New Economics Papers
on Banking
Issue of 2012‒05‒08
twenty-two papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. Effects of equity capital on the interest rate and the demand for credit. Empirical evidence from Spanish banks By Alfredo Martín-Oliver; Sonia Ruano; Vicente Salas-Fumás
  2. Banking sector's international interconnectedness: Implications for consumption risk sharing in Europe By Thomas Nitschka
  3. Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the Spanish Dynamic Provisioning Experiments By Jiménez, G.; Ongena, S.; Peydro, J.L.; Saurina, J.
  4. Modelling the liquidity ratio as macroprudential instrument By Jan Willem van den End; Mark Kruidhof
  5. Why do UK banks securitize? By Mario Cerrato; Moorad Choudhry; John Crosby; John Olukuru
  6. Bank monitoring incentives and optimal ABS By Pagès, H.
  7. A dynamic analysis of bank bailouts and constructive ambiguity By Eijffinger, Sylvester C W; Nijskens, Rob
  8. Banks, Free Banks, and U.S. Economic Growth By Matthew Jaremski; Peter L. Rousseau
  9. A note on foreign bank entry and bank corporate governance in China By Hasan, Iftekhar; Xie, Ru
  10. "Measuring Macroprudential Risk through Financial Fragility: A Minskyan Approach" By Eric Tymoigne
  11. Time to Set Banking Regulation Right By Jacopo Carmassi; Stefano Micossi
  12. Tackling the “Too Big To Fail” conundrum: Integrating market and regulation By Renato Maino
  13. Do Loan Officers' Incentives Lead to Lax Lending Standards? By Ben-David, Itzhak; Agarwal, Sumit
  14. 2012-13 Determinants of bank credit in small open economies: The case of six Pacific Island Countries By Parmendra Sharma, Neelesh Gounder
  15. Competition Between Mail and Electronic Substitutes in the Financial Sector: A Hotelling Approach By Cremer, Helmuth; De Donder, Philippe; Dudley, Paul; Rodriguez, Frank
  16. A mathematical treatment of bank monitoring incentives By Pagès, H.; Possamai, D.
  17. Leading Behavior of Interest Rate Term Spreads and Credit Risk Spreads in Korea By Won-Gi Kim; Noh-Sun Kwark
  18. The (Un-) importance of Chapter 7 wealth exemption levels By Jochen, Mankart
  19. Liquidity, Term Spreads and Monetary Policy By Yunus Aksoy; Henriqu S Basso
  20. The Return of Financial Repression By Reinhart, Carmen
  21. Modelling macroeconomic eects and expert judgements in operational risk : a Bayesian approach By Capa Santos, Holger; Kratz, Marie; Mosquera Munoz, Franklin
  22. A DSGE-Based Assessment of Nonlinear Loan-to-Value Policies: Evidence from Hong Kong By Funke, Michael; Paetz, Michael

  1. By: Alfredo Martín-Oliver (Universitat de les Illes Balears); Sonia Ruano (Banco de España); Vicente Salas-Fumás (Universidad de Zaragoza)
    Abstract: We examine the consequences of imposing higher capital requirements on banks (as under Basel III or, recently, in the case of large banks in the European context) for bank dynamics in complying with the new standards and for the long-term effects on bank lending rates and the demand for bank credit. The analysis combines econometric estimations of the determinants of equity capital ratios and lending rates with simulations of market equilibrium results for loan interest rates and the demand for bank credit, based on a parameterised model of the Spanish banking industry. We find that the gap between the target and the actual capital ratio is reduced by around 40% every year, mainly with retained earnings. We also find that raising the equity capital ratio by one percentage point increases bank lending rates by 4.2 basis points. Finally, the simulation exercise shows that the estimated increase in the cost of funds for banks associated with a one percentage point increase in the equity capital ratio leads to a fall of 0.8% in the total demand for bank credit. These results suggest that the social costs of higher equity capital requirements for banks are expected to be greater in the transition period, when banks are adjusting to the new standards, than in the steady state of the new industry equilibrium, when all banks comply with the new ratio
    Keywords: Bank capital regulation, Basel III, bank lending rates, demand for credit
    JEL: D24 G21
    Date: 2012–04
  2. By: Thomas Nitschka
    Abstract: Cross-border asset and liability holdings allow countries to insulate their consumption streams from idiosyncratic output shocks, i.e. consumption risk sharing. By contrast, banks' international interconnectedness spread the U.S. subprime mortgage crisis to various economies with adverse macroeconomic consequences. This paper evaluates the partial impact of banks' cross-border links on the ability of their host countries to share consumption risk internationally. It shows that the impact of banks' links to the non-bank sector in the rest-of-the-world on consumption risk sharing is negligible while strong interbank links are associated with relatively little consumption risk sharing of banks' host countries.
