Financial derivatives and bank risk: evidence from eighteen developed markets

We examine the relationship between equity risk and the use of financial derivatives with a sample of 555 banks from eighteen developed markets from 2006 to 2015. Our main findings suggest that banks’ use of financial derivatives increased their risk. This increase in risk can be driven by banks’ use of derivatives for speculative purposes, by suboptimal hedging to obtain hedge accounting status, or from accounting mismatches that generate volatility in earnings. We also show that this relationship is nonlinear. Too-Big-To-Fail banks and those that employ a traditional retail banking business model are subject to lower idiosyncratic risk. We address endogeneity concerns using instrumental variables capturing the use of derivatives with portfolio ranking. Overall, our study contributes to understanding the impact of derivatives use on bank risk and the risk consequences of a bank’s business model choice.     

The impact of central bank digital currency variation on firm's implied volatility

The paper investigates whether a firm's implied volatility is affected by the volatility of central bank digital currencies. Our sample covers 2853 listed companies in the United States from 2014 to 2018. First, we find the variation of central bank digital currency has a positive impact on a firm’s implied volatility. Second, the healthier firms’ conditions can reduce the relationship between central bank digital currency variation and a firm’s implied volatility. Third, the positive relation between central bank digital currency and firm’s implied volatility still exists in investment-grade, speculative-grade, and unrated firms. Finally, to eliminate the endogeneity problem, we adopt simultaneous equation models (SEM) and find our results are still robust after excluding endogenous concerns. Our research provides a reminder for corporate managers and new implications for policymakers.     

The relationship between liquidity risk and credit risk in banks

This paper investigates the relationship between the two major sources of bank default risk: liquidity risk and credit risk. We use a sample of virtually all US commercial banks during the period 1998–2010 to analyze the relationship between these two risk sources on the bank institutional-level and how this relationship influences banks’ probabilities of default (PD). Our results show that both risk categories do not have an economically meaningful reciprocal contemporaneous or time-lagged relationship. However, they do influence banks’ probability of default. This effect is twofold: whereas both risks separately increase the PD, the influence of their interaction depends on the overall level of bank risk and can either aggravate or mitigate default risk. These results provide new insights into the understanding of bank risk and serve as an underpinning for recent regulatory efforts aimed at strengthening banks (joint) risk management of liquidity and credit risks.     

Deriving value or risk? Determinants and the impact of emerging market banks’ derivative usage

This paper examines the determinants of the emerging market banks’ derivative usage and the impact of derivative usage on bank value, total risk and bank stability. Our empirical evidence first suggests that derivative usage is driven primarily by net interest margin, bank concentration and institutional strength. In addition, although derivative usage appears to reduce emerging market bank value, it does not affect total risk. Moreover, emerging market banks can reduce bank instability using derivatives. Our findings have important implications for investors and policy makers focusing on emerging derivatives markets.     

Corporate Governance and Mergers and Acquisitions Performance in Banks: Evidence under the Special Regulatory Environment in Taiwan

In this study, we focus on the relation between bank governance and bank merger results under Taiwan’s special regulatory environment in 2000. Adopting governance variables (executive remuneration, managerial ownership, and board diversity), we find that managerial ownership is positively related to bank merger results and that board size is negatively correlated with bank mergers’ performance. This study supports sound governance mechanisms to prevent banks from pursuing a value-loss merger and acquisition (M&A). Our results offer the insight that internal bank governance structures have a bigger impact on the value effects from bank mergers. Thus, regulators may elevate the performance of bank M&As by enhancing corporate governance codes.     

Customers’ dissatisfaction with banking channels and their intention to leave banks: The moderating effect of trust and trusting beliefs

Banks have the challenging task of managing customer experience across many traditional and technological channels in today’s financial services world. Recent studies and anecdotal evidence suggest that many customers are dissatisfied with their experiences across channels that are supposed to provide a seamless experience. This customer dissatisfaction potentially diminishes a financial service organization’s customer base, and requires the firm to rely on a more fickle customer mix and erodes its reputation. This paper investigates the relationship between individuals’ dissatisfaction with their primary bank channel and their intention to leave their bank in the future. The first study examines individuals’ overall trust in their bank as a potential moderator in the relationship that reduces customers’ likelihood to leave the bank even though they are dissatisfied with a particular banking channel. The second study goes one step further and examines the effect of three trusting beliefs about the bank potentially held by the customer: competence, integrity, and benevolence beliefs. Findings indicate that when customers have a high level of trust in their banks, they are less likely to leave their banks even though they are dissatisfied with their primary banking channel. Furthermore, while competence and benevolence beliefs about the bank have a similar moderating effect, integrity beliefs do not.     

