New Economics Papers
on Banking
Issue of 2010‒12‒11
fourteen papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. A Macro Stress Test Model of Credit Risk for the Brazilian Banking Sector By Francisco Vazquez; Benjamin M. Tabak; Marcos Souto
  2. The impact of public guarantees on bank risk taking: evidence from a natural experiment By Reint Gropp; Christian Gruendl; Andre Guettler
  3. Public credit registries as a tool for bank regulation and supervision By Girault, Matias Gutierrez; Hwang, Jane
  4. Capital Regulation after the Crisis: Business as Usual? By Hellwig, Martin
  5. The Impossible Trio in CDO Modeling By Emmanuel Schertzer; Yadong Li; Umer Khan
  6. Extracting information from structured credit markets By Noss, Joseph
  7. The Inefficiency of Refinancing: Why Prepayment Penalties Are Good for Risky Borrowers By Christopher J. Mayer; Tomasz Piskorski; Alexei Tchistyi
  8. Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons By Òscar Jordà; Moritz Schularick; Alan M. Taylor
  9. Neglected risks, financial innovation, and financial fragility By Nicola Gennaioli; Andrei Shleifer; Robert Vishny
  10. OTC Derivatives Market in India: Recent Regulatory Initiatives and Open Issues for Market Stability and Development By Dayanand Arora; Francis Xavier Rathinam
  11. Going for broke: New Century Financial Corporation, 2004-2006 By Landier, Augustin; Sraer, David; Thesmar, David
  12. Regulatory Medicine Against Financial Market Instability: What Helps And What Hurts? By Stefan Kerbl
  13. Liquidity Problems in the FX Liquid Market By Vladimir Borgy; Julien Idier; Gaëlle Le Fol
  14. The Macrodynamics of Household Debt By Yun Kim; Alan Isaac

  1. By: Francisco Vazquez; Benjamin M. Tabak; Marcos Souto
    Abstract: This paper proposes a model to conduct macro stress test of credit risk for the banking system based on scenario analysis. We employ an original bank level data set with disaggregated credit loans for business and consumer loans. The results corroborate the presence of a strong procyclical behavior of credit quality, and show a robust negative relationship between (the logistic transformation of) NPLs and GDP growth, with a lag response up to three quarters. The models also indicate substantial variations in the cyclical behavior of NPLs across credit types. Stress tests suggest that the banking system is well prepared to absorb the credit losses associated with a set of distressed macroeconomic scenarios without threatening financial stability.
    Date: 2010–11
  2. By: Reint Gropp (EBS Business School, Department of Finance, Accounting, and Real Estate, Gustav-Stresemann-Ring 3, 65189 Wiesbaden, Germany.); Christian Gruendl (EBS Business School, Department of Finance, Accounting, and Real Estate.); Andre Guettler (EBS Business School, Department of Finance, Accounting, and Real Estate,.)
    Abstract: In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7.5% and the average loan size declined by 17.2%. Remaining borrowers paid 46 basis points higher interest rates, despitetheir higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee and that none of these effects are present in a control group of German banks to whom the guarantee was not applicable. Furthermore, savings banks adjusted their liabilities away from risk-sensitive debt instruments after the removal of the guarantee, while we do not observe this for the control group. We also document in an event study that yield spreads of savings banks’ bonds increased significantly right after the announcement of the decision to remove guarantees, while the yield spread of a sample of bonds issued by the control group remained unchanged. The results suggest that public guarantees may be associated with substantial moral hazard effects. JEL Classification: G21, G28, G32.
    Keywords: banking, public guarantees, credit risk, moral hazard, market discipline.
