Optimal bank interest margins under capital regulation in a call-option utility framework

This paper examines the optimal bank interest margin under capital regulation when the bank's preference admits an additive call-option representation including both the like of higher equity return and the dislike of higher equity risk. In the call-option utility maximization, an increase in the capital requirement results in an increased amount of loans held by a bank at a reduced margin when loan quality is in distress. We also show that the impact on the bank interest margin from an increase in the capital requirement which ignores the dislike, that we call such behavior call-option equity maximization, leads to significant underestimation. Our results cast doubt on the effectiveness of capital regulation to exert a risk-reducing and return-increasing effect on the bank in particular where loan quality becomes worse, thereby adversely affecting the stability of the banking system.     

Default probability of a captive credit bank with government capital injections: A capped barrier option approach

Auto dealers use floorplan financing to buy cars from the original equipment manufacturer (OEM) with credit typically provided by the OEM's captive credit bank. The purpose of this paper is to explicate and model captive bank lending to dealers and determine the loan-risk default probability in equity returns of the captive bank under government capital injections during a financial crisis. The lending function of the captive bank necessitates modeling equity return as a “capped” barrier option. Numerical exercises show that a decrease in the discount rate of the floorplan financing or an increase in the amount of government capital injection decreases the default probability in equity returns of the captive bank. Floorplan or government assistance enables the captive bank to be much less prone to loan risk, specifically with large-scale dealers which can substantially affect the stability of the banking system.     

Cyclical behavior of the financial stability of eurozone commercial banks

In light of the financial crisis and the European sovereign debt crisis, we investigate the cyclical behavior of the financial stability of banks of the Eurozone, using an unbalanced dynamic panel of 722 commercial banks covering the period 1999–2013, and the generalized method of moments system. We find a negative relationship between business cycle and bank risk-taking, indicating that financial stability is procyclical. In addition, the study shows that lending activity increases risk-taking while rising capital requirements boost financial stability. Moreover, our findings suggest positive co-movements between the business cycle and lending, compared to bank's capital, whereby the procyclicality of lending and bank capital have negative effects on the financial stability of commercial banks in the Eurozone. We notice then that the cyclical behavior of commercial banks, in terms of capital requirements and lending activities, depends on their size. Therefore, lending and capital of smaller banks are procyclical while lending and capital of larger banks are countercyclical. Finally, we find the Troika institutions’ bailouts programs significantly impacted banking stability in the Eurozone.     

The Role of Foreign Capital in the Banking Sector of Korea and Its Implications for Developing Countries

The entry of foreign capital marked a significant change in the Korean banking sector. It played a critical role in transforming insolvent banks into profit-making banks. The acquisition of domestic banks by foreign private equity funds restructured the management by changing the corporate governance and pursuing result-oriented policies, while it had a negative impact on the national economy in general. Korea’s experience shows that the role of foreign private equity funds in the domestic banking sector needs to be evaluated from the perspective of both the performance of each bank and its effect on the national economy.     

A barrier option framework for rescue package designs and bank default risks

Rescue packages adopted to stabilize the banking system are generally divided into three categories: government purchases of distressed assets, government guaranteed debt issuance programs, and direct equity capital injections. Countries afflicted by the recent financial crisis launched general programs in one or two, and even in three different categories. In this paper, we examine that the design of a government rescue package for a distressed bank depends on the expected reduction of the default risk in the bank's equity returns. We find that the bank's default risk is negatively related to distressed loan purchases, and to capital injections, but positively related to guaranteed debt issuance. We also find that the rescue package including all three categories is not guaranteed to increase stability for the rescued bank. Specifically, the combination of distressed loan purchases and capital injections is superior to the package of the three categories in addition to the solo instrument. This suggests that an effective design of a government rescue package for the financial services industry largely depends on its targets.     

