Contagion and banking crisis – International evidence for 2007–2009

Policy makers aim to avoid banking crises, and although they can to some extent control domestic conditions, internationally transmitted crises are difficult to tackle. This paper identifies international contagion in banking during the 2007–2009 crisis for 54 economies. We identify three channels of contagion – systematic, idiosyncratic and volatility – and find evidence for these in 45 countries. Banking crises are overwhelmingly associated with the presence of both systematic and idiosyncratic contagion. The results reveal that crisis shocks transmitted from a foreign jurisdiction via idiosyncratic contagion increase the likelihood of a systemic crisis in the domestic banking system by almost 37 percent, whereas increased exposure via systematic contagion does not necessarily destabilize the domestic banking system. Thus while policy makers and regulatory authorities are rightly concerned with the systematic transmission of banking crises, reducing the potential for idiosyncratic contagion can importantly reduce the consequences for the domestic economy.     

Cross-border interbank networks,banking risk and contagion

Recent events have highlighted the role of cross-border linkages between banking systems in transmitting local developments across national borders. This paper analyzes whether international linkages in interbank markets affect the stability of interconnected banking systems and channel financial distress within a network consisting of banking systems of the main advanced countries for the period 1994–2012. Methodologically, I use a spatial modeling approach to test for spillovers in cross-border interbank markets. The results suggest that foreign exposures in banking play a significant role in channeling banking risk: I find that countries that are linked through foreign borrowing or lending positions to more stable banking systems abroad are significantly affected by positive spillover effects. From a policy point of view, this implies that in stable times, linkages in the banking system can be beneficial, while they have to be taken with caution in times of financial turmoil affecting the whole system.     

Explaining banking stability in Sub-Saharan Africa

The study examined banking stability in Sub-Saharan Africa. The results reveal that banking spread (Net Interest Margin – NIM) is the main determinant of stability and the major means to achieve stability during crises periods. We however find the existence of a threshold effect in NIM.Crises in the banking sector consistently showed to reduce stability. While the results show that high percentage of foreign banks reduce stability, we find foreign banks help stabilize the banking sector in periods of crises. The results show that diversification could also have a positive impact on stability (Z-score) even though this relationship was not robust enough. The results also largely support the competition-fragility view. Particularly, we find that less competition during crises periods can help improve stability. Again, we find evidence for both concentration-stability and concentration-fragility hypotheses depending on the stability measure used. We however find that when large banks in concentrated markets are well regulated, stability could be improved. Weak regulatory environment reduces stability (Z-score) directly and matters during crises periods. Our results are robust to the use of different indicators of stability and estimation methods.     

Asset prices and banking distress: A macroeconomic approach

This paper links banking with asset prices in a dynamic macroeconomic model, to provide a simple characterization of financial instability. In contrast with historical bank runs, recent banking crises were driven by deteriorating bank assets. Hence, in contrast with bank run models, this paper focuses on the interaction of falling asset prices, bank losses, credit contraction and bankruptcies. This interaction can explain credit crunches, financial instability, and banking crises, either as fundamental or as self-fulfilling outcomes. The model distinguishes between macroeconomic and financial stability. Its simplicity helps understand balance sheet effects and delivers closed-form solutions without resorting to linearization. For instance, the critical threshold beyond which an asset price decline triggers financial instability can be related explicitly to the structural parameters of the economy.     

Social networks in the global banking sector

We show that banks with shared social connections partner more often in the global syndicated loan market and that central banks in the network play dominant roles in various interbank transactions, indicating that social connections facilitate business connections. However, more centralized banks in the network also contribute significantly to the global systemic risk. Moreover, we find the soft information generated by social networks is particularly valuable when potential partners operate under different accounting and regulatory standards. Finally, we show that the recent banking crisis significantly limited the positive soft information effects of social networks in the global banking system.     

Coincident correlations of growth and cash flow in banking

Prior empirical research indicates that loan growth in the banking industry is positively related to cash flow. I offer an alternative methodology that is better able to capture the effect of cash flow on loan growth while controlling for the potentially coincident effect of loan growth on cash flow. Using a sample of 171,389 observations on banks, 1986–2007, I find that causality runs more consistently from growth to cash flow than from cash flow to growth. This extends prior empirical research by Houston and James (1998) and Campello (2002) on cash flow sensitivities in the banking industry.     

