Balance Sheet Exposure Research Articles

From carry trades to trade credit: Financial intermediation by non-financial corporations

We use detailed firm-level data from Mexico to document that non-financial corporations engage in carry trades by borrowing in foreign currency (FX) and lending in domestic currency, largely in the form of trade credit, accumulating currency risk in the process. Firms are more active in carry-trades when FX borrowing is relatively cheaper and build currency risk by accumulating peso assets. We use the 2009 Mexican peso depreciation to show that firms that were more active in carry trades experienced larger reductions in investment. Nevertheless, their extension of trade credit remained stable, insulating their trading partners from their balance sheet exposure to the shock.

An empirical study of usage of interest rate swaps among Indian mid-cap corporates

PurposeInterest rate derivatives (IRDs) are the essential components of financial risk management and are used across various industry sectors. The objective is to analyze the differences in approach to managing interest rate risks between the Indian corporates that execute IRDs and the ones that do not.Design/methodology/approachInterest rate fluctuations require Indian corporates to hedge their exposures in foreign currency interest rates. This is all the more true for mid-sized corporates because of their balance sheet exposures. Additionally, they may not have the resources to formulate risk management policies. This paper analyzes data collected from financial statements of a diverse set of companies that use IRD and helps in formulating such a strategy.FindingsThe results indicate significant differences for some of the parameters like information asymmetry and agency cost between users and non-users of IRDs. The study further suggests causality between users of derivatives and parameters like size, growth and debt.Research limitations/implicationsThe study compares users and non-users of IRDs, thereby identifying factors unique to users of IRDs. It also studies causality relations which explain the motivation to do IRDs. Thus, it enables risk managers to use this as a reference point to decide on their strategies.Originality/valueWhile there are multiple studies across geographies and sectors including commercial banks in India on the usage of interest rate swaps, this study focuses on Indian mid-tier corporates. Furthermore, the study distinguishes between users and non-users based on financial parameters, which in turn would provide a framework for decision-hedging strategies.

Ireland

This technical note1 investigates the interconnectedness between the market-based finance (MBF) sector in Ireland and the rest of the financial system, with a view to assessing potential financial stability risks. The MBF sector, the largest component of the financial system, totals over 14 times GDP and is comprised of the funds sector—both money-market (170 percent of GDP) and investment funds (850 percent of GDP)— as well as other financial institutions (OFIs), which comprise of special purpose entities (SPEs, 240 percent of GDP) and a catch-all category entitled “OFI residual” (160 percent of GDP). Chapter I provides an overview of the potential financial stability risks associated with the MBF sector, with a focus on the funds sector, and places it in its domestic and global context. Chapter II maps out the interlinkages between the non-banks, banks, and the real sector using network analysis to assess the strength and direction of interconnectedness. Chapter III delves into the balance sheet exposures of major categories of Irish funds, the largest component of the MBF sector, to further assess channels of risk transmission. The analysis focuses on a network of complex inter-sectoral financial relationships, based on a range of lending and borrowing instruments, and several findings emerge.

Employing lesser-known corporate development strategies while avoiding problematic blind spots

PurposeAll too often M&A deal making falls into the trap of head-to-head competition that drives valuations to “sky-high” levels. The author suggests ways to avoid the trap. 10; 10; 10;Design/methodology/approachFour lesser-known corporate development strategies offer lucrative alternatives to engaging in an M&A bidding war.FindingsOne strategy: The derivatives market allows executives to acquire financial products to hedge their material balance sheet exposures when market pricing is incredibly low.Practical/implicationsRelatively few acquirers make initial “toehold” investments in their targets prior to making a bid.Originality/valueThe strategic logic of hyper-efficient resource utilization has rarely been popular, despite how “obvious” it may initially appear. Most executives seem psychologically oriented to a growth-based approach irrespective of the risks that approach may generate over time. 10;

Testing Bank Resiliency Through Time

<ns3:p>A resilient banking system meets the demands of households and businesses for financial services during both benign and severe macroeconomic and financial conditions. Banks' ability to weather severe macroeconomic shocks, and their willingness to continue providing financial services, depends on their levels of capital, balance sheet exposures, and ability to generate earnings. This note uses the Forward-Looking Analysis of Risk Events (FLARE) stress testing model to evaluate the resiliency of the banking system by consistently applying severe macroeconomic and financial shocks each quarter between 2014:Q1 and 2021:Q3.</ns3:p>

Sovereign risk spill-overs in the banking sectors of Central America and the Caribbean

This paper examines the relationship between sovereign credit ratings and bank stability in Central America and the Caribbean (CAC). We use data on 177 banks from 24 countries for the period 1999–2014 and find that sovereign rating downgrades precede deterioration in bank stability. The finding highlights the importance of understanding the transmission channels and the amplification of sovereign risk spill-overs. With respect to the former, we found evidence to support both the “balance sheet exposure” and “asset valuation adjustments” arguments found in the literature. Concerning the latter, the sovereign risk spill-overs are more intense in countries with low foreign currency reserves, limited financial transparency and weak central bank independence. Our findings support the argument that banks are vulnerable to the aggravation of sovereign risk concerns and thus, the zero risk weight to sovereigns should be reviewed.

