Bank activity and funding strategies: The impact on risk and returns

This paper examines the implications of bank activity and short-term funding strategies for bank risk and return using an international sample of 1,334 banks in 101 countries leading up to the 2008 financial crisis. Expansion into noninterest income-generating activities such as trading increases the rate of return on assets, and it could offer some risk diversification benefits at very low levels. Nondeposit, wholesale funding in contrast lowers the rate of return on assets, while it can offer some risk reduction at commonly observed low levels of nondeposit funding. A sizable proportion of banks, however, attract most of their short-term funding in the form of nondeposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating noninterest income or attracting nondeposit funding are very risky, consistent with the demise of the US investment banking sector.     

Portfolio analysis of asset and liability management in small-, medium- and large-sized banks

The paper presents an analysis of the commercial banking firm based on Markowitz portfolio analysis. A bank is treated as a portfolio of five banking assets and three banking liabilities. The average rate of return and risk of each asset and liability is estimated empirically for groups of banks categorized by size — small, medium and large. Banks' rates return on equity are defined as the weighted average of the assets' rates of return less the liabilities' rates of return. Quadratic programming is used to delineate the set of banking portfolios which have the maximum rate of return on equity at each level of risk.     

The integrated impact of credit and interest rate risk on banks: A dynamic framework and stress testing application

Credit and interest rate risk are the two most important risks faced by commercial banks in their banking book. In this paper we derive a consistent and comprehensive framework to measure the integrated impact of both risks. By taking account of the repricing characteristics of assets, liabilities and off balance sheet items, we assess the integrated impact of credit and interest rate risk on banks’ economic value and capital adequacy. We then stress test a hypothetical but realistic bank using our framework and show that it is fundamental to measure the impact of credit and interest rate risk jointly.     

Does the stock market value bank diversification?

This paper investigates whether or not functionally diversified banks have a comparative advantage in terms of long-term performance/risk profile compared to their specialized competitors. To that end, this study uses market-based measures of return potential and bank risk. We calculate the franchise value over time of European banks as a measure of their long-run performance potential. In addition, we measure risk as both the systematic and the idiosyncratic risk components derived from a bank stock return model. Finally, we analyze the return/risk trade-off implied in different functional diversification strategies using a panel data analysis over the period 1989–2004. A higher share of non-interest income in total income affects banks’ franchise values positively. Diversification of revenue streams from distinct financial activities increases the systematic risk of banks while the effect on the idiosyncratic risk component is non-linear and predominantly downward-sloping. These findings have conflicting implications for different stakeholders, such as investors, bank shareholders, bank managers and bank supervisors.     

Bank panics and the endogeneity of central banking

Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets, so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with well-diversified big banks are less prone to inefficient bank runs because diversification alleviates the information asymmetry. In addition, big banks can self-monitor through publicly observable branch closure. Systems of many small banks form incentive-compatible bank coalitions to emulate the big banks during times of crisis. Such coalitions improve efficiency by monitoring member banks and issuing money that is a kind of deposit insurance—a precursor of central banking.     

Do different forms of government ownership matter for bank capital behavior? Evidence from China

This study attempts to reconcile the conflicting theoretical predictions regarding how government ownership affects bank capital behaviour. Using a unique Chinese bank dataset over 2006–2015 we find that government-owned banks have higher target capital ratios and adjust these ratios faster compared to private banks, supporting the ‘development/political’ view of the government’s role in banking. This effect is stronger for local government-owned and state enterprise-owned banks than for central government-owned banks. We also find that undercapitalized government-owned banks increase equity while undercapitalized foreign banks contract assets and liabilities as their respective main strategy to adjust their capital ratios.     

Parliamentary election cycles and the Turkish banking sector

This paper analyzes the effects of parliamentary election cycles on the Turkish banking system. Using annual bank-level data representing all banks in Turkey during 1963–2007, we present evidence of meaningful differences in the structure of bank assets, liabilities and financial performance across different stages of the parliamentary election cycle. However, we find that government-owned banks’ behavior does not meaningfully differ from that of either domestic and foreign-owned private-sector banks before, during or after elections. Our estimates also show that government-owned banks underperform both domestic and foreign-owned private-sector counterparts.     