On the rationale of bank lending in pre-crisis Thailand

Evidence from credit files is provided to examine bank lending determinants of Thai commercial banks. Their lending practice follows reasonable patterns as a standard set of variables, including indirect risk variables, explains much of the variance in interest rate spread. Reflecting institutional differences with mature markets, we find a higher importance of relationship banking and risk control via credit availability. Information about later default reveals prudent relationship lending. However, banks could have made better use of available information about borrowers’ riskiness. These findings do not support a general verdict of bad banking but indicate room to improve lending decisions.     

How does equity capital cost affect bank performance during a financial crisis?

This article theoretically examines how equity capital cost affects return performance and safety of a bank and how this effect varies across a financial crisis comparing to a normal time when the bank manager’s performance reveals the like of higher equity return and the dislike of higher equity risk. We derive two main results. First, an increase in the bank’s equity capital cost from an increase of the interest rate of the Federal funds results in a reduced loan risk-taking at an increased optimal bank interest margin, implying better bank performance. Second, by ignoring the dislike, we find that the better performance is reinforced during a financial crisis but is reduced during a normal time. Financial crises and the dislike preference as such contribute a relatively low return and the stability of banking activities.     

Shocks to bank capital: evidence from UK banks at home and away

This article assesses how shocks to bank capital may influence a bank's portfolio behaviour using novel evidence from a UK bank panel data set from a period that predates the recent financial crisis. Focusing on the behaviour of bank loans, we extract the dynamic response of a bank to innovations in its capital and in its regulatory capital buffer. We find that innovations in a bank's capital in this (precrisis) sample period were coupled with a loan response that lasted up to 3 years. The international presence of UK banks allows us to identify a specific driver of capital shocks in our data, independent of bank lending to UK residents. Specifically, we use write-offs on loans to nonresidents to instrument bank capital's impact on UK resident lending. A fall in capital brought about a significant drop in lending in particular, to Private Nonfinancial Corporations (PNFC). In contrast, household lending increased when capital fell, which may indicate that, in this precrisis period, banks substituted into less risky assets when capital was short.     

Understanding Exchange Rate Movements during the 2008 Financial Crisis

During the 2008 financial crisis, many advanced economies, whose banking systems suffered significant capital losses, experienced large and rapid exchange rate depreciations followed by prolonged and gradual appreciation in subsequent periods. In order to understand one possible explanation of these observed exchange rate movements, we develop a simple model of a highly leveraged banking sector in which banks obtain part of their funding from abroad. A fall in bank net worth leads to foreign lenders demanding a higher risk premium on credit supplied to domestic banks. This higher risk premium can be met if the exchange rate experiences an appreciation along the adjustment path, since this raises the value of the bank's earnings in terms of the foreign currency for every period that the foreign risk premium is elevated. In order for the exchange rate to appreciate by a large amount along the adjustment path, it must initially become undervalued – relative to its long-run level – so that in equilibrium the market is willing to bid up its value in subsequent periods. This thus gives rise to the large initial depreciation of the exchange rate followed by its prolonged and gradual appreciation.     

Fiscal deficits,monetary reform and inflation stabilization in romania

Developing countries have witnessed an increase in foreign bank participation during the last decade. Using bank level data for the period 1991–2001, we examine the influence of foreign banks on the financing of small firms in Tanzania. Despite dominating the banking sector, results suggest that the financing of small firms by foreign banks is insignificant compared to domestic banks. Clearly, there is a need for a new approach to policy that will encourage significant foreign bank lending to small firms.     

Risk and regret aversions on optimal bank interest margin under capital regulation

This paper examines the bank's optimal loan rate (and thus the bank's interest margin) under more stringent capital regulation when the bank is not only risk-averse but also regret-averse. Risk-averse preferences are characterized by an option-based utility function that includes disutility from the dislike of bank equity risk. Regret-averse preferences feature an option-based utility function that includes disutility from having chosen ex-post suboptimal alternatives. We show that an increase in bank capital requirement results in an increased margin under risk aversion dominating regret aversion, whereas it results in a reduced margin under regret aversion dominating risk aversion. The former holds when risk aversion domination stems from increasing risk-averse preference, but not from decreasing regret-averse preference, while the latter holds when regret aversion domination results from either decreasing risk-averse or increasing regret-averse preference. Risk aversion, as such, makes the bank more prudent and less prone to risk-taking, while regret aversion, as such, makes the bank less prudent and more prone to risk-taking.     

