Quantifying structural subsidy values for systemically important financial institutions

Claimants to Systemically Important Financial Institutions (SIFIs) would receive transfers when governments are forced into bailouts. Ex ante, this bailout expectation lowers SIFIs’ daily funding costs. The funding cost advantage reflects both the structural level of the government support and the time-varying market valuation for such a support. Based on a large worldwide sample of banks, we estimate the value of the structural subsidy, by exploiting expectations of state support embedded in credit ratings and by applying the long-run average value of the rating bonus. The value of the structural subsidy was already sizable, 60 basis points (bp), as of the end-2007, before the crisis. It increased to 80 bp by the end-2009.     

A framework for assessing the systemic risk of major financial institutions

In this paper we propose a framework for measuring and stress testing the systemic risk of a group of major financial institutions. The systemic risk is measured by the price of insurance against financial distress, which is based on ex ante measures of default probabilities of individual banks and forecasted asset return correlations. Importantly, using realized correlations estimated from high-frequency equity return data can significantly improve the accuracy of forecasted correlations. Our stress testing methodology, using an integrated micro–macro model, takes into account dynamic linkages between the health of major US banks and macro-financial conditions. Our results suggest that the theoretical insurance premium that would be charged to protect against losses that equal or exceed 15% of total liabilities of 12 major US financial firms stood at $110 billion in March 2008 and had a projected upper bound of $250 billion in July 2008.     

Capital requirements under the credit risk-based framework

This work aims to study the hypothesis of lower capitalization of banks under the risk-based rules introduced in Basel II. In this sense, an assessment of the impact of these rules on the capital requirements for non-financial firms’ credit risk is performed. A comparison with Basel I is presented and intervals of variation for the risk drivers such that capital requirements exceed the ones under Basel I are established. Data for a European country supports the hypothesis of a smaller capitalization of banks under the risk-based framework, as far as credit risk in concerned.     

Assessing financial contagion in the interbank market: Maximum entropy versus observed interbank lending patterns

Interbank markets allow banks to cope with specific liquidity shocks. At the same time, they may represent a channel for contagion as a bank default may spread to other banks through interbank linkages. This paper analyses how contagion propagates within the Italian interbank market using a unique data set including actual bilateral exposures. Based on the availability of information on actual bilateral exposures for all Italian banks, the results obtained by assuming the maximum entropy are compared with those reflecting the observed structure of interbank claims. The comparison indicates that, under certain circumstances, depending on the structure of the interbank linkages, the recovery rates of interbank exposures and banks’ capitalisation, the maximum entropy approach overrates the scope for contagion.     

Systemically important banks and financial stability: The case of Latin America

This paper addresses the issue on how bank size and market concentration affect performance and risks in 17 Latin American countries between 2001 and 2008. The objective is to evaluate whether a too-big-to-fail behavior has been present in the region. Surprisingly, we do not find evidence to support a higher fragility of large Latin American banks. Our results show that systemically important financial institutions appear to outperform others in terms of both cost and profit without the need of taking more risks. This result holds even in concentrated markets, i.e., where there are few dominant banks and many others with small size in relation to the market. A highly unequal banking market in terms of assets, however, is detrimental for the performance of smaller banks and it also decreases stability of the whole system. We conclude that regulators should deal with market concentration by reducing the size gap between large and small banks, instead of dealing specifically with systemically important banks.     

Missing elements in US financial reform: A Kübler-Ross interpretation of the inadequacy of the Dodd-Frank Act

The success of any treatment plan depends on how completely the problems it targets have been diagnosed. The precrisis bubble in securitization can be traced to incentive conflict that allows national safety nets to subsidize leveraged risk-taking. Safety-net subsidies encouraged regulation-induced innovations that enabled firms to take hard-to-monitor risks and to make themselves politically, administratively, and economically difficult for government officials to fail and unwind.This paper summarizes the incentive conflicts that led creditors and internal and external supervisors to short-cut and outsource due diligence. The Dodd-Frank strategy of reform does not adequately acknowledge or address these conflicts. The key step needed is to develop an effective statistical metric for measuring the ex ante value of safety-net support in the aggregate and at individual institutions. To accomplish this, government and industry need to rethink the informational obligations that insured financial institutions and their regulators owe to taxpayers as de facto investors and to change the way that information on industry balance sheets and risk exposures is reported, verified, and used. Without reforms in the practical duties imposed on industry and governmental officials and in the way these duties are enforced, financial safety nets will continue to expand and their expansion will undermine financial stability by generating large rewards for creative and aggressive risk-takers that are smart enough to cash in their share of safety-net benefits before they evaporate.     

Interest rate smoothing and financial stability

Central banks smooth fluctuations in interest rates based on a belief that this policy promotes financial stability. This belief is based on a presumption that the direct effect of less interest rate volatility on a bank's likelihood of insolvency is the predominant effect of this policy. The main point of this paper is that these policies also give rise to indirect effects that lower financial stability. These indirect effects occur because the policy itself alters bank behavior. In effect, if the central bank provides (liquidity) insurance (at zero premia), it may introduce a classic moral hazard problem that encourages risk taking by banks. As a result, to maintain a given degree of financial stability, a bank regulator may, in fact, need to impose a higher prudential capital requirement when an interest rate smoothing policy is in place. The paper concludes that the link between interest rate smoothing policy and financial stability may be more complicated than is generally recognized.     

