The Macroeconomic Effects of Shocks to Large Banks’ Capital

We propose a simple approach to quantifying the macroeconomic effects of shocks to large banks’ leverage. We first estimate a standard dynamic model of leverage targeting at the bank level and use it to derive an aggregate measure of the economic capital buffer of large US bank holding corporations. We then evaluate the response of key macro variables to a shock to this aggregate bank capital buffer using standard monetary VAR models. We find that shocks to the capital of large US banks explain a substantial share of the variance of credit to firms and real activity.     

Commonality,macroeconomic factors and banking profitability

We study banks’ profitability in the US economy by means of dynamic factor models. Our results emphasize the importance of a few common cyclical market factors that greatly determine banking profitability. We conduct exhaustive regressions in a big data set of macroeconomic variables aiming to gain interpretability of our statistical factors. This allows us to identify three main macroeconomic factors underlying banking profitability: the financial burden of households and economic activity; household income and net worth and, in the case of ROA and ROE, stress in financial markets. We also provide an integrated perspective to analyse banks’ profitability dynamically and to inform policymakers concerned with financial stability issues, for which banks’ profitability is fundamental. Our models allow us to provide several rankings of vulnerable financial institutions considering the common market forces that we estimate. We emphasize the usefulness of such an exercise as a market-monitoring tool.     

Coordination and non-coordination risks of monetary and macroprudential authorities: A robust welfare analysis

This study compares a central bank’s leaning against the wind approach with a mix of monetary and macroprudential policies under parameter uncertainty in an estimated DSGE model with two financial frictions. We show that uncertainty of the economic environment is an essential constituent in properly designing macroprudential policy. Although coordination between monetary and macroprudential policies minimizes the policymakers’ Bayesian risk, coordination and non-coordination risks threaten the goals of both authorities. The former describes the situation where the authorities partly resign from implementing the monetary policy objectives to stabilize macroprudential risk. The latter is when conducting a non-coordinated macroprudential policy induces higher total Bayesian risk than when only the central bank minimizes the expected total welfare loss. The robust Bayesian macroeconomic rules show that when financial shocks shrink the banks’ or entrepreneurial net worth, a contractionary macroprudential policy should be combined with an expansionary monetary policy. However, if capital adequacy ratio or risk shocks strike the economy, such a conflict in macroeconomics policy instruments disappears, thus synchronizing both policies.     

Financial intermediation and real estate prices impact on business cycles: A Bayesian analysis

How do financial intermediation and real estate prices impinge on the business cycle? I develop a two-sector stochastic general equilibrium model with financial intermediation and real estate collateral to assess the impact of financial conditions and land prices on aggregate fluctuations. I estimate the model with Bayesian methods using a novel data set that includes U.S. macro and financial variables during the period 1975–2010. The results from the estimated model show that financial conditions have a sizable effect on the variability of investment spending, while productivity shocks are the main source of consumption fluctuations. Specifically, on the macro side, (1) financial shocks explain about three quarters of investment spending variability and one third of the variance in hours worked. On the financial side, (2) financial shocks explain most of the variability in land prices, credit spread, and aggregate net worth of the financial sector. The model also accounts for observed unconditional moments of macro and financial variables. Our quantitative results are suggestive of the impact of diverse sources of financial instability, and as such relevant for macro prudential policy analysis.     

Towards a credit network based early warning indicator for crises

This paper presents an agent based model which underlines the importance of credit network and leverage dynamics in determining the resilience of the system, defining an early warning indicator for crises. The model reproduces macroeconomic dynamics emerging from the interactions of heterogeneous banks and firms in an endogenous credit network. Banks and firms are linked through multiple credit relations, which derive from individual target leverage choices: agents choose the more convenient leverage level, according to a basic reinforcement learning algorithm. Simulations are calibrated on balance sheet data of banks and firms quoted in the Japanese stock-exchange markets from 1980 to 2012.     

The impact of government intervention on the stabilization of domestic financial markets and on U.S. banks’ asset composition

The 2007–2009 financial crisis that evolved from various factors including the housing boom, aggressive lending activity, financial innovation, and increased access to money and capital markets prompted unprecedented U.S. government intervention in the financial sector. We examine changes in banks’ balance sheet composition associated with U.S. government intervention during the crisis. We find that the initial round of quantitative easing positively impacts bank liquidity across all bank samples. Our results show a positive impact of repurchase agreement market rates on bank liquidity for small and medium banks. We conclude that banks have become more liquid in the post-crisis period, especially the larger banks (large and money center banks). We show that real estate loan portfolio exposures have reverted to pre-crisis levels for money center banks and remained flat for all other bank samples.     

Financial fragility,sovereign default risk and the limits to commercial bank bail-outs

We show that with intertwined weak banks and weak sovereigns, bank recapitalizations become much less effective. We construct a DSGE model with leverage constrained banks lending to firms and holding domestic government bonds. Bond prices reflect endogenously generated sovereign risk. This introduces a negative amplification cycle: after a credit crisis output losses increase more because higher interest rates trigger lower bond prices and subsequent losses at banks. This further tightens bank leverage constraints, and causes interest rates to rise further. Also bank recapitalizations are then much less effective. Recaps involve swaps of newly issued sovereign bonds for bank equity, the new debt increases sovereign debt discounts, leading to capital losses for the banks on their holdings of sovereign debt that (partially) offset the impact of the recapitalization. The favorable macroeconomic effects of bank recaps on the recovery after a financial crisis are correspondingly lower.     

