This time is different: Causes and consequences of British banking instability over the long run

This paper addresses three questions: (1) How severe were the episodes of banking instability experienced by the UK over the past two centuries? (2) What have been the macroeconomic indicators of UK banking instability? and (3) What have been the consequences of UK banking instability for the cost of credit? Using a unique dataset of bank share prices from 1830 to 2010 to assess the stability of the UK banking system, we find that banking instability has grown more severe since the 1970s. We also find that interest rates, inflation, lending growth, and equity prices are consistent macroeconomic indicators of UK banking instability over the long run. Furthermore, utilising a unique dataset of corporate-bond yields for the period 1860 to 2010, we find that there is a significant long-run relationship between banking instability and the credit-risk premium faced by businesses.     

Bank Lending Standards and Access to Lines of Credit

This paper examines how changes in bank lending standards are related to the availability of bank lines of credit for private and comparable public firms. Overall, we find that access to lines of credit is more contingent on bank lending standards for private than for public firms. The impact of bank lending standards is however asymmetric: while private firms are less likely than public firms to gain access to new lines when credit market conditions are tight, we find no difference between public and private firms in terms of their use or retention of pre‐existing lines. We also find that private firms without lines of credit use more trade credit when bank lending standards are tight, which is suggestive of a supply effect. Overall, the evidence suggests that “credit crunches” are likely to have a disproportionate impact on private firms. However, pre‐existing banking relationships appear to mitigate the impact of these contractions on private firms.     

Universal Banking Under Bilateral Information Asymmetry

The Gramm–Leach–Bliley (GLB) Act of 1999 repealed many provisions of the Glass–Steagall Act that curtailed competition between banks and commercial firms. Significantly, however, the GLB Act did not repeal the constraint on banks from owning equity in commercial firms (“universal banking”). Should banks be allowed to hold equity in corporate borrowers? If allowed, would banks optimally choose to do so? Despite its relevance from a policy perspective, there are surprisingly few theoretical analyses of this issue of “universal banking”. We develop a model in which the bank's advisory role as an “inside” shareholder hinges on its equity stake. The optimal capital structure and the bank's and entrepreneur's equity stakes are endogenously determined in a world with potential double-sided moral hazard. In certain scenarios, the bank may prefer not to hold any equity. Our analysis indicates that allowing optimal bank equity participation may foster improved corporate performance. This benefit of universal banking should be considered in policy debates.     

The impact of competition on bank orientation

How do banks react to increased competition? Recent banking theory significantly disagrees regarding the impact of competition on bank orientation—i.e., the choice of relationship-based versus transactional banking. We empirically investigate the impact of interbank competition on bank branch orientation. We employ a unique data set containing detailed information on bank–firm relationships. We find that bank branches facing stiff local competition engage considerably more in relationship-based lending. Our results illustrate that competition and relationships are not necessarily inimical.     

Effect of Banking Regulation on Performance: Evidence from Turkey

In this study, we investigate the effect of regulation on banking sector performance in an emerging country context. Consecutive crises in the early 2000s led to three waves of reformist banking regulations in Turkey: (1) the banking sector restructuring program in 2002, (2) limitation of the full deposit insurance system in 2004, and (3) a corporate governance-related banking law in 2005. Results show that these actions had a positive effect on bank lending, asset quality, and profitability. Findings also support the view that the sequence and timing of banking reforms in Turkey acted as a shield against the global financial crisis of 2008.     

Banking competition and economic growth: cross-country evidence

The aim of this paper is to analyse the effect of banking competition on industry economic growth using both structural measures of competition and measures based on the new empirical industrial organisation perspective. The evidence obtained in the period 1993–2003 for a sample of 53 sectors in 21 countries indicates that financial development promotes economic growth. The results also show that bank monopoly power has an inverted-U-shaped effect on economic growth, suggesting that bank market power has its highest growth effect at intermediate values. The latter result is consistent with the literature on relationship lending, which argues that bank competition can have a negative effect on the availability of finance for companies that are informationally more opaque.     

Do small businesses still prefer community banks?