The stability–concentration relationship in the Brazilian banking system

In this article, the relation between non-performing loans (NPL) of the Brazilian banking system and macroeconomic factors, systemic risk, and banking concentration is empirically tested. In evaluating this relation, we use a dynamic specification with fixed effects, while using a panel data approach. The empirical results suggest that the banking concentration has a statistically significant impact on NPL, suggesting that more concentrated banking systems may improve financial stability. These results are important for the design of banking regulation policies.     

Credit rating dynamics in the presence of unknown structural breaks

In many credit risk and pricing applications, credit transition matrix is modeled by a constant transition probability or generator matrix for Markov processes. Based on empirical evidence, we model rating transition processes as piecewise homogeneous Markov chains with unobserved structural breaks. The proposed model provides explicit formulas for the posterior distribution of the time-varying rating transition generator matrices, the probability of structural break at each period and prediction of transition matrices in the presence of possible structural breaks. Estimating the model by credit rating history, we show that the structural break in rating transitions can be captured by the proposed model. We also show that structural breaks in rating dynamics are different for different industries. We then compare the prediction performance of the proposed and time-homogeneous Markov chain models.     

Credit rating dynamics and Markov mixture models

Despite mounting evidence to the contrary, credit migration matrices, used in many credit risk and pricing applications, are typically assumed to be generated by a simple Markov process. Based on empirical evidence, we propose a parsimonious model that is a mixture of (two) Markov chains, where the mixing is on the speed of movement among credit ratings. We estimate this model using credit rating histories and show that the mixture model statistically dominates the simple Markov model and that the differences between two models can be economically meaningful. The non-Markov property of our model implies that the future distribution of a firm’s ratings depends not only on its current rating but also on its past rating history. Indeed we find that two firms with identical current credit ratings can have substantially different transition probability vectors. We also find that conditioning on the state of the business cycle or industry group does not remove the heterogeneity with respect to the rate of movement. We go on to compare the performance of mixture and Markov chain using out-of-sample predictions.     

Do liquidity measures measure liquidity?

Given the key role of liquidity in finance research, identifying high quality proxies based on daily (as opposed to intraday) data would permit liquidity to be studied over relatively long timeframes and across many countries. Using new measures and widely employed measures in the literature, we run horseraces of annual and monthly estimates of each measure against liquidity benchmarks. Our benchmarks are effective spread, realized spread, and price impact based on both Trade and Quote (TAQ) and Rule 605 data. We find that the new effective/realized spread measures win the majority of horseraces, while the Amihud [2002. Illiquidity and stock returns: cross-section and time-series effects. Journal of Financial Markets 5, 31–56] measure does well measuring price impact.     

Measuring financial stress in a developed country: An application to Canada

This paper develops an index of financial stress for the Canadian financial system. It is a continuous variable with a spectrum of values, where extreme values are called financial crises. An internal Bank of Canada survey is used to condition the choice of variables. The authors show that alternative measures of financial crisis suggested by the literature do not accurately reflect the Canadian experience, while several measures developed in this paper are more representative and are thus likely better suited to a developed financial system. An accurate characterization of stress is a prerequisite for any researcher attempting to forecast financial crises.     

Convergence and risk-return linkages across financial service firms

We examine the risk and return linkages across US commercial banks, securities firms, and life insurance companies during the 1991–2001 period. After controlling for changes in the broader stock market, interest rates, and foreign currency values, we find that return and risk interdependencies across these financial firms are significant and size-varying; larger institutions display stronger volatility transmission linkages, while smaller ones exhibit more prominent return-related linkages. The tighter link in risk among large financial institutions (FIs) suggests stronger convergence, employment of common models of risk measurement and risk management, and more intense inter-industry competition, particularly between large banks and large securities firms, compared to smaller institutions. Lack of risk spillover among smaller FIs confirms the intuition that they typically assume more localized and idiosyncratic risk. The co-movement of stock returns among smaller FIs has been helped by the effects of locally based factors, such as economic conditions and state regulations, on all such institutions, and a less diversified product set. Differences in spillover patterns between large and smaller institutions have implications on investment choices and mergers and acquisitions in the industry. Introduction of the Gramm-Leach-Bliley Act (1999) has had dissimilar effects on the riskiness of large versus smaller life insurance and securities firms, and an insignificant effect on commercial banks.     

Banking merchants and banking houses: the hidden key to the workings of the Spanish banking system in the nineteenth century

The historical study of the Spanish nineteenth-century banking system has been almost exclusively carried out through a consideration of the experiences of the joint-stock banks. But the very scarce number of these, and their territorial distribution, makes it necessary for us to look for other financial intermediaries who were able to satisfy the demand for banking services in that time and place. We demonstrate that this role was fulfilled by the banking merchants and banking houses operating through individual firms and partnerships. The object of this work is to make their activities better known and vindicate their importance. The sources used for the study are mainly the accounting documents of several banking houses.     

