How does capital affect bank performance during financial crises?

This paper empirically examines how capital affects a bank’s performance (survival and market share) and how this effect varies across banking crises, market crises, and normal times that occurred in the US over the past quarter century. We have two main results. First, capital helps small banks to increase their probability of survival and market share at all times (during banking crises, market crises, and normal times). Second, capital enhances the performance of medium and large banks primarily during banking crises. Additional tests explore channels through which capital generates these effects. Numerous robustness checks and additional tests are performed.     

Communication and financial supervision: How does disclosure affect market stability?

The impact of authorities’ information disclosure on social welfare and market stability has become a widely debated topic since the contribution of Morris and Shin (2002). Despite several theoretical works, this strand of literature remains void of empirical contributions. By assessing how disclosure of stress test results influences market risk perception, we provide factual evidence on how authorities’ enhanced communication affects financial markets’ stability. Our results provide empirical evidence to support Faria-e-Castro et al.’s (2017) theoretical findings, demonstrating that severe stress tests, if enacted in countries with credible fiscal capacity such as the U.S., can lead agents to revise their risk estimations downwards for all banks, notwithstanding their performance in the exercise.     

Freeing Greece from capital controls: Were the restrictions enforced in time?

Recent developments in Greece have caused for the implementation of banking capital controls on the outflow of funds, a policy decision not uncommon, especially in emerging markets. However, the issues of the Greek economy, which seem to stem from the public sector but have been passed on to the banking sector, pose a unique challenge to researchers. In this paper, we employ VBanking, an object-oriented model for banking simulations to examine whether capital controls in Greece were enforced at the appropriate time. Additionally, we propose that the banking sector will not purge this regulation soon. Finally, we demonstrate the destructive effects of capital controls both on the financial system and on the real economy. We present the empirical results of our work, which suggest that the Greek authorities’ response to the deterioration of the banking sector was lagged.     

Adapting financial rationality: Is a new paradigm emerging?

We discuss the implications of an alternative to the efficient market hypothesis (EMH) the adaptive market hypothesis (AMH). The AMH advances a theoretical basis for a new financial paradigm which can better model such phenomena as the recent financial crisis. The AMH regards the financial market order as evolving, tentative and defined by creative destruction in which trading strategies are introduced, mutate to survive, or face abandonment. The concept of investor rationality is less helpful than the distinction between investment strategies which are more or less well adapted to the prevailing market environment. We outline how a more systematic and grounded basis for behavioural finance can be developed in line with the latter approach. Based on this we develop testable hypotheses allowing the AMH to be distinguished from the EMH. Finally, we discuss how the AMH can aid our understanding of important issues in finance. A central insight is that in the survival of richest, as opposed to fittest, implied by the AMH there is much room for misallocation of resources as price and value uncouple. In this shifting financial market order the regulatory State features as a further market in which the vote market verifies or disrupts market conditions.     

What makes a bank risky? Insights from the optimal capital structure of banks

Assessing the risk of bank failures is the paramount concern of bank regulation. This paper argues that in order to assess the default risk of a bank, it is important to consider its financing decisions as an endogenous dynamic process. We provide a continuous-time model, where banks choose the deposit volume in order to trade off the benefits of earning deposit premiums against the costs that occur at future capital structure adjustments. The bank’s asset value may suffer from shocks and follows a jump-diffusion process.     

How loss averse are investors in financial markets?

We investigate loss aversion in financial markets using a typical asset allocation problem. Our theoretical and empirical results show that investors in financial markets are more loss averse than assumed in the literature. Moreover, loss aversion changes depending on market conditions; investors become far more loss averse during bull markets than during bear markets, indicating their more profound disutility for losses when others enjoy gains. Contrary to most previous results, we find that investors are more sensitive to changes in losses than changes in gains.     

How do financial contracts evolve for new ventures?