Investigating explanatory theories on laypeople’s risk perception of personal economic collapse in a bank crisis – the Cyprus case

We investigate the explanatory power of decision, psychometric, and trust theory to describe laypeople’s risk perception of personal economic collapse in a bank crisis. The aim of this investigation is to improve the understanding of the effects of national initiatives for crisis fighting taken to prevent systemic risk. Using a stratified sample of 738 Cypriote citizens, we conducted an investigation in Cyprus in the spring of 2013 when the country was facing a bank crisis. At that point in time, the Cypriote Government had imposed capital controls to prevent a bank run. We find that decision theory variables alone have low explanatory value on laypeople’s risk perception, and that laypeople’s risk perception in this situation is affected primarily by psychometric variables. Further, confidence in one’s own bank also explains risk perception. Our findings contribute novel knowledge about risk perceptions in a financial crisis, with practical crisis management implications for regulators.     

Accounting quality,bank monitoring,and performance pricing loans

We provide new evidence on the determinants of performance pricing provisions in bank loan contracts. We find that firms that are easier to monitor, such as those with better accounting quality, lower information opacity, or a stronger relationship with the lender are more likely to have performance pricing loans. The use of performance pricing is less likely after financial restatement events. Furthermore, we find that the likelihood of using accounting-based (as opposed to credit-rating-based) pricing provisions increases as the firm’s accounting quality increases, and as the strength of the prior lending relation increases. Our results are robust to alternative measures of accounting quality, information opacity, and bank monitoring, and suggest that monitoring costs have a significant impact on the design of debt contracts.     

Bank affiliation and mutual funds’ trading strategy distinctiveness

This study investigates the effect of commercial bank affiliation on mutual fund trading strategy distinctiveness. We find that bank affiliation has a significantly positive relationship with mutual funds’ unique investment strategies, and this phenomenon exhibits better performance, supporting the benefits of bank affiliation. This association is most pronounced around macroeconomic releases, during high economic policy uncertainty periods, and among funds located within a close distance from their parent bank headquarters. Further analysis indicates that the more talented affiliated fund managers tend to pursue the distinctive strategy. Therefore, our evidence reveals that the underlying mechanisms are that affiliated funds own information advantages or hire more skilled fund managers due to the unique position of commercial banks in the economy. Finally, our results suggest that affiliated funds with a higher Strategy Distinctiveness Index attract stronger net inflows and are less exposed to risks. Our findings remain unchanged after several robustness tests.     

Hedging derivatives in the banking industry: Evidence of investor confusion

Hedging derivatives are complex instruments that require particular scrutiny by bank regulators to ensure that a bank’s risk profile is consistent with sound banking practices. The Basel II agreement envisions a system of banking oversight that includes market discipline as a key element of the regulatory framework. A necessary condition in achieving market discipline is that market participants must be able to decipher the underlying conditions from reported results. We examine the relationship between investor confusion and the income effects arising from fair value recognition of hedging derivatives in the banking industry. We use abnormal trading volume as a proxy for investor confusion, and we find a positive and significant relationship between fair value accounting incomes and two alternative measures of abnormal trading volume. The findings suggest that accounting requirements alone may be insufficient to communicate the complexities of hedging derivatives to investors in a way that achieves the market discipline prescribed by Basel II. Bank regulators may need to augment extant efforts for transparency to ensure that risks are adequately communicated to the market.     

Product differentiation,market dynamics and the value relevance of trade payables: Evidence from UK listed firms

This paper provides a comprehensive evidence on how product and market dynamics affect the value relevance of trade payables. Using a sample of 2559 UK listed firms over the period 2005–2014, we find a positive relationship between trade payables and firm performance. Our evidence suggests that trade payables increase (decrease) performance in firms with differentiated products and demand uncertainty (larger market share). We demonstrate that the relative value relevance of bank credit versus suppliers’ credit is dependent on the nature of the product, the level of sales volatility, and market share. We use an innovative approach to assess the robustness of our results to omitted variable bias.     

Bank board structure and performance: Evidence for large bank holding companies

The subprime crisis highlights how little we know about bank governance. This paper addresses a long-standing gap in the literature by analyzing the relationship between board governance and performance using a sample of banking firm data that spans 34 years. We find that board independence is not related to performance, as measured by a proxy for Tobin’s Q. However, board size is positively related to performance. Our results are not driven by M&A activity. But, we provide new evidence that increases in board size due to additions of directors with subsidiary directorships may add value as BHC complexity increases. We conclude that governance regulation should take unique features of bank governance into account.     

