New Economics Papers
on Banking
Issue of 2010‒10‒30
twenty-one papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. Mitigating the pro-cyclicality of Basel II By Rafael Repullo; Jesús Saurina; Carlos Trucharte
  2. Credit risk transfers and the macroeconomy By Ester Faia
  3. Risk-Taking and Asset-Side Contagion in an Originate-to-Distribute Banking Model By Andrea Pinna
  4. Addressing the pro-cyclicality of capital requirements with a dynamic loan loss provision system By José L. Fillat; Judit Montoriol-Garriga
  5. Cyclical Effects of Bank Capital Buffers with Imperfect Credit Markets: international evidence By A. R. Fonseca; F. González; L. Pereira da Silva
  6. Systemic Risk Diagnostics By Bernd Schwaab; Andre Lucas; Siem Jan Koopman
  7. Explaining the money demand of non-financial corporations in the Euro area: A macro and a micro view By Carmen Martinez-Carrascal; Julian von Landesberger
  8. Financial Crisis and Crisis Management in Sweden. Lessons for Today By Lars Jonung
  9. Macro Financial Determinants of the Great Financial Crisis: Implications for Financial Regulation By Caprio, Gerard Jr.; D'Apice , Vincenzo; Ferri, Giovanni; Puopolo , Giovanni Walter
  10. Losses from Simulated Defaults in Canada's Large Value Transfer System By Nellie Zhang; Tom Hossfeld
  11. Australian Banking System Resilience: What Should Be Expected Looking Forward? An International Perspective By Pierluigi Bologna
  12. Composition of Capital Flows: A Survey By Koralai Kirabaeva; Assaf Razin
  13. Single-Name Credit Risk, Portfolio Risk, and Credit Rationing By Arnold, Lutz G.; Reeder, Johannes; Trepl , Stefanie
  14. Financial Institution, Asset Bubbles and Economic Performance By Tomohiro Hirano; Noriyuki Yanagawa
  15. Imperfect Interbank Markets and the Lender of Last Resort By Tarishi Matsuoka
  16. An Inquiry into Banking Portfolios and Financial Stability Surrounding "The Great Recession" By Garita, Gus
  17. Arbitrating between Renegotiation and Bankruptcy: The Case of French Banks Facing Distressed SMEs By Régis Blazy; Jocelyn Martel; Nirjhar Nigam
  18. The cross section of money market fund risks and financial crises By Patrick E. McCabe
  19. Diverging Paths to a Network World: Computerizing Spanish and British Savings Banks, 1960-1990 By Maixe-Altes, J. Carles
  20. The Effectiveness of Monetary Policy During the Recent Financial Turmoil By Puriya Abbassi; Tobias Linzert
  21. Credit Crunch in a Small Open Economy By Michał Brzoza-Brzezina; Krzysztof Makarski

  1. By: Rafael Repullo (CEMFI); Jesús Saurina (Banco de España); Carlos Trucharte (Banco de España)
    Abstract: Policy discussions on the recent financial crisis feature widespread calls to address the pro-cyclical effects of regulation. The main concern is that the new risk-sensitive bank capital regulation (Basel II) may amplify business cycle fluctuations. This paper compares the leading alternative procedures that have been proposed to mitigate this problem. We estimate a model of the probabilities of default (PDs) of Spanish firms during the period 1987 2008, and use the estimated PDs to compute the corresponding series of Basel II capital requirements per unit of loans. These requirements move significantly along the business cycle, ranging from 7.6% (in 2006) to 11.9% (in 1993). The comparison of the different procedures is based on the criterion of minimizing the root mean square deviations of each adjusted series with respect to the Hodrick-Prescott trend of the original series. The results show that the best procedures are either to smooth the input of the Basel II formula by using through the cycle PDs or to smooth the output with a multiplier based on GDP growth. Our discussion concludes that the latter is better in terms of simplicity, transparency, and consistency with banks’ risk pricing and risk management systems. For the portfolio of Spanish commercial and industrial loans and a 45% loss given default (LGD), the multiplier would amount to a 6.5% surcharge for each standard deviation in GDP growth. The surcharge would be significantly higher with cyclically-varying LGDs.