Examining the off Balance Sheet Exposure and Efficiency of Indian Commercial Banks – A DEA Approach

The study examined the exposure and efficiency of select public and private sector banks towards off balance sheet items byapplying Data Envelopment Analysis (DEA) on the key financial performance ratios of banks. The study covered a period of 5years ranging from 2013 to 2017 and conducted a year wise analysis. The study selected 20 different type of variables (financialvariables) for building Input –Output Model to test DEA for examining efficiency. These variables are acting as proxy variablesfor indicating the effect of Off balance sheet exposures on the financial health of the business. These variables are extracted fromthe financial statements of respective banks on a year on year basis and required adjustments are done. The study investigated theOff balance sheet exposures in the areas of Foreign Exchange Transactions, Guarantees, Acceptance and Endorsements etc., Theproxy variables, so identified for the study are employed for understanding various efficiencies of banks like scale efficienciesinvolve Constant Returns to Scale (CRS), Variable Returns to Scale (VRS) and average efficiencies like Technical Efficiency(TE), Cost Efficiency (CE), Allocative Efficiency (AE). The study find out that throughout the study period, the select banksexhibited constant returns to scale, except CUB and AXIS Bank in the first year of study (2013) displayed increasing returns toscale due to heavy exposures. In the category of efficiency parameters, AXIS Bank and CUB are displaying lower efficiencies inthe segment of private sector banks and Andhra Bank and OBC exhibiting lower efficiencies in the segment of public sectorbanks. Here lower efficiencies with references to cost savings aspects and output generation, this may be due to their scale ofoperations in the industry. The study concluded that large banks are exhibiting highest efficiencies than compared to small banksoperating in the industry. This is definitely an area for further research to the industry and researchers to examine the direct effectof Off balance sheet transactions (IFRS amendments in this direction only), so that credit risk can be reduced considerably in thebusiness. So that business houses can take up calculated risk in the international markets.

An integrated model for fire sales and default contagion

Fire sales and default contagion are two of the main drivers of systemic risk in financial networks. While default contagion spreads via direct balance sheet exposures between institutions, fire sales describe iterated distressed selling of assets and their associated decline in price which impacts all institutions invested in these assets. That is, institutions are indirectly linked if they have overlapping asset portfolios. In this paper, we develop a model that helps us understand the joint effect of the two contagion channels and investigate structures of financial systems that promote or hinder the spread of an initial local shock. We first consider the contagion process for an explicitly given system and then derive our main results for random ensembles of systems whose macroscopic statistical characteristics of defining parameters are close to each other. In particular, we model direct exposures by means of a random graph. Our approach ensures robustness to local uncertainties and changes in the system. We characterize resilient and non-resilient system structures by criteria that can be used by regulators to assess system stability. Moreover, we provide explicit capital requirements that secure the financial system against the joint impact of fire sales and default contagion.

The Banking View of Bond Risk Premia

ABSTRACT Banks' balance sheet exposure to fluctuations in interest rates strongly forecasts excess Treasury bond returns. This result is consistent with optimal risk management, a banking counterpart to the household Euler equation. In equilibrium, the bond risk premium compensates banks for bearing fluctuations in interest rates. When banks' exposure to interest rate risk increases, the price of this risk simultaneously rises. We present a collection of empirical observations that support this view, but also discuss several challenges to this interpretation.

Priority Sector Lending by Public and Private Sector Banks in India

Priority Lending is critical to the inclusive growth in India. The credit distribution to the priority sectors is vital in ensuring that the economic growth is even and percolates down to all levels in the economy. RBI made it mandatory to the Scheduled Commercial Banks (SCB) in India for providing credit delivery to critical sectors identified as part of priority sector. RBI mandated all the banks should achieve the targets and sub targets of priority sector lending as minimum percent of Adjusted Net Bank Credit (ANBC) or Off - Balance sheet Exposure (OBE) whichever is higher. This paper aims at understanding the credit delivery to Priority Sector by Public Sector Banks (PSBs), Private Sector Banks (PrSBs), analyze the ability of the banks to meet the targets and sub targets as Agriculture Advances, Micro, Small and Medium Enterprises Advances and Weaker Sections Advances and whether these banks are meeting the recommendations of the RBI in providing credit to different sub segments of priority sector especially, Agriculture, MSMEs and Weaker sections. Ratios were calculated to check the proportion of these priority advances in the total advances, the percentage of priority in the ANBC. The statistical tools are used to check the significant variation of priority lending by these banks. Public Sector banks are proved that they are dominant partners in this strategy for sustainability of financial inclusion through lending to all the target and sub targets as per the RBI norms. Major portion of PrSBs lending is towards MSMEs while PSB were targeting more on agriculture and weaker sections.

