Do subordinated debt holders discipline bank risk-taking? Evidence from risk management decisions

I test the market discipline of bank risk hypothesis by examining whether banks choose risk management policies that account for the risk preferences of subordinated debt holders. Using around 500,000 quarterly observations on the population of U.S. insured commercial banks over the 1995–2009 period, I document that the ratio of subordinated debt affects bank risk management decisions consistent with the market discipline hypothesis only when subordinated debt is held by the parent holding company. In particular, the subordinated debt ratio increases the likelihood and the extent of interest rate derivatives use for risk management purposes at bank holding company (BHC)-affiliated banks, where subordinated debt holders have a better access to information needed for monitoring and control rights provided by equity ownership. At non-affiliated banks, a higher subordinated debt ratio leads to risk management decisions consistent with moral hazard behavior. The analysis also shows that the too-big-to-fail protection prevents market discipline even at BHC-affiliated banks.     

The market structure effects of commercial bank entry into underwriting: Evidence from the league tables

This study investigates the market structure effects of the deregulation of the US underwriting industry that allowed commercial banks to expand into investment banking activities. Specifically, it analyses the gains of commercial banks in market rankings and market share, the market position of the traditional top-ranked firms and changes in market concentration. The overall evidence suggests that (a) commercial banks were successful in gaining market share in underwriting, especially in debt offerings; (b) the commercial bank entry into underwriting eroded the dominance of bulge-bracket firms in debt underwriting, but not in equity offerings, where their dominance intensified; and (c) the commercial bank entry helped reduce market concentration in debt but not in equity underwriting. Finally, the study finds that the market share of commercial banks in equity offerings increases when equity underwriting volume rises, whereas market concentration in debt offerings increases when debt underwriting volume falls.     

Equity market information,bank holding company risk,and market discipline

For market discipline to be effective, market factors such as changes in firm equity and debt values and returns, must influence firm decision making. In banking, this can occur directly via bank management or indirectly though supervisory examinations and oversight influencing bank management. In this study, we investigate whether equity market variables can provide timely information and add value to accounting models that predict changes in bank holding company (BOPEC) risk ratings over the 1988–2000 period. Using a variety of equity market indicators, the findings suggest that one-quarter lagged market data adds forecast value to lagged financial statement data and prior supervisory information in the logistic regressions. Furthermore, using extensive out-of-sample testing for the years 2001–2003, we find: (1) that multiple models estimated over different phases of the business and banking cycles are superior to a single model for forecasting BOPEC rating changes; (2) that equity data adds economically significant power in forecasting BOPEC rating upgrades and performs well for identifying no changes; (3) that for downgrades, the accounting model forecasts the best; (4) that modeling the three possible risk ratings categories simultaneously (downgrade, no change and upgrade) minimizes both Type I and Type II classification errors; and (5) that using multiple models to forecast risk ratings enhances the overall percentage of correct classifications.     

The 2007–2009 financial crisis and bank opaqueness

Doubts about the accuracy with which outside investors can assess a banking firm’s value motivate many government interventions in the banking market. Although the available empirical evidence is somewhat mixed, the recent financial crisis has reinforced a common assessment that banks are unusually opaque. This paper examines bank equity’s trading characteristics during “normal” periods and two “crisis” periods between 1993 and 2009. We find only limited (mixed) evidence that banks are unusually opaque during normal periods. However, consistent with theory, crises raise the adverse selection costs of trading bank shares relative to those of nonbank control firms. A bank’s balance sheet composition significantly affects its equity opacity, but we cannot detect specific balance sheet categories that have robust effects.     

Banking regulation and the output cost of banking crises

Using a cross-section time-series of 47 banking crisis episodes in 35 industrial and emerging market economies between the 1970s and 2003, this study analyses the relationship between banking regulation and supervision, and the severity of banking crises measured in terms of the magnitude of output loss. The empirical results show that countries that provide comprehensive deposit insurance coverage and enforce strict bank capital adequacy requirements experience a smaller output cost of crises. Restrictions on bank activities also influence the severity of crises. The results, however, do not suggest that there is a significant impact of bank supervision. In addition, there is no robust evidence that the magnitude of the output cost of crises depends on the extent of banks’ financial intermediation.     

