New Economics Papers
on Banking
Issue of 2007‒05‒26
ten papers chosen by
Roberto J. Santillán–Salgado, EGADE-ITESM

  1. The Impact of Legal Sanctions on Moral Hazard when Debt Contracts are Renegotiable. By Régis Blazy; Laurent Weill
  2. Financing Development: The Role of Information Costs By Jeremy Greenwood; Juan M. Sanchez; Cheng Wang
  3. Estimation risk effects on backtesting for parametric value-at-risk models By J. Carlos Escanciano; Jose Olmo
  4. Welfare Effects of Financial Integration By Fecht, Falko; Grüner, Hans Peter; Hartmann, Philipp
  5. Fire Sales, Foreign Entry and Bank Liquidity By Acharya, Viral V; Shin, Hyun Song; Yorulmazer, Tanju
  6. X-efficiency, Scale Economies, Technological Progress and Competition: A Case of Banking Sector in Pakistan By Idrees Abdul Qayyum; Sajawal Khan
  7. The Impacts of "Shock Therapy" on Large and Small Clients: Experiences from Two Large Bank Failures in Japan By Shin-ichi Fukuda; Satoshi Koibuchi
  8. Determinants of Interest Spread in Pakistan By Idrees Khawaja; Musleh-ud Din
  9. Price Discovery of Credit Spreads for Japanese Mega-Banks: Subordinated Bond and CDS By Naohiko Baba; Masakazu Inada
  10. Interest Rate Spreads in English-Speaking African Countries By Joe Crowley

  1. By: Régis Blazy (CREFI-LSF, Luxembourg University, Luxembourg School of Finance, Luxembourg.); Laurent Weill (LARGE, Université Robert Schuman, Institut d'Etudes Politiques, France)
    Abstract: This research investigates how bankruptcy law influences the design of debt contracts and the investment choice through the sanction of faulty managers. We model a lending relationship between a small firm and a monopolistic bank which decides the loan rate. The firm may perform asset substitution, which is punished by the Law through legal sanctions. These sanctions are implemented in case of costly bankruptcy only. This way of resolving financial distress can be avoided yet, if a private agreement is achieved. First, – when sanctions are high – we show that costly bankruptcy may be preferred by honest firms over private negotiation. Thus costly bankruptcy cannot be avoided under a severe legal environment. However, as the bank internalizes the rules of default, debt contracts are designed so that this situation never happens at equilibrium (“legal efficiency”).Second, a peculiar legislation may incite banks to accept generalized moral hazard (“economic inefficiency”). Then, the legislator can indectly enforce economic efficiency. However he must consider effects beyond the simple comparison between legal sanctions and bankruptcy costs, and focus on the impact of such legal sanctions on the design of the debt contract. Simulated results show that even small changes of legal sanctions may have drastic effects on the firm’s investment policy. Besides, it appears that extreme severity (i.e. 100% of the manager’s wealth is subject to legal sanctions) is not needed to ensure economic efficiency. Last, in some cases, the legislator may have the choice between several levels of legal sanctions all leading to economic efficiency: when choosing between them, the legislator affects the profit sharing only.
    Keywords: Bankruptcy, Credit Lending, Moral Hazard, Sanctions
    JEL: G33 D82 D21
    Date: 2007–05
  2. By: Jeremy Greenwood; Juan M. Sanchez; Cheng Wang
    Abstract: How does technological progress in financial intermediation affect the economy? To address this question a costly-state verification framework is embedded into a standard growth model. In particular, financial intermediaries can invest resources to monitor the returns earned by firms. The inability to monitor perfectly leads to firms earning rents. Undeserving firms are financed, while deserving ones are under funded. A more efficient monitoring technology squeezes the rents earned by firms. With technological advance in the financial sector, the economy moves continuously from a credit-rationing equilibrium to a perfectly efficient competitive equilibrium. A numerical example suggests that finance is important for growth.
