Modelling Deposit Insurance Scheme Losses in a Basel 2 Framework

This paper extends the existing literature on deposit insurance by proposing a new approach for the estimation of the loss distribution of a Deposit Insurance Scheme (DIS) that is based on the Basel 2 regulatory framework. In particular, we generate the distribution of banks’ losses following the Basel 2 theoretical approach and focus on the part of this distribution that is not covered by capital (tail risk). We also refine our approach by considering two major sources of systemic risks: the correlation between banks’ assets and interbank lending contagion. The application of our model to 2007 data for a sample of Italian banks shows that the target size of the Italian deposit insurance system covers up to 98.96% of its potential losses. Furthermore, it emerges that the introduction of bank contagion via the interbank lending market could lead to the collapse of the entire Italian banking system. Our analysis points out that the existing Italian deposit insurance system can be assessed as adequate only in normal times and not in bad market conditions with substantial contagion between banks. Overall, we argue that policy makers should explicitly consider the following when estimating DIS loss distributions: first, the regulatory framework within which banks operate such as (Basel 2) capital requirements; and, second, potential sources of systemic risk such as the correlation between banks’ assets and the risk of interbank contagion.     

Earnings versus capital ratios management: role of bank types and SFAS 114

We document in this paper that large banks use Loan Loss Provisions (LLP) more than small banks to manage reported earnings, but we find no significant difference in the use of LLP to manage capital ratios between large and small banks. Additionally, we document that banks with high risk asset portfolios use more LLP to manage reported earnings as well as capital ratios compared to the banks with low risk asset portfolios. Our findings also show that SFAS 114 has a moderating effect on the use of LLP to manage reported earnings, especially by large banks, but there is no conclusive evidence on the impact of SFAS 114 to manage capital ratios. Furthermore, the findings show that there has been significantly more earnings management during the 2007–2008 financial crisis compared to earlier periods.     

Publicly traded versus privately held: implications for conditional conservatism in bank accounting

Compared with privately held banks, publicly traded banks face greater agency costs because of greater separation of ownership and control but enjoy greater benefits from access to the equity capital market. Differences in control and capital market access influence public versus private banks’ accounting. We predict and find that public banks exhibit greater degrees of conditional conservatism (asymmetric timeliness of the recognition of losses versus gains in accounting income) than private banks. We predict and find that public banks recognize more timely earnings declines, less timely earnings increases, and larger and more timely loan losses. Although public ownership gives managers greater ability and incentive to exercise income-increasing accounting, our findings show that the demand for conservatism dominates within public banks and that the demand for conservatism is greater among public banks than private banks. Our results provide insights for accounting and finance academics, bank managers, auditors, and regulators concerning the effects of ownership structure on conditional conservatism in banks’ financial reporting.

Towards a measure of financial fragility

The paper proposes a measure of financial fragility that is based on economic welfare in a general equilibrium model calibrated against UK data. The model comprises a household sector, three active heterogeneous banks, a central bank/regulator, incomplete markets, and endogenous default. We address the impact of monetary and regulatory policy, credit and capital shocks in the real and financial sectors and how the response of the economy to shocks relates to our measure of financial fragility. Finally we use panel VAR techniques to investigate the relationships between the factors that characterise financial fragility in our model, i.e. banks’ probabilities of default and banks’ profits – to a proxy of welfare.      

Examining the Relationships between Capital,Risk and Efficiency in European Banking

This paper analyses the relationship between capital, risk and efficiency for a large sample of European banks between 1992 and 2000. In contrast to the established US evidence we do not find a positive relationship between inefficiency and bank risk‐taking. Inefficient European banks appear to hold more capital and take on less risk. Empirical evidence is found showing the positive relationship between risk on the level of capital (and liquidity), possibly indicating regulators' preference for capital as a mean of restricting risk‐taking activities. We also find evidence that the financial strength of the corporate sector has a positive influence in reducing bank risk‐taking and capital levels. There are no major differences in the relationships between capital, risk and efficiency for commercial and savings banks although there are for co‐operative banks. In the case of co‐operative banks we do find that capital levels are inversely related to risks and we find that inefficient banks hold lower levels of capital. Some of these relationships also vary depending on whether banks are among the most or least efficient operators.     