    Keywords: banking sector, cross-border assets, consumption risk sharing, interconnectedness,systemic risk
    JEL: E2 F15 G15
    Date: 2012
  3. By: Jiménez, G.; Ongena, S.; Peydro, J.L.; Saurina, J. (Tilburg University, Center for Economic Research)
    Abstract: Abstract: We analyze the impact of the countercyclical capital buffers held by banks on the supply of credit to firms and their subsequent performance. Countercyclical ‘dynamic’ provisioning that is unrelated to specific loan losses was introduced in Spain in 2000, and modified in 2005 and 2008. These policy experiments which entailed bank-specific shocks to capital buffers, combined with the financial crisis that shocked banks according to their available pre-crisis buffers, underpin our identification strategy. Our estimates from comprehensive bank-, firm-, loan-, and loan application-level data suggest that countercyclical capital buffers help smooth credit supply cycles and in bad times have positive effects on firm credit availability, assets, employment and survival. Our findings therefore hold important implications for theory and macroprudential policy.
    Keywords: bank capital;dynamic provisioning;credit availability;financial crisis.
    JEL: E51 E58 E60 G21 G28
    Date: 2012
  4. By: Jan Willem van den End; Mark Kruidhof
    Abstract: The Basel 3 Liquidity Coverage Ratio (LCR) is a micro prudential instrument to strengthen the liquidity position of banks. However if in extreme scenarios the LCR becomes a binding constraint, the interaction of bank behaviour with the regulatory rule can have negative externalities. We simulate the systemic implications of the LCR by a liquidity stress-testing model, which takes into account the impact of bank reactions on second round feedback effects. We show that a flexible approach of the LCR, in particular one which recognises less liquid assets in the buffer, is a useful macroprudential instrument to mitigate its adverse side-effects during times of stress. At extreme stress levels the instrument becomes ineffective and the lender of last resort has to underpin the stability of the system.
    Keywords: Financial stability; Banks; Liquidity; Regulation
    JEL: C15 E44 G21 G32 G28
    Date: 2012–04
  5. By: Mario Cerrato; Moorad Choudhry; John Crosby; John Olukuru
    Abstract: The eight years from 2000 to 2008 saw a rapid growth in the use of securitization by UK banks. We aim to identify the reasons that contributed to this rapid growth. The time period (2000 to 2010) covered by our study is noteworthy as it covers the pre-financial crisis credit- boom, the peak of the financial crisis and its aftermath. In the wake of the financial crisis, many governments, regulators and political commentators have pointed an accusing finger at the securitization market - even in the absence of a detailed statistical and economic analysis. We contribute to the extant literature by performing such an analysis on UK banks, fo- cussing principally on whether it is the need for liquidity (i.e. the funding of their balance sheets), or the desire to engage in regulatory capital arbitrage or the need for credit risk trans- fer that has led to UK banks securitizing their assets. We show that securitization has been significantly driven by liquidity reasons. In addition, we observe a positive link between securitization and banks credit risk. We interpret these latter findings as evidence that UK banks which engaged in securitization did so, in part, to transfer credit risk and that, in comparison to UK banks which did not use securitization, they had more credit risk to transfer in the sense that they originated lower quality loans and held lower quality assets. We show that banks which issued more asset-backed securities before the financial crisis suffered more defaults after the financial crisis.