We formulate and test hypotheses about the role of bank type – small versus large, single-market versus multimarket, and local versus nonlocal banks – in banking relationships. The conventional paradigm suggests that “community banks” – small, single-market, local institutions – are better able to form strong relationships with informationally opaque small businesses, while “megabanks” – large, multimarket, nonlocal institutions – tend to serve more transparent firms. Using the 2003 Survey of Small Business Finance (SSBF), we conduct two sets of tests. First, we test for the type of bank serving as the “main” relationship bank for small businesses with different firm and owner characteristics. Second, we test for the strength of these main relationships by examining the probability of an exclusive relationship and main bank relationship length as functions of main bank type and financial fragility, as well as firm and owner characteristics. The results are often not consistent with the conventional paradigm, perhaps because of changes in lending technologies and deregulation of the banking industry.     

Theories of bank behavior under capital regulation

This paper reviews academic studies of bank capital regulation in an effort to evaluate the intellectual foundation for the imposition of the Basel I and Basel II systems of risk-based capital requirements. The theoretical literature yields general agreement about the immediate effects of capital requirements on bank lending and loan rates and the longer-term impacts on bank ratios of equity to total or risk-adjusted assets. This literature produces highly mixed predictions, however, regarding the effects of capital regulation on asset risk and overall safety and soundness for the banking system as a whole. Thus, the intellectual foundation for the present capital-regulation regime is not particularly strong. The mixed conclusions in the academic literature on banking certainly do not provide unqualified support for moving to an even more stringent and costly system of capital requirements. These widely ambiguous results do suggest, however, that assessing the implications of capital regulation for balance-sheet risk and monitoring effort in diverse banking systems is an important agenda for future theoretical research in the banking area.     

Bank Market Structure, Competition, and SME Financing Relationships in European Regions

How do concentration and competition in the European banking sector affect lending relationships between small and medium sized enterprises (SMEs) and their banks? Recent empirical evidence suggests that concentration and competition capture different characteristics of banking systems. Using a unique dataset on SMEs for selected European regions, we empirically investigate the impact of increasing concentration and competition on the number of lending relationships maintained by SMEs. We find that competition has a positive effect on the number of lending relationships, weak evidence that concentration reduces the number of banking relationships and weak persistent evidence that they tend to offset each other.     

Bank interest rates and credit relationships in Italy

When evaluating the performance of a financial system in supporting the investment activity of the corporate sector, a distinction is usually drawn between “banking economies” and “market economies”, the former being characterized by long-term relations between banks and the industrial sector. Although theoretical studies and empirical results seem to agree that lending relationships increase the available quantity of capital to firms, they have little to say on the cost of bank credit: it is not clear whether a close relationship with a main bank would allow the borrower to pay a lower interest rate or expose him to a monopolistic rent. Using a unique data-set reporting detailed information on the evolution over time of individual bank–borrower relationships in Italy, we show evidence that a main bank provides credit at a lower cost and that some competition helps to reinforce the commitment between the borrower and the bank.     

Single versus multiple banking: lessons from initial public offerings

A vast research in banking addresses the question of the costs and benefits of multiple bank relationships versus a single bank relationship. Although no clear-cutting conclusion is reached, several contributions suggest that multiple bank relationships might lead to a sub-optimal level of monitoring, compared to a single bank relationship, as a result of free riding and coordination problems. We take a novel approach to tackle this research question, by looking at the role, if any, played by the number of lending relationships in initial public offerings (IPOs). We look at the short-term performances of IPOs as measured by underpricing and find that firms that go public with multiple bank relationships exhibit more underpricing than those that go public with a single bank relationship. This finding is independent of the number of bank relationships and/or whether any of the lending banks also acts as underwriter in the offering. We interpret our results as suggesting that the market attributes a weaker certification role to multiple bank relationships because of their less effective monitoring of IPO firms.     