The liquidity of bank assets and banking stability

This paper shows that an increased liquidity of bank assets, paradoxically, increases banking instability and the externalities associated with banking failures. This is because even though higher asset liquidity directly benefits stability by encouraging banks to reduce the risks on their balance sheets and by facilitating the liquidation of assets in a crisis, it also makes crises less costly for banks. As a result, banks have an incentive to take on an amount of new risk that more than offsets the positive direct impact on stability.     

The use of blanket guarantees in banking crises

Policymakers often use guarantees on bank liabilities to prevent or contain bank runs during systemic banking crises, but their success has been debated. Using a sample of 42 episodes of banking crises, this paper finds that blanket guarantees do help to reduce liquidity pressures on banks, but only partially since they do not stem withdrawals from non-residents. Withdrawals following the announcement of guarantees are much more pronounced for non-resident liabilities than for foreign-currency denominated deposits—which may also be held by residents—suggesting that the results on non-residents are not driven by foreign-currency risk but by concerns about the government’s ability and commitment to honor the guarantee to non-resident liability holders.     

What determines the profitability of banks? Evidence from Spain

This paper empirically analyses the factors that determine the profitability of Spanish banks for the period of 1999–2009. We conclude that the high bank profitability during these years is associated with a large percentage of loans in total assets, a high proportion of customer deposits, good efficiency and a low doubtful assets ratio. In addition, higher capital ratios also increase the bank’s return, but only when return on assets (ROA) is used as the profitability measure. We find no evidence of either economies or diseconomies of scale or scope in the Spanish banking sector. Finally, our study reveals differences in the performance of commercial and savings banks.     

Measuring systemic risk: A risk management approach

This paper proposes a new method to measure and monitor the risk in a banking system. Standard tools that regulators require banks to use for their internal risk management are applied at the level of the banking system to measure the risk of a regulator’s portfolio. Using a sample of international banks from 1988 until 2002, I estimate the dynamics and correlations between bank asset portfolios. To obtain measures for the risk of a regulator’s portfolio, I model the individual liabilities that the regulator has to each bank as contingent claims on the bank’s assets. The portfolio aspect of the regulator’s liability is explicitly considered and the methodology allows a comparison of sub-samples from different countries. Correlations, bank asset volatility, and bank capitalization increase for North American and somewhat for European banks, while Japanese banks face deteriorating capital levels. In the sample period, the North American banking system gains stability while the Japanese banking sector becomes more fragile. The expected future liability of the regulator varies substantially over time and is especially high during the Asian crisis starting in 1997. Further analysis shows that the Japanese banks contribute most to the volatility of the regulator’s liability at that time. Larger and more profitable banks have lower systemic risk and additional equity capital reduces systemic risk only for banks that are constrained by regulatory capital requirements.     

Bank liabilities channel

The financial intermediation sector is important not only for channeling resources from agents in excess of funds to agents in need of funds (lending channel). By issuing liabilities it also creates financial assets held by other sectors of the economy for insurance or liquidity purpose. When the intermediation sector creates less liabilities or their value falls, agents are less willing to engage in activities that are individually risky but desirable in aggregate (bank liabilities channel). The paper shows how financial crises driven by self-fulfilling expectations about the liquidity of the banking sector are transmitted to the real sector of the economy. Since the government could also create financial assets by borrowing, the paper analyzes how public debt affects the issuance of liabilities by the financial intermediation sector.     

中国银行业系统流动性风险考察与控制——基于资产抛售价格视角

基于银行业在宏观风险来临时出现的流动性不足和系统性风险,通过建立 DSGE-VAR 模型,考量银行业在宏观经济运行框架下的系统流动性风险,结果发现:银行同业借贷、其他证券资产和交易性负债业务的综合作用会使得银行系统流动性风险总体增大,银行如果想要降低存款提取率对其流动性的影响,就要在银行间市场停止拆出资金、出售政府证券及其他流动资产,并出售潜在的流动性较低的资产.从监管层面来讲,应当通过监管的引导效应将交易性负债进行转化,引导同业借贷和其他证券资产业务向平衡区域集中,并在一定范围内减少银行其他证券资产业务的规模.     