    Date: 2010–12
  3. By: Girault, Matias Gutierrez; Hwang, Jane
    Abstract: This paper is about the importance of the information in Public Credit Registries (PCRs) for supporting and improving banking sector regulation and supervision, particularly in the light of the new approach embodied in Basel III. Against the backdrop of the financial crisis and the existence of information data gaps, the importance of complete, accurate and timely credit information in the financial system is evident. Both in normal times and during crises, authorities need a device that allows them to look at the universe of credits in a detailed and readily way. And more importantly, they need to develop tools that exploit as much as possible the information therein contained. PCR databases contain individual credit information on borrowers and their credits which makes it possible to implement advanced techniques that measure banks'credit risk exposure. It allows optimizing the prudential regulation ensuring that provisioning and capital requirements are properly calibrated to cover expected and unexpected losses respectively. It also permits validating banks'internal rating systems, performing stress tests and informing macroprudential surveillance. In this respect, it is envisioned that the existence of a PCR will be a key factor to enhance the supervision and regulation of the financial system. Furthermore, the extent, accuracy and availability of the information collected by the authorities will determine the usefulness of the PCR as part of their toolkit to monitor the potential vulnerabilities not only on a microprudential level, but also on a macroprudential one.
    Keywords: Banks&Banking Reform,Access to Finance,Financial Intermediation,Debt Markets,Bankruptcy and Resolution of Financial Distress
    Date: 2010–12–01
  4. By: Hellwig, Martin
    Abstract: The paper discusses the reform of capital regulation of banks in the wake of the financial crisis of 2007/2009. Whereas the Basel Committee on Banking Supervision seems to go for marginal changes here and there, the paper calls for a thorough overhaul, moving away from risk calibration and raising capital requirements very substantially. The argument is based on the observation that the current system of risk- calibrated capital requirements, in particular under the modelbased approach, played a key role in allowing banks to be undercapitalized prior to the crisis, with strong systemic effects for deleveraging multipliers and for the functioning of interbank markets. The argument is also based on the observation that the current system has no theoretical foundation, its objectives are ill-specified, and its effects have not been thought through, either for the individual bank or for the system as a whole. Objections to substantial increases in capital requirements rest on arguments that run counter to economic logic or are themselves evidence of moral hazard and a need for regulation.
    Date: 2010–07
  5. By: Emmanuel Schertzer; Yadong Li; Umer Khan
    Abstract: We show that stochastic recovery always leads to counter-intuitive behaviors in the risk measures of a CDO tranche - namely, continuity on default and positive credit spread risk cannot be ensured simultaneously. We then propose a simple recovery variance regularization method to control the magnitude of negative credit spread risk while preserving the continuity on default.
    Date: 2010–12
  6. By: Noss, Joseph (Bank of England)
    Abstract: Structured credit instruments offer an insight into markets’ perceptions of the extent of future credit defaults. Claims of different seniorities incur losses only if defaults reach different magnitudes, so their relative value offers an insight into the likelihood of losses being of different severities. This paper matches the traded values of structured credit products by modelling the defaults of the underlying credits and their interdependence. It offers an improvement on the industry-standard ‘Gaussian copula’ model in its ability to capture the ‘tail event’ of multiple firms defaulting together. This allows policymakers to draw better inference as to the likely scale of defaults implied by structured credit prices. It offers an indication of the extent to which defaults are driven by systemic shocks to firms’ balance sheets. It may also be of use to those who trade structured credit products and may offer an improvement in risk management.
    Keywords: Structured credit instruments; systemic risk; asset prices
    JEL: G12
    Date: 2010–12–02
  7. By: Christopher J. Mayer; Tomasz Piskorski; Alexei Tchistyi
    Abstract: This paper explores the practice of mortgage refinancing in a dynamic competitive lending model with risky borrowers and costly default. We show that prepayment penalties improve welfare by ensuring longer-term lending contracts, which prevents the mortgage pools from becoming disproportionately composed of the riskiest borrowers over time. Mortgages with prepayment penalties allow lenders to lower mortgage rates and extend credit to the least creditworthy, with the largest benefits going to the riskiest borrowers, who have the most incentive to refinance in response to positive credit shocks. Empirical evidence from more than 21,000 non-agency securitized fixed rate mortgages is consistent with the key predictions of our model. Our results suggest that regulations banning refinancing penalties might have the unintended consequence of restricting access to credit and raising rates for the least creditworthy borrowers.
