The impact of the banking sector on economic structure and growth

In this paper, we study the impact of banking sector development on changes in economic structure and growth. We argue that banking sector development has differential effects on industrial sector development and agricultural sector development. We test whether economic structure and growth foster banking sector development. To test our hypotheses, we construct a panel sample of all countries in the world during 1960–2016. We find that banking sector development has a negative effect on agricultural sector development but exerts no effect on industrial sector development. The negative effect of banking sector development on agricultural sector development is only observed for countries with high degrees of banking sector development. Our results further show that agricultural sector development exerts a negative effect on banking sector development while industrial sector development has a positive effect on banking sector development.     

Risk shifting in the US banking system: An empirical analysis

This paper contributes to the empirical literature on risk shifting. It proposes a method to find out whether risk shifting is present in the banking industry and, if so, what type. The type of risk shifting depends on the group of debt holders to whom risk is shifted. We apply this method to the US banking sector in 1998–2011. To study the relationship between risk shifting and the 2008 crisis, the sample is also split into pre-crisis, crisis, and post-crisis periods. Our results suggest that the same type of risk shifting is present in the entire sample and in the pre-crisis and crisis subsamples. We find no evidence of risk shifting after the crisis. Furthermore, holding capital buffers seems to disincentivize risk shifting. This finding appears to provide support for the conservative buffer included in Basel III.     

The impact of the euro on risk exposure of the world’s major banking industries

In this paper, we examine if the introduction of the euro impacted the risk exposures, risk premiums and, hence, the cost of equity of the banking industry of 11 Eurozone countries, five non-Eurozone European countries, and three non-European countries. Using a multi-factor asset-pricing model that allows time variation in the risk exposures, we find a statistically significant and economically large decline in the cost of equity of the banking industry across the three groups of countries following the introduction of the euro. Though we find an increase in the market and currency exposures after the euro, consistent with increased competition among banks, the fall in the cost of equity arises from an economically large decline in the currency premium. As expected, the Eurozone banking industry experienced the largest decrease. Our results are inconsistent with the argument that increased banking competition arising from the legislative changes accompanying the introduction of the euro would result in an increase in the overall risk premium of the banking sector.     

Margining in derivatives markets and the stability of the banking sector

We investigate the effects of margining, a widely-used mechanism for attaching collateral to derivatives contracts, on derivatives trading volume, default risk, and on the welfare in the banking sector. First, we develop a stylized banking sector equilibrium model to develop some basic intuition of the effects of margining. We find that a margin requirement can be privately and socially sub-optimal. Subsequently, we extend this model into a dynamic simulation model that captures some of the essential characteristics of over-the-counter derivatives markets. Contrarily to the common belief that margining always reduces default risk, we find that there exist situations in which margining increases default risk, reduces aggregate derivatives’ trading volume, and has an ambiguous effect on welfare in the banking sector. The negative effects of margining are exacerbated during periods of market stress when margin rates are high and collateral is scarce. We also find that central counterparties only lift some of the inefficiencies caused by margining.     

Heterogeneous market structure and systemic risk: Evidence from dual banking systems

This paper investigates how banking system stability is affected when we combine Islamic and conventional finance under the same roof. We compare systemic resilience of three types of banks in six GCC member countries with dual banking systems: fully-fledged Islamic banks (IB), purely conventional banks (CB) and conventional banks with Islamic windows (CBw). We employ market-based systemic risk measures such as MES, SRISK and CoVaR to identify which sector is more vulnerable to a systemic event. We also compute weighted average GES to determine which sector is most synchronised with the market. Moreover, we use graphical network models to determine the most interconnected banking sector that can more easily spread a systemic shock to the whole system. Using a sample of observations on 79 publicly traded banks operating over the 2005–2014 period, we find that CBw is the least resilient sector to a systemic event, it has the highest synchronicity with the market, and it is the most interconnected banking sector during crisis times.     