    Keywords: Bank capital regulation, Basel II, Pro-cyclicality, Business cycles, Credit crunch
    JEL: E32 G28
    Date: 2010–09
  2. By: Ester Faia (Goethe University Frankfurt, House of Finance, office 3.47, Grueneburgplatz 1, 60323, Frankfurt am Main, Germany.)
    Abstract: The recent financial crisis has highlighted the limits of the "originate to distribute" model of banking, but its nexus with the macroeconomy and monetary policy remains unexplored. I build a DSGE model with banks (along the lines of Holmström and Tirole [28] and Parlour and Plantin [39]) and examine its properties with and without active secondary markets for credit risk transfer. The possibility of transferring credit reduces the impact of liquidity shocks on bank balance sheets, but also reduces the bank incentive to monitor. As a result, secondary markets allow to release bank capital and exacerbate the effect of productivity and other macroeconomic shocks on output and inflation. By offering a possibility of capital recycling and by reducing bank monitoring, secondary credit markets in general equilibrium allow banks to take on more risk. JEL Classification: E3, E5, G3.
    Keywords: credit risk transfer, dual moral hazard, monetary policy, liquidity, welfare.
    Date: 2010–10
  3. By: Andrea Pinna
    Abstract: During the Subprime crisis the entire banking industry risked collapsing under an unprecedented lack of liquidity. This work tries and find what channel allowed a relatively small systemic shock, the increased mortgage delinquency in the US housing market, to spread worldwide with such a terrific impact. I develop a model of financial contagion where banks adopting the originate-to-distribute model satisfy their liquidity needs through repurchase agreements in the money market. I assume there are no early diers in the economy, and I look at crises originating from inaccurate forecasting of asset returns by some banks. The crisis may be inefficient since accurate banks with good fundamentals are unable to roll over their debt and go bankrupt. There is room for the regulator to make accurate banks willing to rescue failing banks.
    Keywords: Repos; Haircut; Rollover; Financial Crises
    JEL: G1 G24 G32 G33
    Date: 2010
  4. By: José L. Fillat; Judit Montoriol-Garriga
    Abstract: The pro-cyclical effect of bank capital requirements has attracted much attention in the post-crisis discussion of how to make the financial system more stable. This paper investigates and calibrates a dynamic provision as an instrument for addressing pro-cyclicality. The model for the dynamic provision is adopted from the Spanish banking regulatory system. We argue that, had U.S. banks set aside general provisions in positive states of the economy, they would have been in a better position to absorb their portfolios’ loan losses during the recent financial turmoil. The allowances accumulated by means of the hypothetical dynamic provision during the cyclical upswing would have reduced by half the amount of TARP funds required. However, the cyclical buffer for the aggregate U.S. banking system would have been depleted by the first quarter of 2009, which suggests that the proposed provisioning model for expected losses might not entirely solve situations as severe as the one experienced in recent years.
    Keywords: Bank capital ; Troubled Asset Relief Program
    Date: 2010
  5. By: A. R. Fonseca; F. González; L. Pereira da Silva
    Abstract: This paper analyzes the cyclical effects of bank capital buffers using an international sample of 2,361 banks from 92 countries over the 1990-2007 period. We find that capital buffers reduce the bank credit supply but – through what could be “monitoring or signaling effects” – have also an expansionary effect on economic activity by reducing lending and deposit rate spreads. This influence on lending and deposit rate spreads is more pronunced in developing countries and during downturns. The results suggest that capital buffers have a counter-cyclical effect in these countries. Our data do not suggest differences in the cyclical effects of capital buffers between Basel I and Basel II.