    JEL: D12 D14 D53 G14 G21 G28 R31 R38
    Date: 2010–12
  8. By: Òscar Jordà; Moritz Schularick; Alan M. Taylor
    Abstract: Do external imbalances increase the risk of financial crises? In this paper, we study the experience of 14 developed countries over 140 years (1870-2008). We exploit our long-run dataset in a number of different ways. First, we apply new statistical tools to describe the temporal and spatial patterns of crises and identify five episodes of global financial instability in the past 140 years. Second, we study the macroeconomic dynamics before crises and show that credit growth tends to be elevated and natural interest rates depressed in the run-up to global financial crises. Third, we show that recessions associated with crises lead to deeper recessions and stronger turnarounds in imbalances than during normal recessions. Finally, we ask if external imbalances help predict financial crises. Our overall result is that credit growth emerges as the single best predictor of financial instability, but the correlation between lending booms and current account imbalances has grown much tighter in recent decades.
    JEL: C14 C52 E51 F32 F42 N10 N20
    Date: 2010–12
  9. By: Nicola Gennaioli; Andrei Shleifer; Robert Vishny
    Abstract: We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.
    Date: 2010–04
  10. By: Dayanand Arora; Francis Xavier Rathinam (Indian Council for Research on International Economic Relations)
    Abstract: The OTC derivatives markets all over the world have shown tremendous growth in recent years. In the wake of the present financial crisis, which is believed to have been exacerbated by OTC derivatives, increasing attention is being paid to analysing the regulatory environment of these markets. In this context, we analyse the regulatory framework of the OTC derivatives market in India. The paper, inter alia, seeks to prove the point that the Indian OTC derivatives markets, unlike many other jurisdictions, are well regulated. Only contracts where one party to the contract is an RBI regulated entity are considered legally valid in India. A good reporting system and a post-trade clearing and settlement system, through a centralised counter party, has ensured good surveillance of the systemic risks in the Indian OTC market. From amongst the various OTC derivatives markets permitted in India, interest rate swaps and foreign currency forwards are the two prominent markets. However, by international standards, the total size of the Indian OTC derivatives markets still remains small because credit default swaps were conspicuously absent in India until now. It appears that Indian OTC derivatives markets will grow fast once again after the present financial crisis is over. This research paper explores those open issues that are important to ensure market stability and development. On the issue of the much discussed competition between exchange-traded and OTC-traded derivatives, we believe that the two markets serve different purposes and would contribute more to risk management and market efficiency, if viewed as complementary. Regarding the introduction of new derivative products for credit risk transfer, the recent announcement by the RBI that it would introduce credit default swaps is a welcome sign. We believe that routing of credit default swaps through a reporting platform and managing its post-trade activities through a centralised counterparty would provide better surveillance of the market. Strengthening the position of the Clearing Corporation of India Ltd. (CCIL) as the only centralised counterparty for Indian OTC derivatives market and better supervision of the off-balance sheet business of financial institutions are two measures that have been proposed to ensure the stability of the market.
    Keywords: Derivatives and Over the Counter Market, Financial Institutions and Services and Government Policy and Financial Regulation
    JEL: G1 G2 G28
    Date: 2010
  11. By: Landier, Augustin; Sraer, David; Thesmar, David
    Abstract: Using loan level data, we investigate the lending behavior of a large subprime mortgage issuer prior to its bankruptcy in the beginning of 2007. In 2004, this firm suddenly started to massively issue new loans contracts that featured deferred amortization ("interestonly loans") to high income and high FICO households. We document that these loans were not only riskier, but also that their returns were more sensitive to real estate prices than standard contracts. Implicitly, this lender dramatically increased its exposure to its own legacy asset, which is what a standard model of portfolio selection in distress would predict. We provide additional evidence on New Century’s lending behavior, which are consistent with a risk shifting strategy. Finally, we are able to tie this sudden change in behavior to the sharp monetary policy tightening implemented by the Fed in the spring of 2004. Our findings shed new light on the relationship between monetary policy and risk taking by financial institutions.