Bank stock returns and economic growth

Previous research has established (i) that a country’s financial sector influence future economic growth and (ii) that stock market index returns affect future economic growth. We extend and tie together these two strands of the growth literature by analyzing the relationship between banking industry stock returns and future economic growth. Using dynamic panel techniques to analyze panel data from 18 developed and 18 emerging markets, we find a positive and significant relationship between bank stock returns and future GDP growth that is independent of the previously documented relationship between market index returns and economic growth. We also find that much of the informational content of bank stock returns is captured by country-specific and institutional characteristics, such as bank-accounting-disclosure standards, banking crises, enforcement of insider trading law and government ownership of banks.     

Capital Market Regimes and Bank Structure in Europe

We hypothesize that fundamental features that distinguish European capital markets have predictably influenced emerging national differences in bank capitalization and loan growth. Using bank‐level data from 13 European countries, 1998 to 2004, we find evidence of positive effects of “equity‐friendly” market features on bank capitalization and positive effects of both “equity‐friendly” and “credit‐friendly” market features on loan growth. The findings are strongest in small banks and in banks with cooperative charters. Our results suggest that ongoing and prospective integration of European banking markets is mitigated by relatively static features of the equity and credit markets on which banks rely.     

Corporate valuation and the resolution of bank insolvency in East Asia

We examine the valuation effect of the resolution of a bank’s insolvency on commercial clients. Our sample includes 29 insolvent banks in Indonesia, Korea, and Thailand that serve as main creditors for 269 publicly traded companies. Our findings suggest that a bank relationship adds value to a firm, and that this value depends on investors’ certainty in the continuity of the banking relationship. Significant cumulative returns for 50 days following the event date suggest that the type of resolution has real effects on the performance of related firms above initial expectations.     

On the wealth and risk effects of commercial bank expansion into securities underwriting: An analysis of Section 20 subsidiaries

We investigate the abnormal returns and market-based risk effects of four Federal Reserve Board decisions to allow bank holding companies to engage in investment banking through Section 20 subsidiaries. Positive abnormal returns for commercial banks were observed for initial, limited powers granted by the Federal Reserve. However, authorization to engage in underwriting corporate debt and equity and subsequent expansion of potential revenues from underwritings produced negative abnormal returns and increases in risk.     

Anatomy of a bail-in

To mitigate potential contagion from future banking crises, the European Commission recently proposed a framework which would provide for the bail-in of bank creditors in the event of failure. In this study, we examine this framework retrospectively in the context of failed European banks during the global financial crisis. Empirical findings suggest that equity and subordinated bond holders would have been the main losers from the €535 billion impairment losses realized by failed European banks. Losses attributed to senior debt holders would, on aggregate, have been proportionally small, while no losses would have been imposed on depositors. Cross-country analysis, incorporating stress-tests, reveals a divergence of outcomes with subordinated debt holders wiped out in a number of countries, while senior debt holders of Greek, Austrian and Irish banks would have required bail-in.     

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.     

The Regulation of Private Money*

Financial crises are bank runs. At root, the problem is short-term debt (private money), which while an essential feature of market economies, is inherently vulnerable to runs in all its forms (not just demand deposits). Bank regulation aims at preventing bank runs. History shows two approaches to bank regulation: the use of high-quality collateral to back banks’ short-term debt and government insurance for the short-term debt. Also, explicit or implicit limitations on entry into banking can create charter value (an intangible asset) that is lost if the bank fails. This can create an incentive for the bank to abide by the regulations and not take too much risk.     

Does the market discipline banks? New evidence from regulatory capital mix

While bank capital requirements permit a bank to freely substitute between equity and subordinated debt, lenders and investors view debt and equity as imperfect substitutes. It follows that, after controlling for the level of regulatory capital, the mix of debt in capital isolates the role that the market plays in disciplining banks. I document that the mix of debt in capital affects bank behavior, but only when investors can impose real constraints. In particular, the mix of debt reduces the probability of failure and future distress for BHC-affiliated institutions (where the investor has control rights through an equity position) and for stand-alone banks before the Basel Accord (when debt issues included restrictive covenants). However, substituting equity for subordinated debt at the bank holding company level or in stand-alone banks since the Basel Accord (where the investor has few protections) only increases the probability of distress and failure.     