    Date: 2010–10
  6. By: Bernd Schwaab (VU University Amsterdam, and European Central Bank); Andre Lucas (VU University Amsterdam); Siem Jan Koopman (VU University Amsterdam)
    Abstract: A macro-prudential policy maker can manage risks to financial stability only if such risks can be reliably assessed. To this purpose we propose a novel framework for systemic risk diagnostics based on state space methods. We assess systemic risk based on latent macro-financial and credit risk components in the U.S., the EU-27 area, and the rest of the world. The time-varying probability of a systemic event, defined as the simultaneous failure of a large number of bank and non-bank intermediaries, can be assessed in- and out of sample. Credit and macro-financial conditions are combined into a straightforward coincident indicator of system risk. In an empirical analysis of worldwide default data, we find that credit risk conditions can significantly and persistently decouple from business cycle conditions due to e.g. unobserved changes in credit supply. Such decoupling is an early warning signal for macro-prudential policy.
    Keywords: financial crisis; systemic risk; credit portfolio models; frailty-correlated defaults; state space methods
    JEL: G21 C33
    Date: 2010–10–18
  7. By: Carmen Martinez-Carrascal (Banco de España, Servicio de Estudios, Alcalá 50, 28014 Madrid, Spain.); Julian von Landesberger (European Central Bank, Directorate General Economics, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper analyses euro area non-financial corporations (NFC) money demand, both from a macro and a microeconomic point of view. At a macro level, money holdings are modelled as a function of real gross added value, the price level, the long-term interest rate on bank lending to non-financial corporations, the own rate of return on M3 and the real capital stock of the NFC sector. The results indicate that NFCs’ money holdings adjust quickly when deviations from their long-run level are registered, and that the large increase observed recently in NFCs’ money holdings has been driven by changes in their fundamentals and hence they stand in line with their long-run equilibrium level. The disaggregated analysis also shows that cash holdings are linked to balance-sheet ratios (such as non-liquid short term assets, tangible assets or indebtedness) and other variables such as the firm’ cash flow, its volatility or the size of the firm, which cannot be taken into account in the macro analysis. Likewise, results indicate that the main drivers of the increase in NFC cash holdings in the last years have been cyclical factors, captured by gross-added value and the cash-flow respectively. Variations in the opportunity cost of holding money, have also contributed to explain M3 developments but more modestly than at the end of the nineties, when its increase contributed negatively to cash accumulation. JEL Classification: E41, C23, C32, D21.
    Keywords: money demand, cointegrated VARs, panel estimation.
    Date: 2010–10
  8. By: Lars Jonung
    Abstract: This paper gives an account of the Swedish financial crisis covering the period 1985–2000, dealing with financial deregulation and the boom in the late 1980s, the bust and the financial crisis in the early 1990s, the recovery from the crisis and the bank resolution policy adopted during the crisis. The paper focuses on three issues: the causes and consequences of the financial crisis, the policy response concerning bank resolution, and the applicability of the Swedish model of bank crisis management for countries currently facing financial problems.
    Keywords: financial, bank, resolution, policy
    Date: 2010
  9. By: Caprio, Gerard Jr.; D'Apice , Vincenzo; Ferri, Giovanni; Puopolo , Giovanni Walter
    Abstract: By analysing the macro financial determinants of the Great Financial Crisis of 2007-2009 on 83 countries, we find that the probability of suffering the crisis in 2008 was larger for countries having higher levels of credit deposit ratio whereas it was lower for countries having higher levels of: i) net interest margin, ii) concentration in the banking sector, iii) restrictions to bank activities, iv) private monitoring. Our findings contribute to the ongoing discussion that can help policymakers calibrate new regulation, by achieving a reasonable trade-off between financial stability and economic growth.
    Keywords: Banking Crisis; Government Intervention; Regulation
    JEL: G18 G15 G21
    Date: 2010–10–21
  10. By: Nellie Zhang; Tom Hossfeld
    Abstract: The Large Value Transfer System (LVTS) loss-sharing mechanism was designed to ensure that, in the event of a one-participant default, the collateral pledged by direct members of the system would be sufficient to cover the largest possible net debit position of a defaulting participant. However, the situation may not hold if the indirect effects of the defaults are taken into consideration, or if two participants default during the same payment cycle. The authors examine surviving participant total losses under both oneand two-participant default conditions, assuming the potential knock-on effects of the default. Their analysis includes the impact of a decline in value of LVTS collateral following an unexpected default. Simulations of participant defaults indicate that the impact on the LVTS is generally small; surviving participants do incur end-of-day collateral shortfalls, but only rarely and in small amounts. Under the two-participant default scenario, the likelihood of the Bank of Canada having to provide funds to ensure LVTS settlement is reasonably low, as is the average residual-coverage amount. The majority of LVTS participants pledge as collateral securities issued by other system members. However, the impact of an issuer of such collateral defaulting is generally not significant in the LVTS.