The Role of Banks in Monetary Policy Transmission: Empirical Evidence from Russia

This paper focuses on the role of the banking sector in monetary policy transmission in an emerging economy with a rapidly developing financial system. Specifically, we examine whether the central bank's monetary policy stance affects banks' lending behavior. Based on a comprehensive quarterly dataset on all Russian banks from 1Q1999 to 1Q2007, we find evidence for the existence of a bank lending channel in Russia. Contrary to several studies on developed economies, the level of a bank's capitalization matters for the transmission process. Better capitalized banks are less likely to adjust their lending practices following a change in the monetary policy stance.     

THE NEW THEORY OF COMMERCIAL BANKING AND BANK LENDING BEHAVIOR

This paper studies the bank's lending decision, based on three observed phenomena: banks earn substantial profits from off‐balance sheet activities and services, which they take into account in their lending decisions. Secondly, the critical point in the customer relation is the loan decision: the probability of the customer staying with the bank is a function of the loan extended each time one is applied for. Third, what is at stake in the loan decision is the expected value of the entire customer relation, which is the probability times the present value of expected future profits. The bank is a maximizer of this expected present value, while making decisions on individual loan applications. It is shown that the bank is in a corner solution with respect to its good customers, and other customers often have an incentive to get to a corner. Therefore, corner solutions may be the rule rather than the exception in the bank's customer relations, and there is no mechanism making the bank indifferent, at the margin, between lending to different customers. It can be optimal to extend loans to (present and expected future) good customers at an interest rate loss. A rationed customer with a concave enough probability function can receive a larger loan by asking for less. Loyalty increases the customer's value to the bank but improves its loan terms only if the customer makes it conditional on the loan extended.     

Did foreign banks stay committed to emerging Europe during recent financial crises?

Our objective is to investigate empirically the behavior of foreign banks with respect to real loan growth during periods of financial crisis for a set of countries in which foreign banks dominate the banking sectors due primarily to having taken over large existing former state-owned banks. The eight countries are among the most developed in emerging Europe, their banking sectors having been modernized by the middle of the last decade. We consider a data period that includes an initial credit boom (2005 – 2007) followed by the global financial crisis (2008 & 2009) and the onset of the Eurozone crisis (2010). Our two innovations with respect to the existing literature on banking during the financial crisis are to separate foreign banks into two categories, namely, subsidiaries of the Big 6 European multinational banks (MNBs) and all other foreign-controlled banks, and to take account of the impact of exchange rates during the period. Our results show that bank lending was impacted adversely by both crises but that the two types of foreign banks behaved differently. The Big 6 banks remained committed to the region in that their lending behavior was not different from that of domestic banks supporting the notion that these countries are treated as a “second home market” by these European MNBs. Contrariwise, the other foreign banks active in the region were involved in fueling the credit boom but then decreased their lending aggressively during the crisis periods. Our results also indicate that bank behavior in countries having flexible exchange rate regimes differs from that in those in (or effectively in) the Eurozone. Our results suggest that both innovations matter for studying bank behavior during crisis periods in the region and, by extension, to other small countries in which banking sectors are dominated by foreign financial institutions having different business models.     