RETHINKING BANK REGULATION: A REVIEW OF THE HISTORICAL EVIDENCE

The debate over bank powers has taken on special urgency with the recent flurry of proposed mergers, such as the Citicorp-Travelers Group combination, that would break down the barriers between commercial and investment banking. After more than a decade of failed attempts to expand the scope of permissible bank activities, the House of Representatives recently voted for the first time in favor of a bill to end these Depression era limitations. The issue will be taken up by the Senate this fall. Most of the rationales for regulating banks fall into two broad categories: (1) the need to control potential conflicts of interest stemming from banks' multiple roles as deposit-takers, lenders, securities underwriters, and investment advisers; and (2) the perceived need to protect against the possibility of bank panics and widespread financial instability. In reviewing the historical evidence compiled by banking and finance scholars over the years, this article finds remarkably little cause for concern and suggests the regulatory cure may be far worse than the disease. On the first issue, the article cites a number of recent studies suggesting that market forces deal more effectively than regulation with conflicts of interests that can arise when commercial banks are engaged in securities underwriting. Contrary to the conventional wisdom, investors during the pre-Glass-Steagall era appear to have been better off when they purchased securities from commercial banks rather than investment banks. Moreover, to enhance their credibility in the market, many commercial banks during this period chose to put some distance between their lending and underwriting activities by establishing separate securities affiliates, thereby creating voluntary “firewalls.” In examining the issue of how the expansion of bank powers would affect economic stability, the second half of the article cites a large body of research–including studies of different historical periods and countries–attesting to the durability of commercial (and universal) banking systems. Indeed, one of the most important findings issuing from this research is that the regulatory safety net has often had the unfortunate impact of undermining rather than promoting financial stability.     

Bank Forward Lending in Alternative Funding Environments

This paper examines the effects of loan commitments on bank lending behavior in both deposit-funding and liability management environments. Assuming that the bank lends exclusively under commitments and that the number of commitments exercised is uncertain, the bank must choose its supply of commitments. Given this choice, the bank becomes a passive lender to commitment holders. Our focus on forward credit markets sheds new light on the private bankers' assertion that they do not directly determine their level of lending, but merely “accommodate” the credit needs of their customers. Similarly, the central banker's claimed inability to control monetary aggregates in the short-run becomes understandable in a new context. It is shown that the advent of liability management will reduce the volume of loan commitments and the expected size of the bank and of the banking system. It is also shown that increased uncertainty regarding borrower takedown behavior diminishes the volume of commitments, expected bank and banking system size.     

Exploring the nexus between financial sector reforms and the emergence of digital banking culture – Evidences from a developing country

Several financial and banking sector reform programs were instituted in different countries over the last three decades. The underlining purpose of these reforms was largely to improve banking sector supervision and regulation, introduce bank privatization mechanism, introduce clearance and settlement systems, infuse competition and to stimulate financial innovation. The objectives of this study are to 1) review the relevant published literature and market survey reports on the financial & banking sector reforms undertaken in Pakistan and elsewhere, 2) analyze how these reform programs develop digital banking culture and increase financial inclusion in the country and 3) guide future research by putting forward a research agenda. The findings of the study suggest a link between the financial and banking sector reforms and the stimulation of financial innovation; the promotion of digital banking culture; and the infusion of financial inclusion in Pakistan. We discuss managerial/policy implications of the study, limitations and presents recommendations for future research.     

Capital Regulation and Competition as a Moderator for Banking Stability

Capital regulation forces banks to fund a substantial amount of their investments with equity. This creates a buffer against losses but also increases the cost of funding. If higher funding costs translate into higher loan interest rates, the bank's assets are also likely to become more risky, which may destabilize the lending bank. This paper argues that the level of competition in the banking sector can determine whether the buffer or cost effect prevails. The endogenous level of competition may be crucial in determining the efficiency of capital regulation in undercapitalized banking sectors, with excess capacities and correlated risks.     

Have changes in the financial structure affected bank profitability? Evidence for Austria

We examine the impact of changes in the financial structure of the Austrian banking sector over the past 15 years, such as disintermediation, internationalization and privatization, on the profitability of banks. Several proxies based on bank balance sheet data at the micro-level as well as macroeconomic variables are used to capture these changes. The case of Austria is particularly interesting because the opening up of the Austrian banking sector due to EU accession and the strong engagement of Austrian banks in Eastern Europe coincided with the global trend toward deregulation of banking activities. Our estimation results, which are based on dynamic panel regression methods, indicate that disintermediation (a lower percentage of loans over total assets) and higher market concentration in the banking sector had a positive effect on bank profitability, while changes in the ownership structure (privatization and increased foreign ownership) as well as more foreign lending by Austrian banks did not have a clear-cut or significant impact on bank profits.     

