Dynamic debt runs and financial fragility: Evidence from the 2007 ABCP crisis

We use the 2007 asset-backed commercial paper (ABCP) crisis as a laboratory to study the determinants of debt runs. Our model features dilution risk: maturing short-term lenders demand higher yields in compensation for being diluted by future lenders, making runs more likely. The model explains the observed tenfold increase in yield spreads leading to runs and the positive relation between yield spreads and future runs. Results from structural estimation show that runs are very sensitive to leverage, asset values, and asset liquidity, but less sensitive to the degree of maturity mismatch, the strength of guarantees, and asset volatility.     

Safer ratios,riskier portfolios: Banks׳ response to government aid

Using novel data on bank applications to the Troubled Asset Relief Program (TARP), we study the effect of government assistance on bank risk taking. Bailed-out banks initiate riskier loans and shift assets toward riskier securities after receiving government support. However, this shift in risk occurs mostly within the same asset class and, therefore, remains undetected by regulatory capital ratios, which indicate improved capitalization at bailed-out banks. Consequently, these banks appear safer according to regulatory ratios, but show an increase in volatility and default risk. These findings are robust to controlling for credit demand and account for selection of TARP recipients by exploiting banks? geography-based political connections as an instrument for bailout approvals.     

Bank lending during the financial crisis of 2008

This paper shows that new loans to large borrowers fell by 47% during the peak period of the financial crisis (fourth quarter of 2008) relative to the prior quarter and by 79% relative to the peak of the credit boom (second quarter of 2007). New lending for real investment (such as working capital and capital expenditures) fell by only 14% in the last quarter of 2008, but contracted nearly as much as new lending for restructuring (LBOs, M&As, share repurchases) relative to the peak of the credit boom. After the failure of Lehman Brothers in September 2008, there was a run by short-term bank creditors, making it difficult for banks to roll over their short term debt. We find that there was a simultaneous run by borrowers who drew down their credit lines, leading to a spike in commercial and industrial loans reported on bank balance sheets. We examine whether these two stresses on bank liquidity led them to cut lending. In particular, we show that banks cut their lending less if they had better access to deposit financing and thus, they were not as reliant on short-term debt. We also show that banks that were more vulnerable to credit-line drawdowns because they co-syndicated more of their credit lines with Lehman Brothers reduced their lending to a greater extent.     

Liquidity risk management and credit supply in the financial crisis

Liquidity dried up during the financial crisis of 2007-2009. Banks that relied more heavily on core deposit and equity capital financing, which are stable sources of financing, continued to lend relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased takedown demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.     

Macroeconomic effects of corporate default crisis: A long-term perspective

Using an extensive data set on corporate bond defaults in the US from 1866 to 2010, we study the macroeconomic effects of bond market crises and contrast them with those resulting from banking crises. During the past 150 years, the US has experienced many severe corporate default crises in which 20–50% of all corporate bonds defaulted. Although the total par amount of corporate bonds has at times rivaled the amount of bank loans outstanding, we find that corporate default crises have far fewer real effects than do banking crises. These results provide empirical support for current theories that emphasize the unique role that banks and the credit and collateral channels play in amplifying macroeconomic shocks.     

Market concentration and the likelihood of financial crises

According to theory, market concentration affects the likelihood of a financial crisis in different ways. The “concentration-stability” and the “concentration-fragility” hypotheses suggest opposing effects operating through specific channels. Using data of 160 countries for the period 1970–2009, this paper empirically tests these indirect effects of financial market structure. We set up a simultaneous system in order to jointly estimate financial stability and the relevant channel variables as endogenous variables. Our findings provide support for the assumption of channel effects in general and both the concentration-stability and the concentration-fragility hypothesis in particular. The effects are found to vary between high and low income countries.     

The eurosystem money market auctions: A banking perspective

This paper analyzes the individual bidding behavior of German banks in the money market auctions conducted by the ECB from the beginning of 2000:IIIQ to the end of 2001:IQ. Our approach takes a variety of characteristics of the individual banks into account, particularly variables that capture the different use of liquidity and the different attitude towards liquidity risk of the individual banks. It turns out that these characteristics are reflected in banks’ bidding behavior. Thus, our study contributes to a deeper understanding of the way liquidity risk is managed in the banking sector.     