    JEL: G21 G28
    Date: 2012–04
  6. By: Pagès, H.
    Abstract: The paper examines a continuous-time delegated monitoring problem between a competitive investor and an impatient bank monitoring a pool of long-term loans subject to Markovian "contagion." Moral hazard induces a foreclosure bias unless the bank is compensated with the right incentive-compatible contract. Fees are paid when the bank's performance is on target and liquidation arises when the bank's performance is sufficiently poor. I show that the optimal contract can be implemented with a whole loan sale involving both credit risk retention based on ABS credit default swaps and credit enhancement in the form of a reserve account. The optimal securitization bears out rulemaking recently proposed in the wake of the Dodd-Frank Act on a number of controversial provisions. I argue that further efficiency gains could be reaped by extending the role of the "premium capture" account into a liquidity buffer capturing performance-based compensation as a way to increase skin in the game over the life of the deal.
    Keywords: ABS Credit Default Swaps, Banking Regulation, Default Correlation, Dynamic Moral Hazard, Optimal Securitization, Risk Retention.
    JEL: G21 G28 G32
    Date: 2012
  7. By: Eijffinger, Sylvester C W; Nijskens, Rob
    Abstract: Bailout expectations have led banks to behave imprudently, holding too little capital and relying too much on short term funding to finance long term investments. This paper presents a model to rationalize a constructive ambiguity approach to liquidity assistance as a solution to forbearance. Faced with a bank that chooses capital and liquidity, the institution providing liquidity assistance can commit to a mixed strategy: never bailing out is too costly and therefore not credible, while always bailing out causes moral hazard. In equilibrium, the bank chooses above minimum capital and liquidity, unless either capital costs or the opportunity cost of liquidity are too high. We also find that the probability of a bailout is higher for a regulator more concerned about bank failure, and when the bailout penalty for the bank is higher; this suggests that forbearance is not entirely eliminated by adopting ambiguity.
    Keywords: banking; commitment; Lender of Last Resort; liquidity; regulation
    JEL: E58 G21 G28
    Date: 2012–04
  8. By: Matthew Jaremski; Peter L. Rousseau
    Abstract: The “Federalist financial revolution” may have jump-started the U.S. economy into modern growth, but the Free Banking System (1837-1862) did not play a direct role in sustaining it. Despite lowering entry barriers and extending banking into developing regions, we find in county-level data that free banks had little or no effect on growth. The result is not just a symptom of the era, as state-chartered banks seem to have strong and positive effects on manufacturing and urbanization.
    JEL: G21 N21 O43
    Date: 2012–04
  9. By: Hasan, Iftekhar (BOFIT); Xie, Ru (BOFIT)
    Abstract: China employs a unique foreign bank entry model. Instead of allowing full foreign control of domestic banks, foreign investors are only permitted to be involved in the local banks as minority shareholders. At the same time, foreign strategic investors are expected to commit to bank corporate governance improvement and new technology support. In this context, the paper examines the effect of foreign strategic investors on Chinese bank performance. Based on a unique data set of bank ownership, performance, corporate governance and stock returns from 2003 to 2007, our regression and event study analysis results suggest that active involvement of foreign strategic investors in bank management have improved the corporate governance model of Chinese banks from a control based model to a market oriented model, and accordingly have promoted bank performance.
    Keywords: China; foreign market entry; corporate governance
    JEL: F23 G21 G28 G34
    Date: 2012–05–02
  10. By: Eric Tymoigne
    Abstract: This paper presents a method to capture the growth of financial fragility within a country and across countries. This is done by focusing on housing finance in the United States, the United Kingdom, and France. Following the theoretical framework developed by Hyman P. Minsky, the paper focuses on the risk of amplification of shock via a debt deflation instead of the risk of a shock per se. Thus, instead of focusing on credit risk, for example, financial fragility is defined in relation to the means used to service debts, given credit risk and all other sources of shocks. The greater the expected reliance on capital gains and debt refinancing to meet debt commitments, the greater the financial fragility, and so the higher the risk of debt deflation induced by a shock if no government intervention occurs. In the context of housing finance, this implies that the growth of subprime lending was not by itself a source of financial fragility; instead, it was the change in the underwriting methods in all sectors of the mortgage markets that created a financial situation favorable to the emergence of a debt deflation. Stated alternatively, when nonprime and prime mortgage lending moved to asset-based lending instead of income-based lending, the financial fragility of the economy grew rapidly.