Reserve Requirements,Liquidity Risk,and Bank Lending Behavior

Although reserve requirements (RR) have been used in emerging markets to smooth credit cycles, the transmission mechanism remains blurry. Using bank‐level data, we unveil the interaction of RR with bank lending. We identify a new channel that works through a decline in banks’ liquid assets and loan supply due to an increase in RR. “Quantitative tightening” through RR raises the short‐term funding needs of the banking system, which is met by collateralized central bank lending, thus depleting banks’ unencumbered liquid assets. Our results suggest that such a shift in bank liquidity is associated with a significant change in lending.     

Is There Excess Capacity in Rural Banking Markets?

The literature indicates that it is difficult to identify and quantify the degree of excess capacity in banking. Economic theory indicates that there are at least three indicators of excess capacity in banking: (a) low loan-to-asset ratios, (b) low profitability and (c) high per unit operating expense relative to some norm. If excess capacity exists, it will be easiest to identify, through these indicators, at small rural banks. This paper finds significant evidence of excess capacity at rural Colorado banks using univariate analysis; simultaneous equations analysis reinforces this conclusion. It appears that the “excess capacity effect”outweighs the “market power effect”in these rural banking markets.     

Are Investment Banks Special Too? Evidence on Relationship‐Specific Capital in Investment Bank Services

The question of whether optimal provision of these services comes mainly from established relationships between banks and client firms or can result from arms'‐length market transactions has been the topic of considerable recent debate. This discussion has paralleled the debate in the commercial banking literature on the “specialness” of banks and whether lending can and should be relational or purely transactional. Whether the provision of investment bank services is relationship‐based or transactional is especially relevant now thanks to recent trends that have blurred the distinction between commercial and investment banks, and changed the competitive landscape for investment bank services. In their study summarized in this article, the authors examine whether investment bank‐client relationships create valuable relationship‐specific capital using stock market evidence from the period surrounding the collapse of Lehman Brothers. Specifically, they studied the effect of the Lehman collapse on companies that used Lehman for (1) underwriting equity offerings, (2) underwriting debt offerings, (3) advice on mergers and acquisitions, (4) analyst research services, and (5) market‐making services. The study addressed two specific questions. First, which investment bank services, if any, are associated with the creation of relationship‐specific capital; and second, what are the value drivers of this relationship capital? The authors report finding that companies that used Lehman as lead underwriter for public equity offerings experienced significantly negative abnormal stock returns in the days surrounding Lehman's bankruptcy announcement. By contrast, they find no significant reaction to the announcement for Lehman's debt underwriting clients or any of the other client categories they examine. While most of these investment bank services have at least the potential to create relationship‐specific capital, the authors' findings suggest that except for equity underwriting, all the other investment bank services appear to be transactional rather than relationship‐based, at least in the average case. Moreover, the authors report significant differences even among different groups of Lehman's equity underwriting clients. An equity underwriting relationship with Lehman appears to have been especially valuable for smaller, younger, and more financially constrained firms—those firms which presumably had a high degree of dependence on Lehman to access the capital market.     

Relationship Banking and the Pricing of Financial Services

We investigate pricing effects of the joint production of loans and security underwritings. We control for firm and borrower characteristics, including differences in sequencing, which are important for pricing. Contrary to previous studies, when banks combine lending and underwriting within the same customer relationship they charge premiums for both loans and underwriting services. Abstracting from effects of joint production within relationships, depository banks engaged in underwriting price lending and underwriting more cheaply than stand alone investment banks. One advantage borrowers enjoy from bundling products within a banking relationship is a form of liquidity risk insurance, which is manifested in a reduced demand for lines of credit. We also find evidence of a “road show” effect; firms enjoy loan pricing discounts on loans that are negotiated at times close to the debt underwritings, whether or not the same bank provides both services. Relationship effects are only visible when lending and underwriting both occur, and are stronger for equity-loan relationships than for debt-loan relationships. Electronic supplementary material  The online version of this article (doi:) contains supplementary material, which is available to authorized users.