Measurement Matters—Alternative Input Price Proxies for Bank Efficiency Analyses

Most bank efficiency studies that use stochastic frontier analysis (SFA) employ each bank’s own implicit input price when estimating efficient frontiers. But at the same time, most studies are based on cost and/or profit models that assume perfect input markets. Traditional input price proxies therefore contain at least substantial measurement error. We suggest here two alternative input market definitions to approximate exogenous input prices. We have access to Bundesbank data, which allows us to cover virtually all German universal banks between 1993 and 2003. The use of alternative input price proxies leads to mean cost efficiency that is significantly five percentage points lower compared to traditional input prices. Mean profit efficiency is hardly affected. Across models, small cooperative banks located in large western states perform best while large banks and those located in eastern states rank lowest. This paper is the result of a research cooperation between the Utrecht School of Economics and Deutsche Bundesbank. It represents the author’s personal opinions and does not reflect the views of the Deutsche Bundesbank.     

International Banking and Liquidity Allocation

This paper explores the comparative advantage of multinational banking over cross-border financial services in terms of capitalizing on a global access to funding sources. We argue that this advantage depends on the benefit and the cost of multinational banks’ intimacy with local markets. The benefit is that it allows multinational banks to create more liquidity. The cost is that it causes inefficiencies in internal capital markets, on which a bank relies to allocate liquidity across countries. We analyze the conditions under which multinational banking is then likely to arise and show that capital requirements have an effect as they influence the degree of inefficiency in internal capital markets for alternative organization structures differently.     

Capital changes at large affiliated banks

The federal bank regulators imposed numerical capital guidelines in December 1981. If these guidelines are binding, then banking organizations may respond to the costs of regulation in various ways. If the regulations are not binding, then further reliance may be placed on market discipline. This study develops two models of changes in the equity capital to assets ratio of large banks affiliated with bank holding companies—a regulatory model in which capital regulations are a binding influence and a market model in which financial markets influence capital ratios. The two models are examined empirically through a disequilibrium framework and maximum likelihood estimation techniques. The results suggest that most banks are predominantly influenced by regulatory forces. Federal Reserve Bank of Atlanta Florida State University     

The Economic Consequences of Banks’ Derivatives Use in Good Times and Bad Times

In a sample of 335 commercial banks, we do not detect a systematic effect on bank values from derivatives use in either the high growth period of 2003–2005 or the low growth period of 2007–2009. These findings apply to all types of derivatives including credit default swaps. Our results suggest that banks take a more balanced approach and restrict their derivative activities to providing derivative services for customers and risk management. We also find that the market disciplined banks significantly for taking TARP funds, indicating that receiving TARP funds was a signal that the banks were financially distressed. Lastly, we cannot discern valuation effects resulting from derivatives use even in large and poorly capitalized banks that are more likely to take risk-shifting opportunities. Collectively, we find no compelling evidence supporting the widespread allegation that derivatives use increased banks’ speculating behaviors and significantly contributed to the loss of value during the subprime mortgage crisis.     

Dynamics of Asset Prices and Transaction Activity in Illiquid Markets: the Case of Private Commercial Real Estate

This paper investigates the relationship between capital flows, turnover and returns for the UK private real estate market. We examine a number of possible implications of capital flows and turnover on capital returns testing for evidence of a price pressure effect, ‘return chasing’ behaviour and information revelation. The main tool of analysis is a panel vector autoregressive (VAR) regression model in which institutional capital flows, turnover and returns are specified as endogenous variables in a two equation system in which we also control for macro-economic variables. Data on flows, turnover and returns are obtained for the ten market segments covering the main UK commercial real estate sectors. Our results do not support the widely-held belief among practitioners that capital flows have a ‘price pressure’ effect on property prices. However, we do find a significant positive relationship between lagged turnover and contemporaneous capital returns, suggesting that asset turnover provides increased price revelation which, in turn, reduces investment risk and increases property values.     