    Keywords: Debt Deflation; Minsky; Financial Fragility; Systemic Risk
    JEL: E12 E32 E44
    Date: 2012–04
  11. By: Jacopo Carmassi; Stefano Micossi
    Abstract: None
    Date: 2012–04
  12. By: Renato Maino
    Abstract: Systemic risk is, by nature, unpredictable. Statistical models can fail to identify it. We need to maintain resource buffers as well as to implement better regulatory controls, and to improve managerial experience, and contingent strategies. International imbalances are nearly up to their sustainable limits, creating new systemic challenges. Some major financial institutions have recently assumed a critical position: they are highly interconnected and hard to replace in a panic. These institutions play key roles in the economy, such as providing market liquidity and pricing assets efficiently. Following deregulation, these institutions became “universal” groups covering a large range of financial markets and products. Internal conflicts of interest, opacity, and manipulated risk measures may arise. Regulation must change and new market instruments could exacerbate these internal problems. Here, we discuss some proposals to enhance the role of the Resolution Authorities (American and European laws are in the process of defining them). In particular, we examine a proposal for high-trigger contingent convertible bonds (HT CoCos), especially conceived for Systemically Important Financial Institutions – SIFIs (Calomiris and Herring, 2011).We propose that the bond conversion should be applied to all SIFIs’ HT CoCos as soon as one SIFI defaults. This solution could have many advantages: less costly recapitalization of the SIFIs’ system, more level playing field in the financial industry, good incentives to shareholders and supervisors to react promptly to potential systemic crisis, introducing breaks in SIFIs’ market values correlation (and with Sovereigns, too). We also provide a quantification of the potential market for such instruments.
    Date: 2012–04
  13. By: Ben-David, Itzhak (OH State University); Agarwal, Sumit (National University Singapore and Federal Reserve Bank of Chicago)
    Abstract: To understand better the role of loan officers' incentives in the origins of the financial crisis, we study a controlled field experiment conducted by a large bank. In the experiment, the incentive structure of a subset of small business loan officers was altered from fixed salary to volume-based pay. We use a diff-in-diff design to show that while the characteristics of loan applications did not change, incentive-paid loan officers book 19% loans with dollar amounts larger by 19%. We show that treated loan officers use their discretion more in the booking decision. Although loans booked by incentive-paid loan officers have better observable credit quality, they are 28% more likely to default. The increase in default is concentrated in loans that wouldn't have been booked in the absence of commission-based compensation, and in loans with excessive dollar amount. Our results support the idea that the explosion in mortgage volume during the housing bubble and the deterioration of underwriting standards can be partly attributed to the incentives of loan officers.
    JEL: G01 G21
    Date: 2012–04
  14. By: Parmendra Sharma, Neelesh Gounder
    Keywords: Bank private sector credit, South Pacific, cross-country analysis
    JEL: E51 G21 C23 E44
  15. By: Cremer, Helmuth (Toulouse School of Economics (GREMAQ, IDEI and Institut universitaire de France)); De Donder, Philippe (Toulouse School of Economics (GREMAQ-CNRS and IDEI)); Dudley, Paul (Head of Regulatory Economics, Royal Mail Group); Rodriguez, Frank (Associate, Oxera)
    Abstract: We build a model where two banks compete for the patronage of consumers by offering them, among other services and products, two forms of transactional media: paper statements and electronic substitutes. Both banks and both products are horizontally di¤erentiated and modeled à la Hotelling(1929). Assuming symmetry of consumer preferences (over banks and, independently, over the two transactional media) and of bankss costs, we obtain that the unique pro…t-maximizing symmetrical prices reect both the transactional media marginal costs and the intensity of competition between banks. Most notably, the intensity of consumers preferences for one variant of transactional medium over another has no inuence on the pro…t-maximizing media prices. Also, there is total pass-through of increases in input prices (such as mail price for paper statements) into prices paid by …nal consumers.