While previous research has characterized the key features of contracts between entrepreneurs and venture capitalists, little is known about the contracts' evolution over time and across funding rounds. We overcome significant data challenges to compile a novel panel dataset of U.S. early-stage ventures that includes the main financial and control rights offered to investors at each (equity) funding round. We find that there is a ‘default contract’ with a distinct combination of rights that the majority of companies gravitate to. This default contract is typically implemented in the initial Series A funding round and rarely deviated from in later rounds. Whenever deviations do occur, terms are usually revised in favour of investors, and not entrepreneurs. Due to this stickiness of the default contract, for successful startups we argue that post-money valuations in later rounds can be a reasonable proxy for the economic value of the firm.     

Crossborder financial contagion to Germany: How important are OTC dealers?

We examine crossborder contagion from a number of financial systems to the German financial system using the information content of CDS prices in a GARCH model. After controlling for common factors which may cause comovement in security prices, we find evidence for contagion from the US and European financial systems. Assessing contagion for dealer and non-dealer banks suggests that contagion from dealer banks is the most prominent source of contagion to the German financial system. While German non-dealer banks are affected both by European and US dealers, only US dealer banks have a contagion effect to German dealer banks.     

How does corporate social responsibility affect financial performance,financial stability,and financial inclusion in the banking sector? Evidence from Pakistan

This paper examines the impact of corporate social responsibility (CSR) on the financial performance, financial inclusion, and financial stability of the banking sector, focusing on annual data for 20 Pakistani commercial banks for the period 2008–2017. The results suggest that CSR, as well as age and size, has a positive impact on all three factors. However, high levels of leverage reduce financial inclusion and financial stability, while financial inclusion is also negatively associated with the tangibility of assets.     

How close a relationship does a capital market have with other such markets? The case of Taiwan from the Asian financial crisis

In assessing how far and how close the relationships are between the Taiwan capital market and other international capital markets in Asian financial case, we examine the co-movement patterns by developing the “unequal variance test”. We find that a closer relationship exists between Taiwan and Hong Kong throughout the sample period than between Taiwan and other Asian countries and the US. It thus appears that adjacent regions with similar backgrounds in terms of their capital markets will reflect price patterns that are more similar to those of Taiwan than those of countries with which Taiwan frequently trades or cooperates.     

Financial regulation and financial inclusion in Sub-Saharan Africa: Does financial stability play a moderating role?

This study examines the impact of financial regulation on financial inclusion in Sub-Saharan Africa, considering the moderating role of financial stability. By analysing the relationship between financial inclusion and the most prominent macro-prudential regulation (capital adequacy), we find that tightening prudential regulations could negatively impact access to finance, thereby conflicting with Sub-Saharan African economies’ financial inclusion goals. More specifically, the capital adequacy requirement tremendously reduces banks’ capacity to provide financial services and this could lead to credit rationing thereby reducing financial inclusion. The results also indicate that, the interaction of financial regulation with financial stability positively impacts financial inclusion. Thus, financial stability augments financial regulation to have an affirmative impact on financial inclusion. The practical implications of this paper are that, one of the ways central governments and policy makers in Sub-Saharan African countries can increase and get the most out of financial inclusion is to formulate policies targeted at reducing capital adequacy requirements of financial institutions and other constraints that limit the operations and efficiency of financial institutions. Such policies should also aim at creating an enabling environment to promote financial stability.     

International financial spillovers to emerging market economies: How important are economic fundamentals?

We assess the importance of economic fundamentals in the transmission of international shocks to financial markets in various emerging market economies (EMEs), covering the so-called taper-tantrum episode of 2013 and seven other episodes of severe EME-wide financial stress since the mid-1990s. Cross-country regressions lead us to the following results: (1) EMEs with relatively better economic fundamentals suffered less deterioration in financial markets during the 2013 taper-tantrum episode. (2) Differentiation among EMEs set in relatively early and persisted through this episode. (3) During the taper tantrum, while controlling for the EMEs’ economic fundamentals, financial conditions also deteriorated more in those EMEs that had earlier experienced larger private capital inflows and greater exchange rate appreciation. (4) During the EME crises of the 1990s and early 2000s, we find little evidence of investor differentiation across EMEs being explained by differences in their relative vulnerabilities. (5) However, differentiation across EMEs based on fundamentals does not appear to be unique to the 2013 episode; it also occurred during the global financial crisis of 2008 and, subsequently, during financial stress episodes related to the European sovereign crisis in 2011 and China’s financial market stresses in 2015.     