    JEL: E44 O11 O16 O43
    Date: 2007–05
  3. By: J. Carlos Escanciano (Indiana University, Bloomington, IN, USA); Jose Olmo (Department of Economics, City University, London)
    Abstract: One of the implications of the creation of Basel Committee on Banking Supervision was the implementation of Value-at-Risk (VaR) as the standard tool for measuring market risk. Thereby the correct specification of parametric VaR models became of crucial importance in order to provide accurate and reliable risk measures. If the underlying risk model is not correctly specified, VaR estimates understate/overstate risk exposure. This can have dramatic consequences on stability and reputation of financial institutions or lead to sub-optimal capital allocation. We show that the use of the standard unconditional backtesting procedures to assess VaR models is completely misleading. These tests do not consider the impact of estimation risk and therefore use wrong critical values to assess market risk. The purpose of this paper is to quantify such estimation risk in a very general class of dynamic parametric VaR models and to correct standard backtesting procedures to provide valid inference in specification analyses. A Monte Carlo study illustrates our theoretical findings in finite-samples. Finally, an application to S&P500 Index shows the importance of this correction and its impact on capital requirements as imposed by Basel Accord, and on the choice of dynamic parametric models for risk management.
    Keywords: Backtesting, Basel Accord, Model Risk, Risk management,Value at Risk, Conditional Quantile
    Date: 2007–05
  4. By: Fecht, Falko; Grüner, Hans Peter; Hartmann, Philipp
    Abstract: This paper compares four forms of inter-regional financial risk sharing: (i) segmentation, (ii) integration trough the secured interbank market, (ii) integration trough the unsecured interbank market, (iv) integration of retail markets. The secured interbank market is an optimal risk-sharing device when banks report liquidity needs truthfully. It allows diversification without the risk of cross-regional financial contagion. However, free-riding on the liquidity provision in this market restrains the achievable risk-sharing as the number of integrated regions increases. In too large an area this moral hazard problem becomes so severe that either unsecured interbank lending or, ultimately, the penetration of retail markets is preferable. Even though this deeper financial integration entails the risk of contagion it may be beneficial for large economic areas, because it can implement an efficient sharing of idiosyncratic regional shocks. Therefore, the enlargement of a monetary union, for example, extending the common interbank market might increase the benefits of also integrating retail banking markets through cross-border transactions or bank mergers. We discuss these results in the context of the ongoing debate on European financial integration and the removal of bank branching restrictions in the United States during the 1990s, and we derive implications for the relationship between financial integration and financial stability. Last we illustrate the scope for cross-regional risk sharing with data on non-performing loans for the European Union, Switzerland and the United States.
    Keywords: cross border lending; financial contagion; financial integration; interbank market
    JEL: F36
    Date: 2007–05
  5. By: Acharya, Viral V; Shin, Hyun Song; Yorulmazer, Tanju
    Abstract: Bank liquidity is a crucial determinant of the severity of banking crises. In this paper, we consider the effect of fire sales and foreign entry on banks' ex ante choice of liquid asset holdings, and the ex post resolution of crises. In a setting with limited pledgeability of risky cash flows and differential expertise between banks and outsiders in employing banking assets, the market for assets clears only at fire-sale prices following the onset of a crisis -- and outsiders may enter the market if prices fall sufficiently low. While fire sales make it attractive for banks to hold liquid assets, foreign entry reduces this incentive. We exhibit international evidence on foreign entry following crises and on banks' ex ante liquidity choice that are consistent with the predictions of the model. Our framework allows us to address the key welfare question as to when there is too much or too little liquidity on bank balance sheets relative to the socially optimal level.
    Keywords: crises; distress; limited pledgeability; liquidation cost; systemic risk
    JEL: D61 E58 G21 G28 G32
    Date: 2007–05
  6. By: Idrees Abdul Qayyum (Pakistan Institute of Development Economics, Islamabad.); Sajawal Khan (Pakistan Institute of Development Economics, Islamabad.)
    Abstract: This study aims at empirical investigation of the x-efficiency, scale economies, and technological progress of commercial banks operating in Pakistan using balance panel data for 29 banks. As banking sector efficiency is considered as a precondition for macroeconomic stability, monetary policy execution, and economic growth. We also make efficiency comparisons between the domestic and foreign banks and big banks. Our results indicate that the domestic banks operating in Pakistan are relatively less efficient than their foreign counterparts for the period 2000-05. The scale economies for small banks, especially foreign banks are higher. Our results suggest the existence of technological progress for all groups of banks for the year 2000 and onward. It was lowest for big banks in 2000 and highest for foreign banks in 2005. Again, technological progress is lower for domestic banks relative to foreign banks. The results show also that the market share of big five banks are declining over the period but average interest spread shows fluctuations. The main conclusions that can be drawn from these results are that mergers are more likely to take place, especially in small banks. If the mergers do take place between small domestic banks and foreign banks, these will reduce cost due to scale economies as well as x-efficiency (because foreign banks are x-efficient relative to small domestic banks). Even if mergers do take place between small and big banks, cost will reduce without conferring any monopolistic power to these banks. This will also help in stability of the financial sector, which is an important concern of the State Bank of Pakistan (SBP). So the best policy option for SBP is to encourage mergers, while keeping a check on interest spread, so that the benefits from reduction in cost due to mergers are passed on to depositors and borrowers.