Hedge funds,CDOs and the financial crisis: An empirical investigation of the “Magnetar trade”

The so called Magnetar trade (a kind of capital structure arbitrage on the US housing market, using CDS and synthetic CDOs, and exploiting rating-dependent mispricing of risk) has gained a high publicity due to a Pulitzer Prize awarded media story from two journalists of ProPublica (an online news outlet). The story essentially claimed that the mortgage investment strategy of the hedge fund Magnetar during the period between 2006 and mid 2007 was based on a desire to construct CDO deals with riskier assets so that they could place bets that portions of their own deals would fail. This paper provides several pieces of evidence in line with the argument that tranches from Magnetar-sponsored CDOs present overly risky investments. However, investors and rating agencies appear to have adjusted their required spread levels and ratings to reflect this higher riskiness, at least to some extent.     

Credit spread interdependencies of European states and banks during the financial crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, the Netherlands, Portugal, and Spain) and their domestic banks during the period between June 2007 and May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects sovereign CDS spreads more strongly in the short run. However, the impact becomes insignificant in the long term. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.     

Bank/sovereign risk spillovers in the European debt crisis

This paper investigates contagion between bank and sovereign default risk in Europe over the period 2007–2012. We define contagion as excess correlation, i.e. correlation between banks and sovereigns over and above what is explained by common factors, using CDS spreads at the bank and at the sovereign level. Moreover, we investigate the determinants of contagion by analyzing bank-specific as well as country-specific variables and their interaction. Using the EBA’s disclosure of sovereign exposures of banks, we provide empirical evidence that three contagion channels are at work: a guarantee channel, an asset holdings channel and a collateral channel. We find that banks with a weak capital buffer, a weak funding structure and less traditional banking activities are particularly vulnerable to risk spillovers. At the country level, the debt ratio is the most important driver of contagion. Furthermore, the impact of government interventions on contagion depends on the type of intervention, with outright capital injections being the most effective measure in reducing spillover intensity.     

Risk management,corporate governance,and bank performance in the financial crisis

The recent financial crisis has raised several questions with respect to the corporate governance of financial institutions. This paper investigates whether risk management-related corporate governance mechanisms, such as for example the presence of a chief risk officer (CRO) in a bank’s executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008. We measure bank performance by buy-and-hold returns and ROE and we control for standard corporate governance variables such as CEO ownership, board size, and board independence. Most importantly, our results indicate that banks, in which the CRO directly reports to the board of directors and not to the CEO (or other corporate entities), exhibit significantly higher (i.e., less negative) stock returns and ROE during the crisis. In contrast, standard corporate governance variables are mostly insignificantly or even negatively related to the banks’ performance during the crisis.     

Market discipline, financial crisis and regulatory changes: Evidence from Indonesian banks

Following the 1997/1998 financial crisis, Indonesian banks experienced major regulatory changes, including the adoption of the blanket guarantee scheme (BGS) in 1998, a limited guarantee (LG) in 2005, and changes in capital regulation in 1998 and 2001. We examine the impact of these regulatory changes on market discipline during the period 1995-2009. The price of deposits is used to measure market discipline in a dynamic panel data methodology on a sample of 104 commercial banks. We find a weakening of market discipline following the introduction of the BGS. The result is consistent with the deposit insurance scheme being credible in the lower capital requirement environment. The adoption of LG in a recovering economy also mitigates the role of market discipline. However, market discipline is more pronounced in listed banks than unlisted banks and in foreign banks than domestic banks. These results have important implications for banking regulation and supervision, particularly during a crisis period.     

Japan’s banking crisis: An event-study perspective

We calculate abnormal stock returns for Japanese non-financial companies around major events associated with the banking crisis (1995–2000), and find that not all companies were equally sensitive to the malaise of the banking sector: the most affected were small, leveraged, low-tech companies with low credit ratings and low market to book ratios. This is consistent with “credit crunch” theories (companies with limited access to financial markets are sensitive to changes in bank lending) and with claims that innovation is rarely financed by bank debt. We do not find much evidence on the alleged misallocation of loans to support ailing bank clients.     