The relationship between net interest margin and noninterest income using a system estimation approach

This paper examines the determinants of bank net interest margin (NIM) and non-traditional banking activities (NII). A system estimation approach is employed to control for the simultaneity between NIM and NII for commercial banks in a group of 28 financially liberalized countries during the period between 1997 and 2004. We find a statistically significant negative relationship between NIM and NII for the period between 1997 and 2002. A generally positive but statistically insignificant association between NIM and NII is found for the subsequent period (2003–2004). Banks’ increasing involvement in non-traditional activities is negatively correlated with risk-adjusted profitability measures in the former subperiod, suggesting no obvious diversification benefits. However, the share of noninterest income is positively related to the return on assets (ROA) and the return on equity (ROE) for the latter subsample.     

The impact of opacity on bank valuation during the global financial crisis: A channel analysis

Prior literature suggests that opacity in the banking industry is mainly caused by a lack of informativeness in the assessment of the quality of bank assets. Examining a sample of bank holding companies in the United States, we find that there is a negative relationship between opacity and bank valuation during the 2007–2009 global financial crisis. We further attempt to identify two potential channels through which opacity negatively affects bank valuation during the financial crisis: a cash flow channel and an expected return channel. We show that one channel flows from bank profitability, measured by return on equity and return on assets, confirming a cash flow channel, whereas an expected return channel, proxied by the implied cost of capital, only works for small banks. Overall, this study sheds light on the relationship between in-transparency and bank value discount during a global recession.     

How does competition affect bank risk-taking?

A common assumption in the academic literature and in the supervision of banking systems is that franchise value plays a key role in limiting bank risk-taking. As market power is the primary source of franchise value, reduced competition in banking markets has been seen as promoting banking stability. A recent paper by Martínez-Miera and Repullo (MMR, 2010) shows that a nonlinear relationship theoretically exists between bank competition and risk-taking in the loan market. We test this hypothesis using data from the Spanish banking system. After controlling for macroeconomic conditions and bank characteristics, we find support for this nonlinear relationship using standard measures of market concentration in both the loan and deposit markets. When direct measures of market power, such as Lerner indices, are used, the empirical results are more supportive of the original franchise value hypothesis, but only in the loan market. Overall, the results highlight the empirical relevance of the MMR model, even though further analysis across other banking markets is needed.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

Regime switching based portfolio selection for pension funds

This paper shows how a mean variance criterion can be applied to a multi period setting in order to obtain efficient portfolios in an asset and liability context. The optimization model allows for rebalancing activities, transaction costs, stochastic volatilities for both assets and liabilities. Furthermore, a general framework for the projection of pension fund liabilities as well as for the generation of asset returns is given. In a further step the dynamics of the liability maturity structure is modeled as customized index, whose volatility and correlation with asset returns become integral components of the applied regime switching approach. The numerical results illustrate the diversification of the assets and its risk return pattern in dependency of the liability dynamics.     

Measuring Liquidity Mismatch in the Banking Sector

This paper constructs a liquidity mismatch index (LMI) to gauge the mismatch between the market liquidity of assets and the funding liquidity of liabilities, for 2,882 bank holding companies over 2002 to 2014. The aggregate LMI decreases from +$4 trillion precrisis to ?$6 trillion in 2008. We conduct an LMI stress test revealing the fragility of the banking system in early 2007. Moreover, LMI predicts a bank's stock market crash probability and borrowing decisions from the government during the financial crisis. The LMI is therefore informative about both individual bank liquidity and the liquidity risk of the entire banking system.     

An economic capital model integrating credit and interest rate risk in the banking book

Banks often measure credit and interest rate risk in the banking book separately and then add the risk measures to determine economic capital. This approach misses complex interactions between the two risk types. We develop a framework where these risks are analysed jointly. Since banking book positions are generally not marked to market, our model is based on book value accounting. Our simulations show that interactions matter, and that ignoring them leads to risk overstatement. The magnitude of the errors depends on the structure of the balance sheet and on the repricing characteristics of assets and liabilities.