    Keywords: X-efficiency, Scale Economies, Technological Progress, Competition, Spread
    JEL: G14 G18 G21
    Date: 2007
  7. By: Shin-ichi Fukuda; Satoshi Koibuchi
    Abstract: A gshock therapyh might have different impacts between large and small firms. In this paper, we focus on the clients of two large failed Japanese banks - the Long-term Credit Bank of Japan (LTCB) and the Nippon Credit Bank (NCB). We first show that subsequent events after the bank failures allowed the new LTCB to adopt a gshock therapyh but kept the new NCB to face gsoft budget constraintsh. We then show that the different therapies made performances of these two banksf customers very different. Under the shock therapy, large firms showed significant recovery of their profits but small firms did not. In contrast, under the soft budget constraints, large firms did not show recovery and small firms experienced significant decline in their profits when the new bank terminated the banking relationship.
    Keywords: bank failure, shock therapy, soft budget constraints, banking relationship
    JEL: G12 G21 G33
    Date: 2006–10
  8. By: Idrees Khawaja (Pakistan Institute of Development Economics, Islamabad.); Musleh-ud Din (Pakistan Institute of Development Economics, Islamabad.)
    Abstract: Interest spread of the Pakistan’s banking industry has been on the rise for the last two years. The increase in interest spread discourages savings and investments on the one hand, and raises concerns on the effectiveness of bank lending channel of monetary policy on the other. This study examines the determinants of interest spread in Pakistan using panel data of 29 banks. The results show that inelasticity of deposit supply is a major determinant of interest spread whereas industry concentration has no significant influence on interest spread. One reason for inelasticity of deposits supply to the banks is the absence of alternate options for the savers. The on-going merger wave in the banking industry will further limit the options for the savers. Given the adverse implications of banking mergers for a competitive environment, we argue that to maintain a reasonably competitive environment, merger proposals may be subjected to review by an antitrust authority with the central bank retaining the veto over merger approval.
    Keywords: Banks, Determination of Interest Rates, Mergers, Acquisitions
    JEL: G21 E43 G34
    Date: 2007
  9. By: Naohiko Baba (Senior Economist and Director, Financial Markets Department, Bank of Japan. (E-mail:; Masakazu Inada (Institute for Monetary and Economic Studies, Bank of Japan. (E-mail:
    Abstract: This paper empirically investigates the determinants of credit spreads for Japanese mega-banks with emphasis on comparing subordinated CDS spreads with the subordinated bond spreads from the viewpoint of price discovery in both credit markets. The main findings are summarized as follows. First, subordinated CDS and subordinated bond spreads are significantly cointegrated for most banks, and price discovery measures suggest that the CDS spread plays a more dominant role in price discovery than the bond spread. Second, although both CDS and bond spreads significantly react to the Japanese sovereign CDS spread, only the CDS spread reacts significantly to other financial market variables including its own volatility and equity return. Third, both spreads are responsive to the changes in fundamental accounting variables such as the capital? asset ratio and the nonperforming loan ratio. These accounting variables are likely to constitute common factors that are behind the cointegration relationship. Last, significant volatility spillovers are detected from the CDS to bond spreads. This result implies that new information flows more in this direction.
    Keywords: Subordinated Bond, Credit Default Swap, Japanese Banks, Price Discovery, Volatility Spillover, Bivariate GARCH
    JEL: G12 G14 G15
    Date: 2007–05
  10. By: Joe Crowley
    Abstract: This paper examines interest rate spreads in English-speaking African countries. Higher spreads were found to be associated with lower inflation, a greater number of banks, and greater public ownership of banks. Higher deposit interest rates were found to be associated with lower interest rate spreads, but higher net interest margins. A large increase in spreads in the late 1980s and 1990s may be explained by a strengthening of financial sector supervision. Limited data suggested that poor governance, weak regulatory frameworks and property rights, and higher required reserve ratios are associated with higher spreads.
    Date: 2007–05–01

This issue is ©2007 by Roberto J. Santillán–Salgado. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
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