    Keywords: Financial stability; Payment, clearing, and settlement systems; Financial institutions
    JEL: E47 G21
    Date: 2010
  11. By: Pierluigi Bologna
    Abstract: This paper reviews Australian banks’ performance from an international perspective, with a focus on changes in capital and liquidity risk. The paper analyses the extent of any vulnerability that might arise from a potential deterioration in the funding markets and discusses whether liquidity rules, such as those being considered by the Basel Committee on Banking Supervision, may help reduce banks’ liquidity risks and improve financial stability.
    Date: 2010–10–14
  12. By: Koralai Kirabaeva; Assaf Razin
    Abstract: We survey several key mechanisms that explain the composition of international capital flows: foreign direct investment, foreign portfolio investment and debt flows (bank loans and bonds). In particular, we focus on the following market frictions: asymmetric information in capital markets and exposure to liquidity shocks. We show that the information asymmetry between foreign and domestic investors leads to inefficient investment allocation and borrowing in a country that finances its domestic investment through foreign debt or foreign equity. Exposure to liquidity shocks due to the mismatch of debt maturity may induce banking crises and cause sudden reversals of short-term capital flows. When there is asymmetric information between sellers and buyers in the capital market, then due to the adverse selection foreign direct investment is associated with higher liquidation costs than portfolio investment. The difference in exposure to liquidity shocks (in addition to asymmetric information) can explain the composition of equity flows between developed and emerging countries, and the patterns of foreign direct investments during financial crises.
    JEL: F3
    Date: 2010–10
  13. By: Arnold, Lutz G.; Reeder, Johannes; Trepl , Stefanie
    Abstract: This paper introduces non-diversifiable risk in the Stiglitz-Weiss adverse selection model, so that an increase in the average riskiness of the borrower pool causes higher portfolio risk. This opens up the possibility of equilibrium credit rationing. Comparative statics analysis shows that an increase in risk aversion turns a two-price equilibrium into a rationing equilibrium. A two-price equilibrium is more inefficient than a rationing equilibrium, and a usury law that rules out the higher of the two interest rates can be welfare-improving. Contrary to the common result, the equilibrium may be characterized by over-investment.
    Keywords: asymmetric information; credit rationing
    JEL: D82 E51 G21
    Date: 2010
  14. By: Tomohiro Hirano (Financial Research and Training Center, Financial Services Agency, The Japanese Government); Noriyuki Yanagawa (Faculty of Economics, University of Tokyo)
    Abstract: This paper explores the relation between the quality of financial institution and asset bubbles. In this paper, we will show that bubbles can improve the macro performance even if the quality of financial in- stitution is very poor and the financial market does not work well. In this sense, the high quality of financial institution and bubbles are substitutes. We will explore, however, that they are not perfect substi- tutes. Bubbles may burst. If bubbles burst, the economic performance must go down if the quality of financial institution is low. Hence, we will show that not relaying on bubbles, but improving the quality of financial institution is important for long run macro performance.
    Date: 2010–10
  15. By: Tarishi Matsuoka (Graduate School of Economics, Kyoto University)
    Abstract: This paper presents a monetary model in which interbank markets bear limited commitment to contracts. Limited commitment reduces the proportion of assets that can be used as collateral, and thus banks with high liquidity demands face borrowing constraints in interbank markets. These constraints can be relieved by the central bank (a lender of last resort) through the provision of liquidity loans. I show that the constrained-efficient allocation can be decentralized by controlling only the money growth rate if commitment to interbank contracts is not limited. Otherwise, a proper combination of central bank loans and monetary policy is needed to bring the market equilibrium into a state of constrained efficiency.
