2002 to 2014. The aggregate LMI decreases from +$4 trillion precrisis to ?$6 trillion in 2008. We conduct an LMI stress test revealing the fragility of the banking system in early 2007. Moreover, LMI predicts a bank's stock market crash probability and borrowing decisions from the government during the financial crisis. The LMI is therefore informative about both individual bank liquidity and the liquidity risk of the entire banking system.     

Optimal Bank Reorganization Policies and the Pricing of Federal Deposit Insurance

Optimal dynamic regulatory policies for closing ailing banks and for deposit insurance premia are derived as functions of the rate of flow of bank deposits, and interest rate on deposits, the economy's risk-free interest rate, and the regulators' bank audit/administration costs. Under competitive conditions, the threshold assets-to-deposits ratio below which a bank should be optimally closed is shown to be greater than or equal to one. Optimal deposit insurance premia and probabilities of bank closure are shown to be nondecreasing in the bank's risk on investment and nonincreasing in the bank's current assets-to-deposits ratio.     

Limited liability and bank safety net procedures ∗

A model is presented of bank behaviour which identifies the factors determining a bank's optimal capital/asset ratio, its optimal liquidity ratio, the expected value of non-performing loans and the probability of bank failure. We propose that this last variable can act as an index of bank credit-worthiness. The main factors determining this index are (i) the risk associated with bank asset returns, (ii) the variability of bank deposits, (iii) the costs associated with bank failure and (iv) the implicit or explicit government subsidy involved in depositor protection schemes. The principal general conclusion of the paper is that regulations governing capital requirements, liquidity requirements and depositor protection should be (a) risk related and (b) integrated. Depositor protection can be improved through relatively high capital requirements. However, the optimal strategy is for all bank safety net procedures and incentive mechanisms to be related to the riskiness of individual bank portfolios.     

Do climate risk beliefs shape corporate social responsibility?

Global climate change is one of the most pressing issues of our time, potentially affecting everyone, both individuals and businesses. This paper examines whether differences in beliefs about climate change affect firms' decision-making in Corporate Social Responsibility (CSR) commitment. Using county-level climate change beliefs data from Yale Climate Opinion Maps, we find that firms' Environmental, Social, and Governance (ESG) scores are higher if they are located in counties where more people believe in global climate change. We then use natural disasters as exogenous shocks to the beliefs about climate risk and continue to find a positive association between CSR and perceptions of climate risks. Furthermore, we discover a stronger correlation between CSR and climate risk beliefs when firms have more local investors.     

Banking and commerce: A liquidity approach

This paper looks at the advantages and disadvantages of mixing banking and commerce, using the “liquidity” approach to financial intermediation. Bringing a nonfinancial firm into a banking conglomerate may be advantageous because it makes it easier for the bank to dispose of assets seized in a loan default. The conglomerate's internal market increases the liquidity of such assets and improves the bank's ability to perform financial intermediation. More generally, owning a nonfinancial firm may act either as a substitute or a complement to commercial lending. In some cases, a bank will voluntarily refrain from making loans, choosing to become a non-bank bank in an unregulated environment.     

Collateral Framework: Liquidity Premia and Multiple Equilibria

Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank's collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This policy can potentially induce sovereign debt crises and defaults that would not otherwise occur. The success of the ECB's temporary suspension of these features of its collateral framework during the pandemic illustrates the practical relevance of this mechanism.     

THE VALUE IMPACTS OF CAPITAL ADEQUACY REGULATION AND STOCHASTIC DEPOSITS

The relationship between a bank's soundness and the set of factors evaluated by supervisory agencies is so complex that the regulation of certain factors might have unintended consequences. This paper demonstrates that, ceteris paribus, binding capital adequacy regulation in the presence of stochastic deposits both reduces the expected future value of a bank and increases the uncertainty of that bank's future value. The uncertainty conclusion is not inconsistent with the notion of a decrease in the probability of financial distress as equity is substituted for debt; it involves an altogether different uncertainty and one that has heretofore not been recognized in either the theory of the banking firm or the literature of capital adequacy.     

Bank market power,asset liquidity and funding liquidity: International evidence

Our investigation of the association between bank market power and liquidity in 101 countries reveals that a bank's initial gains of market power lead to increases in bank liquidity, but does so at a diminishing rate. Beyond an empirically determined threshold, further increases in market power are inversely associated with bank liquidity. From a cross-sectional viewpoint, banks that lack market power hold more liquid assets and are net lenders in the interbank market. In contrast, dominant banks hold less liquid assets and are net interbank borrowers. For a given level of market power, ceteris paribus, developed nation banks hold less asset liquidity and obtain more interbank funding liquidity than their developing country peers. These results remain equally relevant during the 2007–2009 global financial crisis (GFC).     

A Dilemma between Liquidity Regulation and Monetary Policy: Some History and Theory

History suggests a conflict between current Basel III liquidity ratios and monetary policy, which we call the liquidity regulation dilemma. Although forgotten, liquidity ratios, named “securities-reserve requirements,” were widely used historically, but for monetary policy (not regulatory) reasons, as central bankers recognized the contractionary effects of these ratios. We build a model rationalizing historical policies: a tighter ratio reduces the quantity of assets that banks can pledge as collateral, thus increasing interest rates. Tighter liquidity regulation paradoxically increases the need for central bank's interventions. Liquidity ratios were also used to keep yields on government bonds low when monetary policy tightened.     

Climate transition risk,profitability and stock prices

We investigate whether climate transition risk is reflected in the financial performance and cross-section pricing of publicly-traded European and US firms. Using a firm-level carbon risk score (CRS) that assesses the vulnerability of a firm's value to transition to a low-carbon economy, we find that firms with the lowest transition risk exposures perform better financially, and that European firms are more sensitive to transition risks than US firms. We also find that stocks with low exposure to transition risk offer greater returns to investors, consistent with the fact that stock prices of firms do not adequately reflect underlying climate transition risk. Relative financial performance of less vulnerable firms and underreaction effects to transition risk decreased after COP21.     

An inconvenient cost: The effects of climate change on municipal bonds

Counties more likely to be affected by climate change pay more in underwriting fees and initial yields to issue long-term municipal bonds compared to counties unlikely to be affected by climate change. This difference disappears when comparing short-term municipal bonds, implying the market prices climate change risks for long-term securities only. Higher issuance costs for climate risk counties are driven by bonds with lower credit ratings. Investor attention is a driving factor, as the difference in issuance costs on bonds issued by climate and nonclimate affected counties increases after the release of the 2006 Stern Review on climate change.