Deposit insurance, bank regulation, and financial system risks

Empirical evidence is presented to show that in modern times banks can hedge liquidity shocks but could not do so prior to FDIC insurance. However, the government's limitations in properly pricing FDIC insurance are leading to many current examples of moral hazard. A model is presented to show that if insurance premiums are set to be “actuarially fair,” incentives for banks to take excessive systematic risks remain. Motivated by empirical evidence that money market mutual funds also can hedge liquidity shocks, I consider an alternative government insurance system that mitigates distortions to risk-taking yet preserves liquidity hedging and information synergies.     

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.     

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.     

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.     

Consolidation in banking and financial stability in Europe: Empirical evidence

Using aggregate balance sheet data from banks across the EU-25 over the period from 1997 to 2005 we provide empirical evidence that national banking market concentration has a negative impact on European banks’ financial soundness as measured by the Z-score technique while controlling for macroeconomic, bank-specific, regulatory, and institutional factors. Furthermore, our analysis reveals that Eastern European banking markets exhibiting a lower level of competitive pressure, fewer diversification opportunities and a higher fraction of government-owned banks are more prone to financial fragility whereas capital regulations have supported financial stability across the entire European Union.     

The economics of conflicts of interest in financial institutions

A conflict of interest exists when a party to a transaction can gain by taking actions that are detrimental to its counterparty. This paper examines the growing empirical literature on the economics of conflicts of interest in financial institutions. Economic analysis shows that, although conflicts of interest are omnipresent when contracting is costly and parties are imperfectly informed, there are important factors that mitigate their impact and, strikingly, it is possible for customers of financial institutions to benefit from the existence of such conflicts. The empirical literature reaches conclusions that differ across types of conflicts of interest but are overall more ambivalent and certainly more benign than the conclusions drawn by journalists and politicians from mostly anecdotal evidence.     

Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time

A main cause of the crisis of 2007-2009 is the various ways through which banks have transferred credit risk in the financial system. We study the systematic risk of banks before the crisis, using two samples of banks respectively trading Credit Default Swaps (CDS) and issuing Collateralized Loan Obligations (CLOs). After their first usage of either risk transfer method, the share price beta of these banks increases significantly. This suggests the market anticipated the risks arising from these methods, long before the crisis. We additionally separate this beta effect into a volatility and a market correlation component. Quite strikingly, this decomposition shows that the increase in the beta is solely due to an increase in banks’ correlations. Thus, while banks may have shed their individual credit risk, they actually posed greater systemic risk. This creates a challenge for financial regulation, which has typically focused on individual institutions.     

The pernicious effects of contaminated data in risk management

Banks hold capital to guard against unexpected surges in losses and long freezes in financial markets. The minimum level of capital is set by banking regulators as a function of the banks’ own estimates of their risk exposures. As a result, a great challenge for both banks and regulators is to validate internal risk models. We show that a large fraction of US and international banks uses contaminated data when testing their models. In particular, most banks validate their market risk model using profit-and-loss (P/L) data that include fees and commissions and intraday trading revenues. This practice is inconsistent with the definition of the employed market risk measure. Using both bank data and simulations, we find that data contamination has dramatic implications for model validation and can lead to the acceptance of misspecified risk models. Moreover, our estimates suggest that the use of contaminated data can significantly reduce (market-risk induced) regulatory capital.     

Concentrated control,institutions, and banking sector: An international study

Using a broad sample of listed commercial banks in East Asia and Western Europe, this paper investigates the relations among concentrated control, a set of bank operating characteristics, and legal and regulatory regimes. We find that banks with concentrated control exhibit poorer performance, lower cost efficiency, greater return volatility, and higher insolvency risk, relative to widely held ones. We also document that legal institutions and private monitoring effectively reduce the detrimental effects of concentrated control and that official disciplinary power plays a weak governance role, whereas government intervention exacerbates the adverse effects. Further evidence shows that the relations between control concentration and bank operating characteristics are curvilinear and vary according to the types of controlling owners. Overall, our findings support the contention that country-level institutions play important roles in constraining insider expropriation, and that private monitoring mechanisms are more effective than are public rules and supervision in governing banks.     

A perspective on the symptoms and causes of the financial crisis

Prior to the 2007–2008 financial crisis, banking sector profits were very high but the profitability of financial intermediation was poor. Using a novel model of banking, this article argues that the high profits were achieved through balance sheet expansion and growing default, liquidity, and term risk mismatches between assets and liabilities. As a result, large banks’ financial leverage rose as they became less liquid, setting the conditions for a systemic banking crisis. This article argues that the increase in financial leverage was possible due to misguided changes in the regulatory framework, specifically, the Basel I capital accord and reductions in reserve requirements. Finally, this article overviews and assesses the policy response in the aftermath of the crisis.     

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.     

Earnings expectations and the quality of financial services

Using complaint data filed by consumers with the Consumer Financial Protection Bureau against financial institutions, we show that banks receive, on average, 13.3% more customer complaints in the quarter immediately after they narrowly beat analysts’ earnings forecasts. The effect is mainly driven by banks’ attempts to reduce their non-interest expenses to beat earnings benchmarks. The relationship is stronger when bank CEOs receive a greater proportion of incentive-based compensation. Overall, our paper demonstrates how capital market incentives exacerbate shareholder–customer conflicts.     

Liquidity Provision,Bank Capital,and the Macroeconomy

New bank equity must come from somewhere. In general equilibrium, raising bank capital requirements means either that banks produce less short‐term debt (as debt holders must become shareholders), or short‐term debt is not reduced and the banking system acquires nonbank equity (as the shareholders in nonbanks become shareholders in banks). The welfare effects involve a trade‐off because bank debt is special as it is used for transactions purposes, but more bank capital can reduce the chance of bank failure (producing welfare losses).