    Date: 2010–09
  12. By: Stefan Kerbl
    Abstract: Do we know if a short selling ban or a Tobin Tax result in more stable asset prices? Or do they in fact make things worse? Just like medicine regulatory measures in financial markets aim at improving an already complex system. And just like medicine these interventions can cause side effects which are even harder to assess when taking the interplay with other measures into account. In this paper an agent based stock market model is built that tries to find answers to the questions above. In a stepwise procedure regulatory measures are introduced and their implications on market liquidity and stability examined. Particularly, the effects of (i) a ban of short selling (ii) a mandatory risk limit, i.e. a Value-at-Risk limit, (iii) an introduction of a Tobin Tax, i.e. transaction tax on trading, and (iv) any arbitrary combination of the measures are observed and discussed. The model is set up to incorporate non-linear feedback effects of leverage and liquidity constraints leading to fire sales and escape dynamics. In its unregulated version the model outcome is capable of reproducing stylised facts of asset returns like fat tails and clustered volatility. Introducing regulatory measures shows that only a mandatory risk limit is beneficial from every perspective, while a short selling ban - though reducing volatility - increases tail risk. The contrary holds true for a Tobin Tax: it reduces the occurrence of crashes but increases volatility. Furthermore, the interplay of measures is not negligible: measures block each other and a well chosen combination can mitigate unforeseen side effects. Concerning the Tobin Tax the findings indicate that an overdose can do severe harm.
    Date: 2010–11
  13. By: Vladimir Borgy (Banque de France - Banque de France); Julien Idier (Banque de france - Banque de France); Gaëlle Le Fol (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris Dauphine - Paris IX)
    Abstract: Even though the FX market is one of the most liquid financial market, it would be an error to consider that it is immune against any liquidity problem. This paper analyzes on a long sample (2000-2009), the all set of quotes and transactions in three main currency pairs (EURJPY, EURUSD, USDJPY) on the EBS platform. To characterize the FX market liquidity, we consider the spread, the traded volume, the number of transactions and the Amihud (2002) statistic for illiquidity. We also propose the computation of a new liquidity indicator, BIL, that solely relies on price series availability. The main benefit of such measure is to be easily calculated on almost any financial market as well as to have a clear interpretation in terms of liquidity costs. Using all these advanced liquidity analyses, we finally test the accuracy of these measures to detect liquidity problems in the FX market. Our analysis, based on a signaling approach, shows that liquidity problems have arisen during specific episodes in the early 2000's and more generally during the recent financial turmoil.
    Keywords: FX market; Liquidity; financial crisis
    Date: 2010
  14. By: Yun Kim (Department of Economics, Trinity College); Alan Isaac (Department of Economics, American University)
    Abstract: Recent research finds that corporate leverage affects macroeconomic dynamics and can contribute to financial fragility. We show that consumer debt is also important. We add consumer debt to a stock-flow consistent neo-Kaleckian growth model and explore the macrodynamic ramifications. Consumer debt influences effective demand, the profit rate, and economic growth. Unsurprisingly, laxer consumer credit constraints stimulate growth in the short run. However, the long-run effects may be growth reducing. Looser consumer credit can also make the system more vulnerable to changes in the state of confidence, the interest rate, and the saving propensity of rentiers. When consumer debt levels are high, a small increase in the interest rate or increase in the rentiers’s saving propensity, or reduction in the state of confidence can destabilize the macroeconomy. We further extend the model endogenizing the retention ratio. We find that the model becomes structurally unstable. This allows a simple characterization of economic crisis: a downswing in the state of confidence destabilize the macroeconomy. We also observe that higher interest rates and more prudent behavior of rentiers can be destabilizing.
    Keywords: Corporate debt, Consumer debt, Dynamics, Instability
    JEL: B59 E12 E22 O41
    Date: 2010–11

This issue is ©2010 by Christian Calmès. 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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