Prices,debt and market structure in an agent-based model of the financial market

We develop an agent-based model in which heterogeneous and boundedly rational agents interact by trading a risky asset at an endogenously set price. Agents are endowed with balance sheets comprising the risky asset as well as cash on the asset side and equity capital as well as debt on the liabilities side. A number of findings emerge when simulating the model: we find that the empirically observable log-normal distribution of bank balance sheet size naturally emerges and that higher levels of leverage lead to a greater inequality among agents. Furthermore, greater leverage increases the frequency of bankruptcies and systemic events. Credit frictions, which we define as the stickiness of debt adjustments, are able to explain a key difference in the relation between leverage and assets observed for different bank types. Lowering credit frictions leads to an increasingly procyclical behavior of leverage, which is typical for investment banks. Nevertheless, the impact of credit frictions on the fragility of the model financial system is complex. Lower frictions do increase the stability of the system most of the time, while systemic events become more probable. In particular, we observe an increasing frequency of severe liquidity crises that can lead to the collapse of the entire model financial system.     

Monetary policy and risk taking

We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel – monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and is particularly significant on the bank funding side. Then, to rationalize this evidence we build a macroeconomic model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.     

Systemic risk governance in a dynamical model of a banking system with stochastic assets and liabilities

We consider the problem of governing systemic risk in an assets–liabilities dynamical model of a banking system. In the model considered, each bank is represented by its assets and liabilities. The net worth of a bank is the difference between its assets and liabilities and bank is solvent when its net worth is greater than or equal to zero; otherwise, the bank has failed. The banking system dynamics is defined by an initial value problem for a system of stochastic differential equations whose independent variable is time and whose dependent variables are the assets and liabilities of the banks. The banking system model presented generalizes those discussed in Fouque and Sun (in: Fouque, Langsam (eds) Handbook of systemic risk, Cambridge University Press, Cambridge, pp 444–452, 2013) and Fatone and Mariani (J Glob Optim 75(3):851–883, 2019) and describes a homogeneous population of banks. The main features of the model are a cooperation mechanism among banks and the possibility of the (direct) intervention of the monetary authority in the banking system dynamics. By “systemic risk” or “systemic event” in a bounded time interval, we mean that in that time interval at least a given fraction of banks have failed. The probability of systemic risk in a bounded time interval is evaluated via statistical simulation. Systemic risk governance aims to maintain the probability of systemic risk in a bounded time interval between two given thresholds. The monetary authority is responsible for systemic risk governance. The governance consists in the choice of assets and liabilities of a kind of “ideal bank” as functions of time and in the choice of the rules for the cooperation mechanism among banks. These rules are obtained by solving an optimal control problem for the pseudo mean field approximation of the banking system model. Governance induces banks in the system to behave like the “ideal bank”. Shocks acting on the banks’ assets or liabilities are simulated. Numerical examples of systemic risk governance in the presence and absence of shocks acting on the banking system are studied.

     

What makes Islamic banks different? A multivariate approach

Using data from 8615 banks (including 123 Islamic banks) in 124 developed and developing countries for the period between 2006 and 2012, we examine the financial characteristics that distinguish between conventional and Islamic banks. As banks’ financial characteristics are multi-faceted concepts, our indicators are constructed using principal component analysis. We find that Islamic banks are more capitalized, more liquid and more profitable, but have more volatile earnings compared to US and European banks. However, similarities in terms of liquidity and earnings volatility are more noticeable when the sample is limited to banks operating in countries where both systems coexist. Finally, we find that higher capital makes the returns of Islamic banks more volatile, while higher liquidity decreases the profitability of conventional banks.     

Bank capital and the macroeconomy: Policy considerations

We develop a macroeconomic model in which the balance sheet condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity, and that a long transition period helps avoid undesirable side effects. Finally, we show that the marginal effects of policies can be larger during “crises” because of the nonlinear interactions between some financial frictions and policy actions.     

Is foreign-bank efficiency in financial centers driven by home or host country characteristics?

This paper investigates whether home or host country factors can explain differences in technical efficiency among foreign banks operating in the Luxembourg financial center. We first address heterogeneity across banks by using the group-wise bootstrap to compare DEA measures of bank efficiency between branches and subsidiaries, focused and diversified banks, and euro area and non-euro area banks. We then control for these factors in a second-stage regression indentifying the impact of country-specific regulatory and macroeconomic variables on individual bank efficiency scores. Our regulatory indicators capture the strictness of capital requirements, private monitoring, official disciplinary power and restrictions on bank activities. Our macroeconomic indicators capture GDP per capita in the home country and its position in the business cycle. Our results carry policy implications for bank regulators in both home and host countries and provide insight into banks’ choice between establishing a branch or a subsidiary to develop cross-border activities through international financial centers.     