Price incentives and consumer payment behaviour

In this paper we estimate the effect of particular price incentives on consumer payment patterns using transaction-level data. We find that participation in a loyalty program and access to an interest-free period tend to increase credit card use at the expense of alternative payment methods, such as debit cards and cash. Interestingly though, the pattern of substitution from cash and debit cards differs according to the price incentive. An implication of the findings is that the Reserve Bank reforms of the Australian payments system are likely to have influenced observed payment patterns.     

Inflation targeting: Is IT to blame for banking system instability?

In light of the financial crisis, the practice of inflation targeting (IT) has been blamed for authorities’ failure to respond to the increase in financial systemic risk and to the development of asset bubbles. However, utilizing a rich database containing nearly 5500 commercial banks from 70 countries (among which, 22 are IT) for the period 1998–2012, this paper argues that on average, inflation targeting national banking systems (i) are more stable; (ii) possess sounder systemically important banks; and (iii) are less distressed than (or at least as distressed as) other banks during periods of global liquidity shortages. Our results are robust to a series of tests, such as when we compare countries with the same legal origins or control for the delegation of bank supervision responsibility to bodies other than the central bank. Overall, we conclude that IT cannot be blamed for contributing to financial fragility.     

Eliminating entry barriers for the provision of banking services: Evidence from ‘banking correspondents’ in Brazil

This paper shows that the contractual arrangement of ‘banking correspondents’ has eliminated entry barriers for the provision of banking services in Brazil. With the bank correspondents, banks are allowed to reach the almost 2200 municipalities without bank branches in 2000, connecting 45 million people to the financial sector. The evidence is based on the estimation of an entry model of financial providers in Brazilian municipalities. I estimate a zero population entry threshold for banking correspondents for the period from 2002 to 2007. The estimated population entry thresholds for bank branches in the same period are relatively stable at approximately 8000–9000 people. The population entry thresholds for the second to fifth players for banking correspondents are also consistently lower than those for bank branches.     

Crisis-related shifts in the market valuation of banking activities

We examine changes in banks’ market-to-book ratios over the last decade, focusing on the dramatic and persistent declines witnessed during the financial crisis. The extent of the decline and its persistence cannot be explained by the delayed recognition of losses on existing financial instruments. Rather, it is declines in the values of intangibles – including customer relationships and other intangibles related to business opportunities – along with unrecognized contingent obligations that account for most of the persistent decline in market-to-book ratios. These shifts reflect a combination of changed economic circumstances (e.g., low interest rates reduce the value of core deposits; meager growth opportunities reduce the value of customer relationships) and changed regulatory policies. Together, these changes in the business environment since the financial crisis have led investors to associate little value with intangibles. For example, changing market perceptions of the consequences of leverage have affected the way investors value banks; prior to the crisis, higher leverage, ceteris paribus, was associated with greater value (reflecting the high relative cost of equity finance), but during and after the crisis, as default risk and regulatory concerns came to the fore, lower leverage was associated with greater value. Reflecting the rising importance of regulatory risks (e.g., the uncertain consequences of the Volcker Rule), after controlling for other influences, dividend payments (a signal of management and regulatory perceptions of the persistence of financial strength) matter for market prices much more after the crisis, while increases in recurring fee income matter less.     

Order flow,dealer profitability,and price formation

We analyze the dynamics of the S&P 500 futures price, finding both short- and long-run effects of order flow on price. While price moves strongly with the order flow in the short-run, the long-run impact is slightly negative, attributable to costly slippage from a hedging propensity in futures markets. We find strong evidence of a state dependence in the relation between price and order flow, using both volume and floor trader income measures as states. We also find that both the long- and short-run impacts of order flow are greater when dealer income is higher.     

A factor analysis approach to measuring European loan and bond market integration

By using an existing and a new convergence measure, this paper assesses whether bank loan and bond interest rates are converging for the non-financial corporate sector across the euro area. Whilst we find evidence for complete bond market integration, the market for bank loans remains segmented, albeit to various degrees depending on the type and size of the loan. Factor analysis reveals that rates on large loans and small loans with long rate fixation periods have weakly converged in the sense that, up to a fixed effect, their evolution is driven by common factors only. In contrast, the price evolution of small loans with short rate fixation periods is still affected by country-specific dynamic factors. There are few signs that bank loan rates are becoming more uniform with time.