Monetary and banking policy transmission through interest rates: an empirical application to the USA,Canada, the UK and the Eurozone

The main purpose of this paper is an examination of the pass‐through interest rate transmission from the wholesale rates (central bank and/or money market rates) to the retail rates (deposit and lending rates) of the banking system. Knowledge of the transmission substantially helps us to calculate the pass‐through interest rate margin or mark‐up in the banking systems under examination (USA, Canada, the UK and the Eurozone). The selection of the wholesale interest rate is also an important part of this pass‐through transmission framework because it is related to the money supply process and therefore the central bank's policy capabilities. In the empirical part, a Johansen (1988) cointegration based error‐correction procedure (ECM‐GE) is implemented for the wholesale interest rate selection. Then an LSE–Hendry general‐to‐specific model (GETS) is applied, for the revelation of the banking sector pass‐through interest rate behaviour. In the empirical part, on the issue of the wholesale interest rate selection, the USA and the Eurozone seem to favour the Money Market rate while the UK and Canada favour the central bank policy rate. The results indicate two types of interest rate pass‐through behaviour, with market structure implication – namely, the US and UK banking systems contrasted with Canada–Eurozone.     

The impact of foreign capital on the Chinese banking market

In China, the foreign capital share of banks was restricted to 25% until 2006. Does such a relatively low share of foreign capital have any impact on the banking sector? In this paper, we use panel data on 19 major banks during 1996–2004 to shed light on the impact of foreign capital participation on the Chinese banking industry. We find that although the operating performance of foreign-owned banks is basically worse than that of domestic banks, as the market share of foreign-owned banks rises, they improve. For domestic banks, non-interest income decreases, while interest income increases. Therefore, the net effect of the foreign-owned banks' share on the profitability of domestic banks is small.     

Taxes,risk taking,and financial stability

After the global financial crisis, the use of taxes to enhance financial stability received new attention. This paper analyzes the corrective role of taxes in banking and compares two instruments, namely, an allowance for corporate equity (ACE), which mitigates the debt bias in corporate taxation, and a Pigovian tax on bank debt (bank levy). We emphasize financial stability gains driven by lower bank asset risk and develop a principal-agent model, in which risk taking depends on the bank's capital structure and, by extension, on the tax treatment of debt and equity. We find that (i) the ACE unambiguously reduces risk taking, (ii) bank levies reduce risk taking if they are independent of bank performance but may be counterproductive otherwise, and (iii) taxes are especially effective if regulatory capital requirements are constrained to low levels.     

Government interventions in banking crises: effects of alternative schemes on bank lending and risk taking

We analyse the effects of policy measures to stop the fall in loan supply following a banking crisis. We apply a dynamic framework in which a debt overhang induces banks to curtail lending or choose a fragile capital structure. Government assistance conditional on new banking activities, like on new lending or on debt and equity issues, allow banks to influence the scale of assistance and externalise risks, implying overinvestment or excessive risk taking or both. Assistance without reference to new activities, like granting lump sum transfers or establishing bad banks, does not generate adverse incentives, but may have higher fiscal costs.     

The Impact of Foreign Entry on Chinese Banks

Utilizing hand collected data concerning foreign ownership in the Chinese banking sector, we examine whether foreign ownership improves the efficiency of Chinese banks. Foreign banks tend to provide cooperation in retail banking rather than in corporate or private banking. We find no robust evidence of an improvement in the efficiency of an average bank that receives foreign strategic investments. However, the bank cost and profit efficiency significantly improve when foreign strategic investments provide retail banking and internal control assistance respectively to local banks. These findings suggest that foreign investment improves local bank efficiency when it transfers technologies that are lacking in local banks.     

The transmission of bank capital requirements and monetary policy to bank lending in Germany

We investigate the transmission of changes in bank capital requirements and monetary policy, and their interaction, on German banks’ corporate loan growth and lending rates. Our results show that increases in capital requirements are associated with an immediate decrease in total domestic and cross‐border bank lending. Changes in the euro area's monetary policy stance are positively related to corporate loan interest rates in general. Regarding the interacting effect of national bank capital requirements and euro area monetary policy, we observe that the transmission of accommodative euro area monetary policy to corporate lending rates can be attenuated by contemporaneous increases in bank capital requirements. Moreover, more strongly capitalized banks increase their loan growth in response to accommodative monetary policy whereas, for weaker banks, increasing capital requirements implies a decrease in their corporate loan growth. Our results confirm a tradeoff between higher capital requirements and accommodating monetary policy originating from banks’ capital constraints.