Bank competition,concentration and EU SME cost of debt

Despite the plentiful debate on the effects of bank competition on SME access to finance and growth, only few studies have explored the impacts on SME cost of debt. This study examines how bank market power affects the credit costs of SMEs by using unique matched SME-bank data from 17 EU countries. We show that bank market power reduces the cost of debt for SMEs. Such a favorable effect is stronger for SMEs that are less informationally transparent, and in the economies subject to less credit information depth and business extent of disclosure. These findings support the Information-based Hypothesis, whereby market power motivates banks to invest in soft information acquisition and to build lending relationships to reduce information costs. In addition, we show that despite the favorable effects of relationship lending brought by bank market power, SME credit conditions worsen in a more concentrated banking market.     

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).     

Banking industry volatility and banking crises

While studies using balance sheet information of banks and macroeconomic indicators to forecast banking crises are prolific, empirical research using market information of banks is relatively sparse. We investigate whether banking industry volatility, constructed with the disaggregated approach from Campbell et al. [Campbell, J.Y., Lettau, M., Malkiel, B.G., Xu, Y., 2001. Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk? The Journal of Finance 56, 1–43] using exclusively publicly available market information of banks, is a good predictor of systemic banking crises in the analyses including data from 18 developed and 18 emerging markets. We find that banking industry volatility performs well in predicting systemic banking crises for developed markets but very poor for emerging markets, which suggest that the impact of market forces on the soundness of the banking system might be different for developed and emerging markets. We also find that those macroeconomic and banking risk management indicators have different impact on the probability of banking crises. Therefore, the traditional cross-country results of the studies on banking crises need to be interpreted cautiously.     

The fading stock market response to announcements of bank bailouts

We analyze the effects on bank valuation of government policies aimed at shoring up banks’ financial conditions during the 2008–2009 financial crisis. Governments injected into troubled institutions massive amounts of fresh capital and/or guaranteed bank assets and liabilities. We employ event study methodology to estimate the impact of government-intervention announcements on bank valuation. Using traditional approaches, announcements directed at the banking system as a whole were associated with positive cumulative abnormal returns, whereas announcements directed at specific banks with negative ones. Findings are consistent with the hypothesis that individual institutions were reluctant to seek public assistance. However, when we correct standard errors for bank-and-time effects, virtually all announcement impacts vanish in Europe, whereas they weaken in the United States. The policy implication is that the large public commitments were either not credible or deemed inadequate relative to the underlying financial difficulties of banks.     

A Model of Shadow Banking

We present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry‐ups when investors neglect tail risks.     

Should banks be geographically diversified? Empirical evidence from cross-country diversification of European banks

Using a sample of European bank, this paper investigates the impact of banks' geographic diversification on their cost of equity capital. Examining the geographic diversification of European banks gives an insight on the value of cross-border banking. To measure diversification between major geographic areas in which the bank operates, the Herfindahl–Hirschman Index, based on revenues generated at home and abroad is constructed for each bank. To address the problem of endogeneity, system generalized method of moments estimator is used. The main finding of the analysis is that, other things equal, more geographic diversified banks have higher cost of equity capital than geographically focused ones. This result implies that the adverse market valuation effect of geographic diversification (increase in agency problem) dominates the positive ones (increase in efficiency and reduction in risk).     

Financial markets development,business cycles,and bank risk in South America

In this paper, we examine whether banking crises or business cycles affect the influence of financial markets development on bank risk in a sample of 37 publicly listed commercial banks in seven South American countries over a 22-year period between 1991 and 2012. Banking crises in this region offer a natural setting in which the impact of financial markets development on bank risk is examined. We find that financial markets development improves banks’ capitalization ratio and reduces their exposure to non-traditional banking activities, suggesting that financial markets development on average reduces bank risk. In addition, banking crises and business cycles appear to moderate the impact of financial markets development on bank risk. In the aftermath of banking crises, banks appear to concentrate more on their core traditional banking activities.