    Date: 2012–03–13
  16. By: Pagès, H.; Possamai, D.
    Abstract: In this paper, we take up the analysis of a principal/agent model with moral hazard introduced in [15], with optimal contracting between a competitive investor and an impatient bank monitoring a pool of long-term loans subject to Markovian contagion. We provide here a comprehensive mathematical formulation of the model and show using martingale arguments in the spirit of Sannikov [17] how the maximization problem with implicit constraints faced by investors can be reduced to a classic stochastic control problem. The approach has the advantage of avoiding the more general techniques based on forward-backward stochastic differential equations described in [6] and leads to a simple recursive system of Hamilton-Jacobi-Bellman equations. We provide a solution to our problem by a verification argument and give an explicit description of both the value function and the optimal contract. Finally, we study the limit case where the bank is no longer impatient.
    Keywords: Default Correlation, Dynamic Moral Hazard, Forward-Backward Stochastic Differential Equations.
    JEL: G21 G28 G32
    Date: 2012
  17. By: Won-Gi Kim (Department of Economics, Texas A&M University); Noh-Sun Kwark (Department of Economics, Sogang University, Seoul)
    Abstract: Interest rate term spreads and credit spreads have been well known to have a predictive power for future fluctuations of output in many developed countries. This study examines leading behaviors of interest rate term spreads and credit risk spreads in Korea in two ways. First, we apply various empirical methods for finding leading behavior of interest rate term spreads and credit risk spreads in business fluctuations over the period spanning from May 1995 to January 2012. Second, using structural VAR models, we decompose the sources of fluctuations of output and interest rate spreads into two sorts, permanent real shocks and temporary financial shocks and examine the impulse response of each variable to the shocks focusing on the leading behavior of the spreads over the business cycle. We establish successfully the leading behavior of the term spread and the credit risk spread in Korea that the term spread tends to increase and the credit risk spread tends to shrink about 4 to 6 months before an expansion. We also find that much of the output fluctuations are attributed to real shocks while fluctuations in the interest rate spreads come from temporary financial shocks.
    Keywords: Term spread; Credit risk spreads; Forecast-error variance decompo- sition
    JEL: E32 F3
    Date: 2012–03
  18. By: Jochen, Mankart
    Abstract: This paper examines the effects of the Chapter 7 wealth exemption level on welfare, bankruptcy filings, debt and asset holdings. I build on the heterogeneous agent life cycle model by Livshits, MacGee, and Tertilt (2007) which features uninsurable income and expense shocks. I extend their model by allowing borrowers to simultaneously invest in the risk free asset. When a borrower defaults on her debt by filing for Chapter 7 bankruptcy, she can keep her assets up to the wealth exemption level. Wealth exemption levels are important for two reasons. First, they explain the credit card debt puzzle identified by Gross and Souleles (2002b). Around thirty percent of borrowers, both in the model and in the data, who borrow at high interest rates simultaneously save at low interest rates. Second, ignoring the exemption level biases results because it overstates the costs of defaulting. At the same time, wealth exemption levels are unimportant in the sense that they have an impact only at low exemption levels. The effects of increases in the exemption level fade out very quickly. There is no strong positive relationship between exemption levels, which vary across U.S. states, and default rates in the model. This is in contrast to the previous literature, but consistent with the data. The reason is that those borrowers who might default do not own much wealth. Therefore, only very few households are affected by increases in the exemption level. A further result is that aggregate savings are increasing in the exemption level because a high exemption level gives poor agents who might default an incentive to save.