Systemic liquidity contagion in the European interbank market

Systemic liquidity risk, defined by the International Monetary Fund as “the risk of simultaneous liquidity difficulties at multiple financial institutions,” is a key topic in financial stability studies and macroprudential policy-making. In this context, the complex web of interconnections of the interbank market plays the crucial role of allowing funding liquidity shortages to propagate between financial institutions. Here, we introduce a simple yet effective model of the interbank market in which liquidity shortages propagate through an epidemic-like contagion mechanism on the network of interbank loans. The model is defined by using aggregate balance sheet information of European banks, and it exploits country and bank-specific risk features to account for the heterogeneity of financial institutions. Moreover, in order to obtain the European-wide topology of the interbank network, we define a block reconstruction method based on the exchange flows between the various countries. We show that the proposed contagion model is able to estimate systemic liquidity risk across different years and countries. Results suggest that our effective contagion approach can be successfully used as a viable alternative to more realistic but complicated models, which not only require more specific balance sheet variables with high time resolution but also need assumptions on how banks respond to liquidity shocks.

     

Banks’ risk taking,financial innovation and macroeconomic risk

This paper shows how financial innovation in combination with the fall of macroeconomic risk can explain the strong growth of the primary and secondary credit markets in the U.S. economy. We document empirically the fall in macroeconomic risk, the expansion of the prime and secondary credit market and we provide evidence that changes in macroeconomic risk are closely related to the evolution of the prime market. In the theoretical part of the paper we study in a simple portfolio optimization framework the effect of financial innovation and macroeconomic risk on banks’ risk taking. The results of the model show that financial innovation increases bank appetite for risky investment both in the prime and secondary markets and that this effect is stronger in environments with low aggregate macroeconomic risk. In addition the banking system becomes less stable because of the portfolio risk of each individual bank increases.     

Risky bank lending and countercyclical capital buffers

We study the properties of a monetary economy with an essential role for risky bank lending. Banks issue deposits and lend to entrepreneurs. Because banks׳ lending rate cannot be made contingent on aggregate shocks, and because banks face capital adequacy regulations, they require a capital buffer against loan losses. Capital adequacy regulations are modeled on the Basel-III rules, including a minimum capital adequacy ratio, an endogenous capital conservation buffer, and a countercyclical capital buffer. We find that a countercyclical capital buffer leads to a significant increase in welfare. It also reduces the need for countercyclical adjustments in policy interest rates.     

Loan Loss Provisions by Banks in Hong Kong, Malaysia and Singapore

This paper studies loan loss disclosures by banks in Hong Kong, Malaysia, and Singapore for the period 1993 through 2000. We find that unexpected loan loss provisions are positively related to bank stock returns and future cash flows. This indicates that Asian bank managers increase loan loss provisions to signal favorable cash flow prospects, and bank investors bid bank stock prices up when unexpected provisions are positive. These results are consistent with those obtained by Wahlen (1994) for US banks. We also examine the impact of the Asian financial crisis of 1997 on the loan loss variables. The results indicate that the association between the unexpected loan loss provisions and bank stock returns and future cash flows was significantly lower in the crisis years, relative to the non‐crisis period. Evidently, discretionary loan loss provisions had no signaling value during the crisis. This suggests that macroeconomic uncertainty influenced the strategic behavior of Asian bank managers and investors.     

Conventional Monetary Policy Transmission During Financial Crises: An Empirical Analysis

This paper studies the effects of a conventional monetary policy shock in the USA during times of high financial stress. The analysis is carried out by introducing a smooth transition factor model where the transition between states (‘normal’ and high financial stress) depends on a financial conditions index. Employing a quarterly dataset over the period 1970:Q1 to 2008:Q4 containing 108 US macroeconomic and financial time series, I find that a monetary policy shock during periods of high financial stress has stronger and more persistent effects on macroeconomic variables such as output, consumption and investment than it has during ‘normal’ times. Differences in effects among the regimes seem to originate from nonlinearities in both components of the credit channel, i.e. the balance sheet channel and the bank‐lending channel. Copyright © 2016 John Wiley & Sons, Ltd.     

Bank competition,financial development and macroeconomic stability: Empirical evidence from emerging economies

In this study, we investigate the potential contribution of bank competition to macroeconomic stability, and the interactive role of financial development. We classify macroeconomic stability into economic and financial stability. Economic stability is represented by the volatility of actual and unexpected output growth, whereas financial stability is assessed by the aggregate Z-score and volatility of the private credit-to-gross domestic product ratio. We employ two structural and two non-structural measures of bank competition in our analysis. Applying a two-step dynamic panel system (GMM) to macroeconomic data from 48 developing nations from 1999 to 2018, we find a bell-shaped relationship between bank competition and macroeconomic stability. The findings imply that a higher level of bank competition promotes macroeconomic stability by reducing output growth volatility, fluctuations in private credit, and the probability of bank default. There is an optimal level of bank competition beyond which it may foster economic and financial instability. Moreover, financial development enhances bank competition’s positive impact on macroeconomic stability.