Risk as strategy: defending against catastrophic turns of fortune

PurposeThe author offers executives a strategic process for proactively mitigating the risk of catastrophic unwanted Black Swan surprises that can severely, and often abruptly, impair a balance sheet.Design/methodology/approachOne practical way to apply the author’s approach is through hedging concentrated balance sheet exposures when market volatility is low or contracting.FindingsThough no one can reliably anticipate pandemics and related stock market turbulence, executives do not have to predict the future to economically protect their balance sheets from Black Swan events.Practical implicationsManagers can construct Black Swan scenarios to assess how an unforeseen, disadvantageous future could develop and which risk management derivative would best mitigate it.Originality/valueThis strategic approach to managing balance-sheet-threatening risks could help a firm outperform its competitors during future crises and catastrophes.

The role of bank funding in systematic risk transmission

The transmission of risk among financial institutions is not limited to systematic risk and interest rate factors, but is also affected by the interconnectedness of institutions through balance sheet exposures. It is recognized that univariate specifications have severe limitations in explaining banks observed performance and measurement of risk, and may obscure possible unintended effects of bank capital regulation. Consequently, we link systematic risk to balance sheet factors and allow for dependencies in the covariance structure. We find that funding structure and balance sheet factors asymmetrically affect observed systematic risk in the largest Australian banks.

Do SMEs Benefit from Unconventional Monetary Policy and How? Microevidence from the Eurozone

AbstractWe study the impact of the announcement of the European Central Bank's (ECB's) Outright Monetary Transactions Program on small firms’ access to finance using a matched firm‐bank data set from eight Eurozone countries. We find that following the announcement, credit access improved relatively more for firms borrowing from banks with high balance sheet exposures to impaired sovereign debt, with such firms less likely to be refused a loan or to be price rationed. Loan terms also improved as manifested by lengthening of loan maturities. Unconventional monetary policy has a positive impact on firms’ investment and profitability, while its effect on firm innovation is weaker.

The Banking View of Bond Risk Premia

Banks' balance-sheet exposure to fluctuations in interest rates strongly forecasts excess Treasury bond returns. This result is consistent with optimal risk management, a banking counterpart to the household Euler equation. In equilibrium, the bond risk premium compensates banks for bearing fluctuations in interest rates. When banks' exposure to interest rate risk increases, the price of this risk simultaneously rises. We present a collection of empirical observations supporting this view, but also discuss several challenges to this interpretation.

Optimal Currency Area: A twentieth Century Idea for the twenty-first Century?

We take stock of the history of the European Monetary Union and pegged exchange-rate regimes in recent decades. The post-Bretton Woods greater financial integration and under-regulated financial intermediation have increased the cost of sustaining a currency area and other forms of fixed exchange-rate regimes. Financial crises illustrated that fast-moving asymmetric financial shocks interacting with real distortions pose a grave threat to the stability of currency areas and fixed exchange-rate regimes. Members of a currency union with closer financial links may accumulate asymmetric balance-sheet exposure over time, becoming more susceptible to sudden-stop crises. In a phase of deepening financial ties, countries may end up with more correlated business cycles. Down the road, debtor countries that rely on financial inflows to fund structural imbalances may be exposed to devastating sudden-stop crises, subsequently reducing the correlation of business cycles between currency area’s members, possibly ceasing the gains from membership in a currency union. A currency union of developing countries anchored to a leading global currency stabilizes inflation at a cost of inhibiting the use of monetary policy to deal with real and financial shocks. Currency unions with low financial depth and low financial integration of its members may be more stable at a cost of inhibiting the growth of sectors depending on bank funding.