    Keywords: Overlapping generations, money, interbank markets, limited commitment, the lender of last resort
    JEL: E42 E51 G21
    Date: 2010–10
  16. By: Garita, Gus
    Abstract: By utilizing the extreme dependence structure and the conditional probability of joint failure (CPJF) between banks, this paper characterizes a risk-stability index (RSI) that quantifies (i) common distress of banks, (ii) distress between specific banks, and (iii) distress to a portfolio related to a specific bank. The results show that financial stability is a continuum; that the Korean and U.S. banking systems seem more prone to systemic risk; and that Asian banks experience the most persistence of distress. Furthermore, a panel VAR indicates that "leaning against the wind" reduces the instability of a financial system.
    Keywords: Conditional probability of joint failure; contagion; dependence structure; distress; multivariate extreme value theory; panel VAR; persistence; risk.
    JEL: C10 F42 E44
    Date: 2010–10–18
  17. By: Régis Blazy (LaRGE Research Center, Université de Strasbourg); Jocelyn Martel (ESSEC Business School); Nirjhar Nigam (Luxembourg School of Finance)
    Abstract: This empirical paper investigates the determinants of the arbitration taking place after a corporate default. Two ways of resolving financial distress are conceivable: either the creditors privately renegotiate with the debtor, or a formal bankruptcy procedure is triggered off. This arbitration depends on the legal context and, more specifically, on the national bankruptcy code. No study has been done on the French Civil Law. Yet, this legal system has inspired other important legislations in continental Europe. We use original data coming from the recovery units of five French commercial banks. Our sample gathers 735 credit lines allocated to 386 distressed companies (233 of them are used in our econometric regressions). Our variables encompass the profile of the company, the origin of the default (with a specific focus on faulty management), the nature of the credit relationship, and the type of borrowings. We test four hypotheses. Hypothesis H1 focuses on a tradeoff between the arguments based on coordination issues and the counterarguments based on the stakeholders’ bargaining power. Such tradeoff may depend on the legal environment. Hypothesis H2 suggests that, to support renegotiation, a bank needs information on the project’s profitability (adverse selection), and on the managers’ reliability (moral hazard). To reach an agreement, the bank must believe both conditions prevail. Hypothesis H3 predicts the likelihood of renegotiation increases with the bank’s financial involvement (size effect). Hypothesis H4 focuses on the level of collateralization (when the bank has inclination for liquidation, collaterals may increase the occurrence of bankruptcy, provided the law facilitates such liquidation and protects the bank’s priority on junior claims). To test H1 to H4, we use sequential LOGIT modeling to split between the variables explaining the decision to engage (or not) renegotiation and the variables explaining the success (or the failure) of renegotiation. Regarding H1, we find the “coordination argument” is of secondary importance compared to the “bargaining power counterargument”. Indeed, whatever the coordination issues, a major bank may not wish to renegotiate simply because the competition with the other minor creditors is expected to be weak under bankruptcy, and/or because the debtor cannot survive without the bank’s financial support. Consequently, even a court-administered procedure (as in France) may not have dissuasive effects provided the bank’s bargaining power is strong enough. Regarding H2, we show the project profitability and the managers’ reliability are two essential conditions to escape bankruptcy, but it needs time to discover them. Consequently, the first step of the arbitration (i.e. renegotiation attempt vs. direct bankruptcy ) does not depend on these conditions. Regarding H3, our results suggest that, when the lending is bigger and/or when the debt contract is longer, the chance of undertaking renegotiation is higher, but this does not predict such renegotiation shall be successful. Last, regarding H4, we do not find any evidence that the level of collateralization significantly influence the tradeoff between informal renegotiation and formal bankruptcy. Indeed, in France, liquidation is viewed as a secondary objective, and the social claims outrank the secured ones.
    Keywords: Bankruptcy, Renegotiation, Banks, SME, Sequential LOGIT.