Euro area banking and monetary policy shocks in the QE era

This paper assesses the effects of monetary policy shocks on the macroeconomy and the euro area banking sector after the global financial crisis. First, financial risk-return indicators of the banking sector based on a compound option-based structural credit risk model are embedded in a large macro-financial quarterly database covering the period 2008Q4–2019Q4. Second, a SFAVAR identifies and estimates the shocks’ responses relating them to the endogenous build-up of banks’ vulnerabilities which are consistent with the internally coherent structure of the credit risk model. By introducing structure in the understanding of banks’ asset-liability management behavior following monetary policy shocks, the research strategy contributes to disentangling results that are often mixed in the empirical literature. The study finds that unconventional monetary policy, in particular the Asset Purchase Program of the European Central Bank, seems to have been more successful than conventional monetary policy in raising output and inflation. The desired boost to bank lending has been muted and loan cyclicality has varied across countries and loan types. The performance of the banking sector following monetary policy shocks can be characterized by a drop in expected return on equity and assets, a relaxation of lending conditions and increased correlation between banks’ assets return and the market return, a mechanism pointing to enhanced risk-taking. While banks’ probabilities of default fall following monetary policy shocks, the price of risk increases. Banks’ net worth rises via higher market capitalization and implied assets value together with lower volatility, despite often incurring more debt. Risk-taking in the banking sector may pose a risk to financial stability, especially if its effects on banks’ vulnerability spread and increase systemic risk. The unintended endogenous build-up of macro-financial vulnerabilities may need to become part of monetary policymaking.     

The impact of central bank transparency on systemic risk—Evidence from Central and Eastern Europe

The aim of this paper is to analyze the impact of central bank transparency on systemic risk in emerging banking markets using a sample composed of 34 banks from Central and Eastern Europe for a period spanning from 2005 through 2012. Results indicate a positive and significant relationship between central bank transparency and financial institutions’ contribution to systemic risk. On the other side, increased central bank transparency significantly reduces the idiosyncratic risk of banks. The relationship is influenced by the restrictiveness of regulatory framework. We argue that a more transparent central bank is beneficial for the banking sector from a microprudential perspective. However, it may create incentives for financial institutions to engage in risky activities and through herd behavior may increase individual contribution to the risk of the banking system.     

The impact of banking sector stability on the real economy

This article studies the relationship between the degree of banking sector stability and the subsequent evolution of real output growth and inflation. Adopting a panel VAR methodology for a sample of 18 OECD countries, we find a positive link between banking sector stability and real output growth. This finding is predominantly driven by periods of instability rather than by very stable periods. In addition, we show that an unstable banking sector increases uncertainty about future output growth. No clear link between banking sector stability and inflation seems to exist. We then argue that the link between banking stability and real output growth can be used to improve output growth forecasts. Using Fed forecast errors, we show that banking sector stability (instability) results in a significant underestimation (overestimation) of GDP growth in the subsequent quarters.     

Contagion risk in the Australian banking and property sectors

The Australian banking system emerged from the global crisis virtually unhurt, with most banks still profitable, adequately capitalized, and with AA credit ratings. Are there any risks or vulnerabilities in this success story? This paper analyzes Australia’s systemic banking risk and attempts to determine if this risk increased with the recent global crisis and whether this risk is related to the downturn experienced in the real estate market. We use extreme value theory to measure banks’ and property firms’ univariate Value at Risk, as well as multivariate intra-sector and inter-sector contagion risks. Of the 13 sectors analyzed, we find that the property sector exhibits the highest level of extremal dependence with the banking sector. The credit crisis significantly increased the probability of a bank or property firm crashing. Moreover, contagion risks significantly increased not only within the banking and property sectors, but also between those sectors.     

Systemic Risk in the Chinese Shadow Banking System: A Sector-Level Perspective

We propose to measure the systemic risk in the shadow banking sector. Instead of testing how many institutions will fail due to the initial breakdown of one institution as extant network models do, we associate the systemic risk of one shadow banking sector with the total amount of unexpected losses it might generate both directly and indirectly. Our model focuses on balance sheet contagion and applies a loop algorithm to risk transfer. The result shows that trust companies were the main culprit of financial instability and commercial banks assumed the main risks over 2007–12 in the Chinese shadow banking system.     

The aftermath of the subprime crisis: a clustering analysis of world banking sector

The banking sector has been on the spotlight in both academic and policy circles since the outburst of the subprime bubble. The crisis has its roots in the US, but there were spillover effects around the world. We study the behavior of the banking sector of 40 countries during the period 2007–2010, using a new clustering methodology. Our methodology combines regime switching models in the modeling of longitudinal variations with cluster analysis that identifies groups of countries with similar profiles. Our results show that although there were periods of intense contagion, the impact was uneven among sample countries. The crisis had episodic effects on some countries, while others had severe devaluations after the Lehman Brothers bankruptcy. Finally, a small group of banking systems has plunged into a long severe crisis.     

Is sovereign risk related to the banking sector?

We examine whether the banking sector within a nation is related to sovereign risk. We hypothesize that more competitive and sophisticated financial systems are less prone to panics or bank runs, and consequently will be associated with superior sovereign credit ratings. Using Ordered Probit with Aggregate Time Effects methodology, our results show that banking sector characteristics such as concentration in the banking system, liquidity of bank assets, and size of financial system are significantly related to sovereign credit ratings. Since the use of these sovereign ratings is ubiquitous in international finance in varied applications such as determination of the cost of international borrowing by governments, international cost of capital for FDI, and others, the relationships identified in this paper have important public policy implications.     