The ties that bind: Bank relationships and small business lending

The importance of bank relationships for small firms’ ability to raise external finance is well-documented, yet the mechanism through which relationships improve access to capital markets has received little empirical attention. This paper uses hand-collected, proprietary data from a mid-sized bank in the United States to identify the channels that strengthen the relationship between a small business and its bank. In contrast to earlier work that focuses on the role of relationships in alleviating information and incentive problems in lending, I find that the source of value in relationship banking is not limited to enhanced monitoring. Exploiting a unique feature of this dataset, I examine two channels of relationship strength that directly measure the stream of non-lending profits generated from (1) the non-credit services cross-sold to the borrower, and (2) the additional bank clients referred by the borrower. I document that non-lending profitability empirically determines the risk-adjusted terms of lending. In models of loan price that already include both the bank’s proprietary risk rating and traditional risk proxies, non-lending profits significantly improve explanatory power and account for up to half of the total explained variation. Conditional on risk profile, a one-standard deviation increase in aggregate non-lending profits lowers the loan interest rate by 32 basis points and increases access to credit by 26%.     

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.     

Relationship Banking and Loan Syndicate Structure: The Role of Private Equity Sponsors

Using a sample of syndicated loans to private equity (PE)‐backed initial public offering companies, we examine how a third‐party bank relationship influences the syndicate structure of a loan. We find that a stronger relationship between the lead bank and the borrower's PE firm enables the lead bank to retain a smaller share of the loan and form a larger and less concentrated syndicate, especially when the borrower is less transparent. A stronger PE‐bank relationship also attracts greater foreign bank participation. Our findings suggest that the lead bank's relationship with a large equity holder of the borrower facilitates information production in lending.     

Banking Market Size Structure and Financial Stability: Evidence from Eight Asian Countries

Using commercial bank data from eight major Asian countries, we examine the relationship between the banking market size structure and the stability of financial institutions. We also analyze the effect of bank upsizing on the financial stability. Our results show that a rise in large banks’ market power, accompanying an increase in their market shares, lowers the capital adequacy of small banks. Small banks’ nonperforming loans and the possibility of their bankruptcy also increase as large banks’ market shares rise. We further show that larger banks tend to have lower capital adequacy ratios, liquidity ratios, and distance-to-default ratios. Our study suggests that large banks’ greater market shares are associated with small banks’ financial instability. Overall, these findings are consistent with the notion of the recent banking literature that has important antitrust policy implications.     

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.     

Business collateral and personal commitments in SME lending

Using a database of SME credit approvals from a large Belgian bank, this paper extends the empirical evidence on the determinants of collateral by examining the determinants of business collateral simultaneously with the determinants of personal collateral/commitments. Our results suggest that firm and relationship characteristics seem to be more important determinants of collateral/commitment protection than loan and lender characteristics. Family firms are more likely to offer a higher degree of collateral/commitment protection while introducing competition between banks decreases this likelihood. The collateral requirement decreases in the length of the bank-borrower relationship. Furthermore, trade credit seems to have a signalling effect. The ‘lazy banks hypothesis’ was not supported. Our results suggest that beside risk arguments, also commercial arguments help explain the pledging of collateral. Using a continuation-ratio logit model, we discover several differences in the determinants of the collateralisation decision and the determinants of the type of collateral/commitments.     

The contribution of bank regulation and fair value accounting to procyclical leverage

Our analysis of how banks’ responses to asset price changes can result in procyclical leverage reveals that, for banks with a binding regulatory leverage constraint, absent differences in regulatory risk weights across assets, procyclical leverage does not occur. For banks without a binding constraint, fair value and bank regulation both can contribute to procyclical leverage. Empirical findings based on a large sample of U.S. commercial banks reveal that bank regulation explains procyclical leverage for banks relatively close to the regulatory leverage constraint and contributes to procyclical leverage for those that are not. We also show that fair value accounting does not contribute to procyclical leverage.     

Central bank financial strength and inflation: Is there a robust link?

Central bank financial strength has not been a fundamental issue for a substantial period of time. However, recent theoretical and empirical studies argue that central banks need to maintain a sufficient level of financial strength to perform their functions effectively and to achieve monetary policy objectives. In this study, we examine the empirical relationship between central bank financial strength and inflation using an unbalanced panel data set for a sample of selected advanced and emerging countries. We observe a statistically significant and robust negative relationship between central bank financial strength and inflation. This relationship is robust in the presence of other determinants of inflation and for alternative estimation methods. Our results have important implications for policy makers and central bankers. Particularly, our results suggest that avoiding persistent losses and maintaining the health of the central bank balance sheet remain vital pre-conditions for desirable policy outcomes of a central bank.