A modern reincarnation of Mundell-Fleming's trilemma

A modern incarnation of the trilemma is essential for understanding the evolving global financial architecture, and for coming up with ways to mitigate financial fragility. The scarcity of policy instruments relative to the policy goals implies complex country-specific tradeoffs between the policy goals. The financial crises of the 1990s induced Emerging markets to converge to trilemma's middle ground -- managed exchange-rate flexibility, controlled financial integration, and viable but limited monetary independence. Capital flight crises added financial stability to trilemma's policy goals. New policies were added to deal with financial fragility associated with financial integration, including precautionary management of international reserves by emerging markets, swap lines among OECD's central banks, and macroeconomic prudential regulations. These trade-offs are impacted by a country's balance sheet exposure to hard currencies, the exchange-rate regime, and the growing sensitivity to shocks emanating from the U.S. and the Eurozone in the aftermath of the Global Financial Crisis.

Balance sheets after the EMU: an assessment of the redenomination risk

Abstract The probability of a partial or complete break-up of the euro has risen over the last years. Such an event could create a balance sheet problem for economic agents, if the redenomination process introduced significant currency mismatches between the asset and liability sides. We propose a new assessment of this redenomination risk, by country and by main institutional sector, for two scenarios: a single country exit and a complete break-up. Our main conclusion is that, even though the problem has to be taken seriously, its order of magnitude should not be exaggerated. Only a few sectors are at significant risk: public debts of Greece and Portugal, financial sectors of Greece, Ireland and Luxembourg. In particular, the balance sheet exposure of the non-financial private sector to the redenomination risk appears to be limited.

A Modern Reincarnation of Mundell-Fleming's Trilemma

A modern incarnation of the trilemma is essential for understanding the evolving global financial architecture, and for coming up with ways to mitigate financial fragility. The scarcity of policy instruments relative to the policy goals implies complex country-specific tradeoffs between the policy goals. The financial crises of the 1990s induced Emerging markets to converge to trilemma’s middle ground -- managed exchange-rate flexibility, controlled financial integration, and viable but limited monetary independence. Capital flight crises added financial stability to trilemma’s policy goals. New policies were added to deal with financial fragility associated with financial integration, including precautionary management of international reserves by emerging markets, swap lines among OECD’s central banks, and macroeconomic prudential regulations. These trade-offs are impacted by a country’s balance sheet exposure to hard currencies, the exchange-rate regime, and the growing sensitivity to shocks emanating from the U.S. and the Eurozone in the aftermath of the Global Financial Crisis.

Balance sheet effects on monetary and financial spillovers: The East Asian crisis plus 20

We study how the financial conditions in the Center Economies [the U.S., Japan, and the Euro area] impact other countries over the period 1986 through 2015. Our methodology relies upon a two-step approach. We focus on five possible linkages between the center economies (CEs) and the non-Center economics, or peripheral economies (PHs), and investigate the strength of these linkages. For each of the five linkages, we first regress a financial variable of the PHs on financial variables of the CEs while controlling for global factors. Next, we examine the determinants of sensitivity to the CEs as a function of country-specific macroeconomic conditions and policies, including the exchange rate regime, currency weights, monetary, trade and financial linkages with the CEs, the levels of institutional development, and international reserves. Extending our previous work (Aizenman et al., 2016), we devote special attention to the impact of currency weights in the implicit currency basket, balance sheet exposure, and currency composition of external debt. We find that for both policy interest rates and the real exchange rate (REER), the link with the CEs has been pervasive for developing and emerging market economies in the last two decades, although the movements of policy interest rates are found to be more sensitive to global financial shocks around the time of the emerging markets’ crises in the late 1990s and early 2000s, and since 2008. When we estimate the determinants of the extent of connectivity, we find evidence that the weights of major currencies, external debt, and currency compositions of debt are significant factors. More specifically, having a higher weight on the dollar (or the euro) makes the response of a financial variable such as the REER and exchange market pressure in the PHs more sensitive to a change in key variables in the U.S. (or the euro area) such as policy interest rates and the REER. While having more exposure to external debt would have similar impacts on the financial linkages between the CEs and the PHs, the currency composition of international debt securities does matter. Economies more reliant on dollar-denominated debt issuance tend to be more vulnerable to shocks emanating from the U.S.

The topology of overlapping portfolio networks

Abstract This paper analyzes the topology of the network of common asset holdings, where nodes represent managed portfolios and edge weights capture the impact of liquidations. Asset holdings data is extracted from the 13F filings. We consider the degree centrality as the degree in the subnetwork of weak links, where weak links are those that lead to significant liquidations. We explore the applications of this network representation to clustering and forecasting. To validate the weight attribution and the threshold used to define the weak links, we show that the degree centrality is correlated with excess returns, and is significant after we control for the Carhart four factors. The network of weak links has a scale free structure, similar to financial networks of balance sheet exposures. Moreover, a small number of clusters, densely linked, concentrate a significant proportion of the portfolios.