    Keywords: Personal bankruptcy law, wealth exemption level, asset portfolios, credit card debt puzzle
    JEL: E21 D31 K35
    Date: 2012–05
  19. By: Yunus Aksoy (Department of Economics, Mathematics & Statistics, Birkbeck); Henriqu S Basso (University of Warwick)
    Abstract: We propose a model that delivers endogenous variations in term spreads driven primarily by banks' portfolio decision and their appetite to bear the risk of maturity transformation. We first show that fluctuations of the future profitability of banks' portfolios affect their ability to cover for any liquidity shortage and hence influence the premium they require to carry maturity risk. During a boom, profitability is increasing and thus spreads are low, while during a recession profitability is decreasing and spreads are high, in accordance with the cyclical properties of term spreads in the data. Second, we use the model to look at monetary policy and show that allowing banks to sell long-term assets to the central bank after a liquidity shock leads to a sharp decrease in long-term rates and term spreads. Such interventions have significant impact on long-term investment, decreasing the amplitude of output responses after a liquidity shock. The short-term rate does not need to be decreased as much and inflation turns out to be much higher than if no QE interventions were implemented. Finally, we provide macro and micro-econometric evidence for the U.S. confirming the importance of expected financial business profitability in the determination of term spread fluctuations.
    Keywords: Yield Curve, Quantitative Easing, Maturity Risk, Bank Portfolio
    JEL: E43 E44 E52 G20
    Date: 2012–04
  20. By: Reinhart, Carmen
    Abstract: Periods of high indebtedness have historically been associated with a rising incidence of default or restructuring of public and private debts. Sometimes the debt restructuring is more subtle and takes the form of 'financial repression'. Consistent negative real interest rates are equivalent to a tax on bond holders and, more generally, savers. In the heavily regulated financial markets of the Bretton Woods system, a variety of financial domestic and international restrictions facilitated a sharp and rapid reduction or 'liquidation' of public debt from the late 1940s to the 1970s. The restrictions or regulatory measures of that era had their origins in what would now come under the heading of 'macroprudential' concerns in the wake of the severe banking crises that swept many countries in the early 1930s. The surge in public debts that followed during the Great Depression and through World War II only made the case for stable and low interest rates and directed credit more compelling to policymakers. The resurgence of financial repression in the wake of the 2007-2009 financial crises alongside the surge in public debts in advanced economies is documented here. This process of financial 'de-globalization' may have only just begun.
    Keywords: capital controls; debt; financial repression; inflation; interest rates; regulation
    JEL: E2 E3 E6 F3 F4 H6 N10
    Date: 2012–04
  21. By: Capa Santos, Holger (Escuela Politecnica Nacional (EPN)); Kratz, Marie (ESSEC Business School); Mosquera Munoz, Franklin (Escuela Politecnica Nacional (EPN))
    Abstract: This work presents a contribution on operational risk under a general Bayesian context incorporating information on market risk pro le, experts and operational losses, taking into account the general macroeconomic environment as well. It aims at estimating a characteristic parameter of the distributions of the sources, market risk pro le, experts and operational losses, chosen here at a location parameter. It generalizes under more realistic conditions a study realized by Lambrigger, Shevchenko and Wuthrich, and analyses macroeconomic eects on operational risk. It appears that severities of operational losses are more related to the macroeconomics environment than usually assumed.
    Keywords: Basel II; Bayesian inference; Loss distribution approach; Macroeconomics dependence; Operational Risk; Quantitative Risk Management; Solvency 2
    Date: 2012–01–01
  22. By: Funke, Michael (BOFIT); Paetz, Michael (BOFIT)
    Abstract: In the wake of the 2008-2009 global financial crisis, the macroeconomic discussion has returned to the topic of proactive macroprudential policies. One proactive approach, the use of loan-to-value (LTV) policies to curb booming property markets, has long been used by Hong Kong’s monetary authorities to actively manage and mitigate the potential fallout from housing price bubbles. Here, we analyse the merits of this countercyclical macroprudential policy in a New Keynesian DSGE model. We conclude that nonlinear LTV policy rules implemented in reaction to episodes of high property price inflation can limit transmission of housing price cycle effects to the real economy.
    Keywords: macroprudential policy; DSGE model; loan-to-value ratio; Hong Kong
    JEL: C63 E21 E32 E69 F41
    Date: 2012–05–02

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