Modeling Structural and Temporal Variation in the Market's Valuation of Banking Firms

Hidden capital exists whenever the accounting measure of a firm's net worth diverges from its economic value. Such unbooked capital has on-balance-sheet and off-balance-sheet sources. This paper develops a model to estimate both forms of hidden capital and to test hypotheses about their determinants. In effect, the analysis expands the two-index model by endogenizing the market and interest-rate sensitivities of any stock and decomposing each sensitivity into on-balance-sheet and off-balance-sheet elements. For a sample of banks during 1975–1985, the model finds considerable variation in both forms of hidden capital.     

Securitization and Banks’ Equity Risk

This research explores the effects of securitization on the market’s perception of banks’ risk exposure between 2002 and 2007. Our results show that, contrary to some prior evidence in the literature, securitizing banks actually had lower systematic betas until 2007. We find no evidence of increasing idiosyncratic risk with securitization. We identify significant structural break in 2007, when securitizing banks experienced jumps in both systematic and idiosyncratic risks. Finally, we confirm the general belief that larger banks tend to have higher systematic risk and lower idiosyncratic risk because of diversification.     

Rating systems,procyclicality and Basel II: an evaluation in a general equilibrium framework

The introduction of Basel II has raised concerns about the potential impact of risk-sensitive capital requirements on the business cycle. Several approaches have been proposed to assess the procyclicality issue. In this paper, we adopt a general equilibrium model and conduct comprehensive analysis of different proposals. We set out a model that allows to evaluate different rating systems in relation to the procyclicality issue. Our model extends previous models by analysing the effects of different rating systems on banks’ portfolios (as in Catarineu et al. in Econ Theory 26:537–557, 2005) and the contagion effects relevant to financial stability (as in Goodhart et al. in Ann Finance 1:197–224, 2005). The paper presents comparative statics results comparing a cycle-dependent and a neutral rating system from the point of view of banks profit maximization. Our results suggest that banks’ preferences about point in time or through the cycle rating systems depend on the banks’ characteristics and on the business cycle conditions in terms of expectations and realizations.     

Institutional Shareholders and Bank Capital

We examine the relationship between institutional ownership and bank capital. Using a large sample of U.S. banks, we show that banks with greater institutional ownership operate with substantially higher capital ratios. The results are robust to controlling for standard determinants of bank capital structure, including market- and accounting-based risk measures. The results hold both for indexers and non-indexers, indicating that the effect of institutional ownership on bank capital cannot be explained by self-selection. We further address endogeneity concerns using an instrumental variable strategy based on the inclusion of banks in the S&P index. We find supporting evidence that the superior monitoring abilities of institutional investors, which reduce the severity of agency costs, is the main explanation for our results.     

Regulate one service,tame the entire market: Credit cards in Turkey

In credit card markets banks provide both payment and credit services. Two regulations were recently enacted in the Turkish credit card market: one on payment services in 2005 and the other on credit services in 2006. By employing the well-known  and  method and a unique quarterly data set for 21 Turkish banks between 2002 and 2008, we investigate the extent of banks’ market power in the Turkish credit card market before and after the regulations. Unlike most of the existing literature, which considers competition and regulation for either credit or payment services and ignores the externalities between them, we consider the entire market by taking both services into account. Fixed effects estimations reveal that banks enjoyed collusive oligopoly power before the regulations. Although the first regulation did not have much impact, the second led to rises in both banks’ total revenues and competition in the entire market.     

How do banks adjust their capital ratios?

We analyze the dynamics of banks’ regulatory capital ratios. Using monthly regulatory data of large German banks, we estimate the target level and the adjustment speed of the capital ratio for each bank separately. There exists a target level for a substantial percentage of banks. Unlike with panel regressions, we can estimate individual adjustment speeds and find large variation across banks. Adjustments on the liability side are most effective, although adjustment rates on the asset side are higher. Private commercial banks (neither state-owned nor cooperative) and banks with a high level of proprietary trading are more likely to adjust their capital ratio tightly. Banks with a target capital ratio compensate for low target ratios with low asset volatilities and high adjustment speeds. They seem to care mainly about the resulting probability to comply with the regulatory minimum. Assuming low variation of this probability explains most of the large cross-sectional variation of bank capital.     