    JEL: G33 K22
    Date: 2010
  18. By: Patrick E. McCabe
    Abstract: This paper examines the relationship between money market fund (MMF) risks and outcomes during crises, with a focus on the ABCP crisis in 2007 and the run on money funds in 2008. I analyze three broad types of MMF risks: portfolio risks arising from a fund's assets, investor risk reflecting the likelihood that a fund's shareholders will redeem shares disruptively, and sponsor risk due to uncertainty about MMF sponsors' support for distressed funds. I find that during the run on MMFs in September and October 2008, outflows were larger for MMFs that had previously exhibited greater degrees of all three types of risk. In contrast, as the asset-backed commercial paper (ABCP) crisis unfolded in 2007, many MMFs suffered capital losses, but investor flows were relatively unresponsive to risks, probably because investors correctly believed that sponsors would absorb the losses. However, the consequences of MMF risks were quite costly for some sponsors: Using a unique data set of sponsor interventions, I show that sponsor financial support was more likely for MMFs that previously earned higher gross yields (a measure of portfolio risk) and funds with bank-affiliated sponsors. Funds' gross yields and bank affiliation (but not funds' ratings) also would have helped forecast holdings of distressed ABCP. This paper provides some useful lessons for investors and policymakers. The significance of MMF risks in predicting poor outcomes in past crises highlights the importance of monitoring such risks, and I offer some useful proxies for doing so. The paper also argues for greater attention to the systemic risks posed by the industry's reliance on discretionary sponsor support.
    Date: 2010
  19. By: Maixe-Altes, J. Carles
    Abstract: The development of shared data processing networks and their consequences for new retail banking services from the 1960s to the 1980s in both Spanish and British savings banks are the topic of this research. Each of the two competitive environments responded in its own way to the processes of technological and organizational change. As a result this paper observes cross-country variations in the presence of convergence and globalisation. This approach focus on the impact of computer communication networks as a result of corporate strategy in Spanish savings banks. But relevant aspects of computerization in Britain are considered to highlight the adaptative capacity of technology in different environments. Also this paper considers organizational forms with similar root in their corporate governance to enable a degree of homogeneity of the analysis of technological change.
    Keywords: technological change; computer communication networks; computerization; regulatory change; savings banks; retail banks; TSB; collaboration; Spain; UK
    JEL: N20 N70 N2
    Date: 2010–09
  20. By: Puriya Abbassi; Tobias Linzert
    Abstract: The recent financial crisis has deeply affected the marginal cost of funding bank loans and thus the proper functioning of the interest rate channel. We analyze the effectiveness of monetary policy in the euro area with respect to the predictability of money market rates on the basis of monetary policy expectations, and the impact of extraordinary central bank measures on money markets. We find that market’s expectations are less relevant for money market rates up to 12 months after August 2007 compared to the pre-crisis period. At the same time, our results indicate that the ECB’s net increase in outstanding open market operations as of October 2008 accounts for at least a 100 basis point decline in Euribor rates. These findings show that central banks have effective tools at hand to conduct monetary policy in times of crises.
    Keywords: Monetary transmission mechanism; Financial Crisis; Monetary policy implementation; European Central Bank; Money market
    JEL: E43 E52 E58
    Date: 2010–10
  21. By: Michał Brzoza-Brzezina (National Bank of Poland, Economic Institute; Warsaw School of Economics); Krzysztof Makarski (National Bank of Poland, Economic Institute; Warsaw School of Economics)
    Abstract: We construct an open-economy DSGE model with a banking sector to analyse the impact of the recent credit crunch on a small open economy. In our model the banking sector operates under monopolistic competition, collects deposits and grants collateralized loans. Collateral effects amplify monetary policy actions, interest rate stickiness dampens the transmission of interest rates, and financial shocks generate non-negligible real and nominal effects. As an application we estimate the model for Poland - a typical small open economy. According to the results, financial shocks had a substantial, though not overwhelming, impact on the Polish economy during the 2008/09 crisis, lowering GDP by approximately 1.5 percent.
    Keywords: credit crunch, monetary policy, DSGE with banking sector
    JEL: E32 E44 E52
    Date: 2010

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