Korean bank governance reform after the Asian financial crisis

We discuss corporate governance reforms in the Korean banking sector, which include reforms in board composition and executive compensation, implemented after the Asian financial crisis in 1997 and examine the stock market's response to the reforms. We find that the banking returns and volatilities became more Granger-causally prior to both KOSPI and finance sector returns after 1998. The announcements of banking governance reforms are generally associated with significant increases in banking sector stock returns. The KIF survey finds that board governance is considered essential in assessing the value of the firm. The participants in the McKinsey survey indicate that they are willing to pay a premium of 24% on average for firms with outstanding corporate governance systems.     

Does interest rate and its volatility affect banking sector development? Empirical evidence from emerging market economies

This study investigates the relationship between interest rate, interest rate volatility, and banking sector development in 12 emerging market economies located around the world. For this purpose, panel data analysis was conducted using annual data from 1980 to 2014. In parallel to the financial development literature, which asserts that banking sector development, as a broad and complex concept, cannot be measured by a single indicator, this study adopts a set of measures of banking sector development. The empirical results reveal that while interest rate has a positive impact on all banking sector indicators, this relationship weakens at higher interest levels, showing a concave relationship between interest rate and banking sector development. In addition, the empirical results provide evidence that interest rate fluctuations have a negative impact on most banking sector development (BSD) indicators, suggesting that the banking sectors of emerging countries are vulnerable to interest rate risks. Furthermore, all measures of the banking sector indicators are positively affected by economic growth rates, while this association weakens at higher levels of income, confirming a nonlinear relationship. Thus, the results have important implications for policymakers in improving the banking system and promoting the economic growth of these emerging economies.     

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.     

The systemic risk of European banks during the financial and sovereign debt crises

European banks became a source of risk to global financial markets during the financial crisis and attention to the European banking sector increased during the sovereign debt crisis. To measure the systemic risk of European banks, we calculate a distress insurance premium (DIP), which integrates the characteristics of bank size, probability of default, and correlation. Based on this measure, the systemic risk of European banks reached its height in late 2011 around €500 billion. We find that this was largely due to sovereign default risk. The DIP methodology is also used to measure the systemic contribution of individual banks. This approach identifies the large systemically important European banks, but Italian and Spanish banks as a group notably increased in systemic importance during the sample period. Bank-specific fundamentals like capital-asset ratios predict the one-year-ahead systemic risk contributions.     

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.     

Back to the basics in banking? A micro-analysis of banking system stability

This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.     

Income diversification and risk: Does ownership matter? An empirical examination of Indian banks

We examine the impact of ownership on income diversification and risk for Indian banks over the period 2001–2009. We investigate both the determinants of non-interest income and the impact of diversification on various profitability and insolvency risk measures for public sector, private domestic, and foreign banks. We document that ownership does matter in the pursuit of non-interest income. Relative to private domestic banks, public sector banks earn significantly less fee-income, while foreign banks report higher fee income. Public sector banks with higher levels of governmental ownership are significantly less likely to pursue non-interest income sources. Fee-based income significantly reduces risk, measured by profitability variables, for public sector banks. Default risk is also reduced for these banks. From a regulatory perspective, it appears that diversification benefits India’s public sector banks. Our research has implications for the changes in the risk profile for banks in emerging banking markets pursuing non-interest revenue sources.     

Measuring systemic importance of financial institutions: An extreme value theory approach

This paper proposes a set of market-based measures on the systemic importance of a financial institution or a group of financial institutions, each designed to capture different aspects of systemic importance of financial institutions. Multivariate extreme value theory approach is used to estimate these measures. Using six big Canadian banks as the proxy for Canadian banking sector, we apply these measures to identify systemically important banks in Canadian banking sector and major risk contributors from international financial institutions to Canadian banking sector. The empirical evidence reveals that (i) the top three banks, RBC Financial Group, TD Bank Financial Group, and Scotiabank, are more systemically important than other banks, while we also find that the size of a financial institution should not be considered as a proxy of systemic importance; (ii) compared to the European and Asian banks, the crashes of the U.S. banks, on average, are the most damaging to Canadian banking sector, while the risk contribution to the Canadian banking sector from Asian banks is quite lower than that from banks in the U.S. and euro area; (iii) the risk contribution to Canadian banking sector exhibits “home bias”, that is, cross-country risk contribution tends to be smaller than domestic risk contribution.