Global retail lending in the aftermath of the US financial crisis: Distinguishing between supply and demand effects

This paper examines the broader effects of the US financial crisis on global lending to retail customers. In particular we examine retail bank lending in Germany using a unique data set of German savings banks during the period 2006 through 2008 for which we have the universe of loan applications and loans granted. Our experimental setting allows us to distinguish between savings banks affected by the US financial crisis through their holdings in Landesbanken with substantial subprime exposure and unaffected savings banks. The data enable us to distinguish between demand and supply side effects of bank lending and find that the US financial crisis induced a contraction in the supply of retail lending in Germany. While demand for loans goes down, it is not substantially different for the affected and nonaffected banks. More important, we find evidence of a significant supply side effect in that the affected banks reject substantially more loan applications than nonaffected banks. This result is particularly strong for smaller and more liquidity-constrained banks as well as for mortgage as compared with consumer loans. We also find that bank-depositor relationships help mitigate these supply side effects.     

Banking crises and market discipline: International evidence

This paper analyzes the effect of banking crises on market discipline in an international sample of banks. We also evaluate how bank regulation, supervision, institutions, and crisis intervention policies shape the effect of banking crises on market discipline. We control for unobservable bank, country, and time specific effects using a panel data set of banks from 66 countries around 79 banking crises. The results suggest that on average market discipline weakens after a banking crisis. This weakening is higher in countries where bank regulation, supervision, and institutions promoted market discipline before the banking crisis, and where a more accommodative approach is adopted to resolve it.     

Money and liquidity in financial markets

We argue that there is a connection between the interbank market for liquidity and the broader financial markets, which has its basis in demand for liquidity by banks. Tightness in the market for liquidity leads banks to engage in what we term “liquidity pull-back,” which involves selling financial assets either by banks directly or by levered investors. Empirical tests on the stock market are supportive. Tighter interbank markets are associated with relatively more volume in more liquid stocks; selling pressure, especially in more liquid stocks; and transitory negative returns. We control for market-wide uncertainty and in the process also contribute to the literature on portfolio rebalancing. Our general point is that money matters in financial markets.     

Bank CEO incentives and the credit crisis

We investigate whether bank performance during the recent credit crisis is related to chief executive officer (CEO) incentives before the crisis. We find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better. Banks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.     

Stock market reaction to fed funds rate surprises: State dependence and the financial crisis

This paper examines the response of US stock returns to Federal Funds rate (FFR) surprises between 1989 and 2012, focusing on the impact of the recent financial crisis. We find that outside the crisis period, stock prices increased as a response to unexpected FFR cuts. State dependence is identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear markets, and tightening credit conditions. However, an important structural shift occurred during the crisis, changing the stocks’ response to FFR shocks and the nature of state dependence. Throughout the crisis period, stocks did not react positively to unexpected FFR cuts, which were interpreted as signals of worsening future economic conditions. This triggered a rebalancing of investment portfolios away from falling equities and towards safe-haven assets. Our results highlight the severity of the crisis and the ineffectiveness of conventional monetary policy close to the zero lower bound.     

Capital management in mutual financial institutions

Capital management by mutual financial institutions (such as credit unions) provides a valuable testing ground for assessing the impact of capital regulation and theories of managerial behaviour in financial institutions. Limited access to external equity capital means that capital accumulation must be met primarily by reliance on retained earnings. To deal with shocks to the capital position and avoid breaching regulatory requirements, managers will aim to have a buffer of capital in excess of the regulatory minimum. Moreover, mutual governance arrangements and an absence of capital market discipline mean that managers have discretion to set target capital ratios which differ significantly from industry averages. This paper develops a formal model of capital management and risk management in mutual financial institutions such as credit unions which reflects these industry characteristics. The model is tested using data from larger credit unions in Australia, which have been subject to the Basel Accord Risk Weighted Capital Requirements since 1993. The data supports the hypothesis that credit unions manage their capital position by setting a short term target profit rate (return on assets) which is positively related to asset growth and which is aimed at gradually removing discrepancies between the actual and desired capital ratio. Desired capital ratios vary significantly across credit unions. There is little evidence of short run adjustments to the risk of the asset portfolio to achieve a desired capital position.