Banks, government bonds, and default: What do the data say?
Nicola Gennaioli, Alberto Martin, Stefano Rossi19 July 2014
There is growing concern – but little systematic evidence – about the relationship between sovereign default and banking crises. This column documents the link between public default, bank bondholdings, and bank loans. Banks hold many public bonds in normal times (on average 9% of their assets), particularly in less financially developed countries. During sovereign defaults, banks increase their exposure to public bonds – especially large banks, and when expected bond returns are high. At the bank level, bondholdings correlate negatively with subsequent lending during sovereign defaults.
Recent events in Europe have illustrated how government defaults can jeopardise domestic bank stability. Growing concerns of public insolvency since 2010 caused great stress in the European banking sector, which was loaded with Euro-area debt (Andritzky 2012). Problems were particularly severe for banks in troubled countries, which entered the crisis holding a sizeable share of their assets in their governments’ bonds – roughly 5% in Portugal and Spain, 7% in Italy, and 16% in Greece (2010 EU Stress Test).
Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.
Large banks have grown significantly in size and become more involved in market-based activities since the late 1990s. Figure 1 shows how the balance-sheet size of the world’s largest banks increased two- to four-fold in the ten years prior to the crisis. Figure 2 illustrates how banks shifted from traditional lending towards market-oriented activities.
To date, much uncertainty exists about how large the spillovers would be from the default of a systemically important bank. This column shows evidence that the market values of US and EU banks hardly respond to changes in the default risk of banks that the Financial Stability Board considers globally systemically important (G-SIBs). However, changes in all G-SIBs’ default risk explain a substantial part of changes in bank market values. These findings have implications for financial-crisis management and prevention policies.
Financial-crisis management and prevention policies often focus on mitigating spillovers from the default of systemically important banks. During the recent crisis, governments avoided large bank failures by insuring and purchasing intermediaries’ troubled assets, by providing them with capital injections, and even by outright nationalisations. After the crisis, financial regulators designed additional requirements for those institutions that the Financial Stability Board designated as globally systemically important banks (G-SIBs).
The two faces of cross-border banking flows: An investigation into the links between global risk, arms-length funding, and internal capital markets
Dennis Reinhardt, Steven Riddiough07 May 2014
Cross-border funding between banks collapsed following the bankruptcy of Lehman Brothers, but the withdrawal of funding was not uniform across countries. This column argues that the composition of cross-border bank-to-bank funding can help to explain why. Interbank funding between unrelated banks is particularly vulnerable to global shocks, but intragroup funding between related banks can act as a stabilising force, particularly for advanced economies with a high share of global parent banks. Policymakers should look at disaggregated cross-border bank-to-bank flows, as doing otherwise could result in a misleading assessment of financial stability risks.
Following the collapse of Lehman Brothers in September 2008, global risk spiked and the world witnessed a collapse in cross-border funding between banks. On closer inspection, however, not all countries’ banking systems experienced a withdrawal of cross-border finance. In fact, a number actually enjoyed an inflow of funding from banks overseas (Figure 1).
Figure 1 Cross-border bank-to-bank flows following the collapse of Lehman Brothers
Exploring the transmission channels of contagious bank runs
Martin Brown, Stefan Trautmann, Razvan Vlahu10 April 2014
Contagious bank runs are an important source of systemic risk. However, with observational data it is near-impossible to disentangle the contagion of bank runs from other potential causes of correlated deposit withdrawals across banks. This column discusses an experimental investigation of the mechanisms behind contagion. The authors find that panic-based deposit withdrawals can be strongly contagious across banks, but only if depositors know that the banks are economically related.
Financial contagion – the situation in which liquidity or insolvency risk is transmitted from one financial institution to another – is viewed by policymakers and academics as a key source of systemic risk in the banking sector. In particular, the events in the 2007–2009 Global Crisis have turned the attention of policymakers towards the potential contagion of liquidity withdrawals across banks and the resulting implications for financial stability.
Estimating the impact of changes in aggregate bank capital requirements during an upswing
Joseph Noss, Priscilla Toffano06 April 2014
The impact of tighter regulatory capital requirements during an economic upswing is a key question in macroprudential policy. This column discusses research suggesting that an increase of 15 basis points in aggregate capital ratios of banks operating in the UK is associated with a median reduction of around 1.4% in the level of lending after 16 quarters. The impact on quarterly GDP growth is statistically insignificant, a result that is consistent with firms substituting away from bank credit and towards that supplied via bond markets.
The recent financial crisis and economic contraction that followed highlighted the crucial role that banks play in facilitating the extension of credit and enabling economic growth. This underlies the economic rationale for imposing regulations on the banking industry, including minimum capital requirements designed to mitigate risks banks would not otherwise account for in their behaviour.
Charles Calomiris talks to Romesh Vaitilingam about his recent book, co-authored with Stephen Haber, ‘Fragile by Design: The Political Origins of Banking Crises and Scarce Credit’. They discuss how politics inevitably intrudes into bank regulation and why banking systems are unstable in some countries but not in others. Calomiris also presents his analysis of the political and banking history of the UK and how the well-being of banking systems depends on complex bargains and coalitions between politicians, bankers and other stakeholders. The interview was recorded in London in February 2014.
How much is enough? The case of the Resolution Fund in Europe
Thomas Huertas, María J Nieto18 March 2014
The European Resolution Fund is intended to reach €55 billion – much less than the amount of public assistance required by individual institutions during the recent financial crisis. This column argues that the Resolution Fund can nevertheless be large enough if it forms part of a broader architecture resting on four pillars: prudential regulation and supervision, ‘no forbearance’, adequate ‘reserve capital’, and provision of liquidity to the bank-in-resolution. By capping the Resolution Fund, policymakers have reinforced the need to ensure that investors, not taxpayers, bear the cost of bank failures.
During the crisis, individual institutions such as Hypo Real Estate required public assistance of €100 billion or more.1 So how can a European Resolution Fund of only €55 billion possibly suffice for all banks in the Eurozone?
It could, provided the Fund is part of a well-designed architecture for regulation, supervision, and resolution, that makes banks not only less likely to fail but also safe to fail – meaning that they can be resolved without cost to the taxpayer and without significant disruption to financial markets or the economy at large.
Who is to blame for the credit crunch: foreign ownership or foreign funding?
Erik Feyen, Raquel Letelier, Inessa Love, Samuel Munzele Maimbo, Roberto Rocha15 March 2014
Eastern Europe was hit especially hard by the credit crunch during the global financial crisis. This column presents new evidence suggesting that reliance on foreign funding was more important than foreign bank ownership per se in exacerbating the post-crisis credit contraction. These findings point to the need to put more emphasis on the discussion of bank business models, regulatory standards, and supervisory arrangements.
Although most developing countries around the world experienced a severe contraction of bank credit during the recent global financial crisis, the Eastern Europe and Central Asia (ECA) region was disproportionately hit after it had experienced very high credit growth (Figure 1).
Viral Acharya talks to Viv Davies about his recent work with Sascha Steffen that, using publicly available data and a series of shortfall measures, estimates the capital shortfalls of EZ banks that will be stress-tested under the proposed Asset Quality Review. They also discuss the difference in accounting rules between US and EZ banks and the future potential for banking union in the Eurozone. The interview was recorded by phone on 25 February 2014.