Is financial advice a cure-all or the icing on the cake for financial literacy? Evidence from financial market participation in China

We examine how financial advice interacts with financial literacy to shape household decisions on stock market participation in China. Particularly, we investigate how the effect of financial advice varies with economic expectations, preferences for asset diversification and the level of financial literacy. Feeding the data of 5274 households into a Probit model that predicts the probability of holding stocks, we find that, while an increase in financial literacy significantly raises the stock market participation of all households, seeking financial advice only increases the participation for those households which have a preference for asset diversification or which have an optimistic expectation about the economy. Moreover, the effect of financial advice is concentrated on households with high financial literacy, implying that an insufficient level of financial literacy is the reason for the poor performance of financial advice in China. We also examine if there are influential trust or quality concerns which would reduce the effectiveness of financial advice but we find no significant evidence for it.     

A new financial order in Asia: Will a RMB bloc emerge?

The objective of this paper is three-fold. First, the monetary and exchange rate regimes of the Asian countries are described and analyzed. The degrees of flexibility in exchange rates and capital controls vary across countries. Some countries have adopted a flexible inflation targeting framework, while others have pursued exchange rate targeting. The paper presents a new result of a tradeoff between price stability and exchange rate stability in the hyperbolic relationship of Asian countries. Second, a framework that analyzes and quantifies the degree of currency internationalization is proposed and applied to the RMB. In every indicator, the RMB’s weight in private-sector international finance has grown in the last several years, both in the private and public sectors. In the settlement role of currency, the RMB is ranked 8th in the BIS survey and 7th in SWIFT usage. This paper exploits data of a recent period when the RMB became de-pegged from the USD and show some of the emerging Asian currencies co-moving with the RMB, more so than the USD. In the official sector, RMB is also increasing its weight. The Chinese central bank has extended the currency-swap agreements with 30-some countries, so that the RMB can be used for trade finance and liquidity assistance. The RMB is adopted as a composition currency of the Special Drawing Rights (SDR), effective in October 2016, with 10.92%, ranking number 3, surpassing the JPY and GBP. Finally, potential impending changes in the Asian monetary and exchange rate regimes in Asia are discussed. Projecting the growth of the Chinese economy into the future, the weight of the RMB in the financial markets will increase globally as well as in Asia.     

How do financial institutions react to a tax increase?

This paper empirically highlights the role and significance of taxes for the capital structure decisions of banks. Using a difference-in-differences methodology, I show that an increase in the local U.S. state corporate tax rate affects the banks’ financing as well as their operating choices. Better-capitalized banks raise their long-term non-depository debt and thus benefit from an enlarged tax shield. Worse-capitalized banks instead reduce their lending because a higher tax rate increases the tax-adjusted cost of funding, which renders the marginal loan unprofitable.     

How should we estimate value-relevance models? Insights from European data

We study the consequences of unobserved heterogeneity when employing different econometric methods in the estimation of two major value-relevance models: the Price Regression Model (PRM) and the Return Regression Model (RRM). Leveraging a large panel data set of European listed companies, we first demonstrate that robust Hausman tests and Breusch-Pagan Lagrange Multiplier tests are of fundamental importance to choose correctly among a fixed-effects model, a random-effects model, or a pooled OLS model. Second, we provide evidence that replacing firm fixed-effects with country and industry fixed-effects can lead to large differences in the magnitude of the key coefficients, with serious consequences for the interpretation of the effect of changes in earnings and book values per share on firm value. Finally, we offer recommendations to applied researchers aiming to improve the robustness of their econometric strategy.     

Lessons from the financial crisis: failure of markets or failure of regulation?