Performance differentiation: cutting losses and maximizing profits of private equity and venture capital investments

Recent research has pointed out the need to differentiate between good versus poor performance of venture capital and private equity investments and to analyze the factors that determine the ‘winners’ and ‘losers’ of a fund. This study examines the different contractual and behavioral characteristics and their influence on the positive and negative performances of private equity investments. Specifically, we analyze how fund managers apply tools and investment behavior to mitigate risks and maximize returns. The empirical investigation of these questions is based on a merged dataset, which combines the Venture Economics and CEPRES databases. It includes a total of 1,011 investments made by 137 different funds that belong to 54 private equity and venture capital firms worldwide over the period from 1979 to 2003. Our results confirm that the reduction of losses and the maximization of investment profits have different antecedents. Although losses are minimized by the use of convertibles and by increasing the venture capital firms’ accumulated experience, profits are increased by the potential of the fund’s management to allocate resources to portfolio companies. Our findings contribute to the understanding of the determinants of venture capital and private equity returns by differentiating between the mitigation of risks and the maximization of profits.      

Risk shifting and regulatory arbitrage: Evidence from operational risk

We document a robust negative relation between operational risk exposure and bank capital levels for a sample of large U.S. banks under the Basel I Capital Accords. The results are consistent with the notion that capital-constrained banks increased operational risk exposure at the time when Basel I regulations did not require an explicit capital charge for operational risk. More broadly, our results show new channel by which financial regulations incentivize banks to shift their risk taking to less regulated risk areas. We focus on the case of operational risk because it went from a largely unregulated risk type to a major risk that accounts for about 25% of large U.S. banks’ risk-weighted assets.     

Informational Barriers to Entry into Credit Markets*

Economic theory suggests that asymmetric information between incumbents and entrants can generate barriers to entry into credit markets. Incumbents have superior information about their own customers and the overall economic conditions of the local credit market. This implies that entrants are likely to experience higher loan default rates than the incumbents. We test these theoretical predictions using a unique database of 7,275 observations on 729 individual banks’ lending in 95 Italian local markets. We find that informational asymmetries play a significant role in explaining entrants’ loan default rates. The default rate is significantly higher for those banks that entered local markets without opening a branch, suggesting that having a branch on site may help to reduce the informational disadvantage. We also uncover a positive correlation between banks’ loan default rates in individual local markets and the number of banks lending in that market. We argue that these informational barriers can help to explain why entry into many local credit markets by domestic and foreign banks was slow, even after substantial deregulation. * The views expressed in this article are those of the authors and do not involve the responsibility of the Bank of Italy. The authors thank Franklin Allen, Dario Focarelli, Andrea Generale, Luigi Guiso, Francesca Lotti, Marco Pagano, Alberto Franco Pozzolo, Paola Sapienza, Alessandro Secchi, two anonymous referees and seminar participants at the Bank of Italy, the Federal Reserve of Chicago, the 2003 BIS Workshop on Applied Banking Research, the 2003 EARIE Conference, the First Banca d’Italia/CEPR Conference on Money, Banking and Finance, the 2004 FIRS Conference on Banking, Insurance and Intermediation and the 2004 EEA Meeting for their comments. The usual disclaimer applies to all of them.     

Dynamic Prudential Regulation: Is Prompt Corrective Action Optimal?

The current U.S. bank capital regulation features prompt corrective action, which mandates regulators to intervene in and liquidate banks based on their book‐value capital ratios. To see if prompt corrective action is optimal, I build a dynamic model of repeated interactions between a banker and a regulator. Under hidden choice of risk, private information on returns and limited commitment by the banker, and costly liquidation, I first characterize the optimal incentive‐feasible allocation. I then demonstrate that the optimal allocation is implementable through the combination of a risk‐based deposit insurance premium and a book‐value capital regulation with stochastic liquidation.