The popular, demagogic narrative after the global financial system's collapse in 2008 has held that the financial crisis signalled the failure of capitalism. However, regulators across the world must realize that the financial crisis was not brought about by the failure of markets but by the failure of governments to appropriately regulate markets. Beginning in the 1980s, and continuing over the quarter-century that followed, regulators afforded the world of big finance an unaffordable luxury: insurance against possible failure. As a result, banks and financial institutions became adept at turning their insulation from disorderly failure, as enforced by free markets, into insulation from market discipline, as inflicted by myopic regulators. This ‘too big to fail’ syndrome combined with the incorrect belief perpetrated by the Federal Reserve Chairman Alan Greenspan that financial companies, powered by a rational motive not to lose money, could police themselves and one another. In turn, such sanguine beliefs led to considerable over-supply of financial innovation. The supply created its own demand as the financial world operated under the implicit guarantee (and market distortion) created by the ‘too big to fail’ syndrome.

The errors laid bare by the financial crisis clearly call for regulatory reform. But in designing that reform, regulators across the world should avoid the temptation to seek heavy-handed new approaches. Instead, policymakers should look to the long-term success of the system of rules whose decay brought about the crisis. Prudent regulations must seek to reinforce the fundamental principle that no one, however big or small, can be made immune to failure. Such pro-market regulation of finance is essential to preserving and fostering countries’ economic futures.     

Asian financial integration: Global or regional? Evidence from money and bond markets

This paper investigates the degree of global versus regional financial integration in Southeast Asia during the period 2004–2012. We examine integration in the money and bond markets in Asia by employing a covered-interest-parity-based measure of financial integration. The impact of the 2008 financial crisis as well as the recent regional bond initiatives on the integration process of Asian money and bond markets respectively are specifically investigated. Empirically, we adopt the Phillips and Sul (2007) convergence methodology that has not been previously employed to examine the integration process in Asian money and bond markets. We find evidence of both global and regional integration in the money market pre 2008 but once the crisis hit, the process of global integration comes to an abrupt halt. However, regional integration, albeit at a slower pace, is still clearly evident in the post-crisis period. As for the Asian bond market, evidence of both global and regional integration is found but, in comparison, the latter is more convergent post 2008. Regional integration is stronger when interest rates with longer maturity are considered. In addition, we identify some convergent subgroups of countries and this suggests that a multi-tiered style of convergence is present.     

Macroeconomic Stability in Developing Countries: How Much Is Enough?

Over the 1990s macroeconomic policies improved in most developingcountries, but the growth dividend from this improvement fellshort of expectations, and a policy agenda focused on stabilityturned out to be associated with a multiplicity of financialcrises. This article examines the contents and implementationof the macroeconomic reform agenda of the 1990s. It reviewsthe progress achieved through fiscal, monetary, and exchangerate policies across the developing world and the effectivenessof the changing policy framework in promoting stability andgrowth. The main lesson is that more often than not slow growthand frequent crises resulted from shortcomings in the reformagenda of the 1990s. These concern limitations in the depthand scope of the reform agenda, its lack of attention to macroeconomicvulnerabilities, and its inadequate attention to complementaryreforms outside the macroeconomic sphere.      

Forestalling capital regulation or masking financial weakness? Evidence from loss reserve management in the property–liability insurance industry

This study examines the extent to which capital thresholds induce insurers to strategically exert accounting discretion to forestall regulatory actions. Using a sample of US property–liability insurers during 1994–2009, we find that when managing their claim loss reserves, the average insurers are insensitive to the pressure of capital regulation as measured by the distance of their RBC ratio to the action threshold. Yet, when the insurers are virtually partitioned by their reserving tendency, the effect of regulatory pressure is significantly related to the downward reserve bias in the under-reserving insurer cohorts. This finding continues to hold even after we utilize the number of ratio violations in the insurance regulatory information systems to purge the financial weakness effect embedded in the distance to RBC bound ratio. Hence, our empirical evidence suggests that insurers that are about to trigger the regulatory threshold will have the incentives to understate their loss reserves to preclude the impending authorized preventive actions. Finally, our analyses also shed light on the heterogeneity of incentives to managing loss reserves among over- and under-reserving insurers.