Bank Fundamentals Research Articles

Equity Financing at Islamic Banks: Do Competition and Bank Fundamentals Matter?

ABSTRACTThis article investigates the effects of market competition and Islamic banks’ fundamental conditions on Islamic banks’ equity (profit and loss sharing [PLS]) financing. We use a monthly data set on nine Indonesian Islamic banks from 2009 to 2014. Our empirical results show that competition significantly increases Islamic banks’ PLS financing activities, suggesting that Islamic banks use this mode of financing to attract more entrepreneurs. This argument is also strengthened by the negative association between bank fundamentals and equity financing. In addition, we also find that the effects of competition on equity financing decrease when Islamic banks are more stable. Our results call on policymakers to monitor the practices in Islamic banks’ equity financing because of the risk embedded in that mechanism and Islamic banks’ tendency to use such instruments in poor fundamental conditions.

Persuading Multiple Audiences: An Information Design Approach to Banking Regulation

A policy-maker concerned with the potential default of a bank conducts an asset quality review and a liquidity stress test under the scrutiny of multiple types of market participants (audiences). Surprisingly, the optimal comprehensive assessment is opaque when the bank has high-quality assets, and transparent when the bank has poor-quality assets. Additionally, the policy-maker imposes debt buybacks and contingent recapitalizations. I find that without the latter, disclosure of information about the bank's fundamentals may backfire. When the policy-maker lacks the technology to test the bank's private information, she designs a liquidity-provision program whereby the government offers to buy assets from the bank in exchange for cash and a public disclosure of the bank's liquidity position. Interventions display a non-monotone pecking order: the private sector funds banks with either high or poor-quality assets, while institutions with assets of intermediate quality participate in the government's liquidity program. My results shed light on the optimal way to disclose information in environments with multiple audiences and multi-dimensional fundamentals.

Funding Fragility And Commercial Bank Failures

I examine the link between funding composition and the hundreds of failures of US commercial banks that followed the 2007-2008 funding phase of the Great Recession. I test whether these failures were induced by market-wide funding freezes that were unrelated to policy fundamentals, or by funding freezes that were idiosyncratic to failed banks but unrelated to bank fundamentals. The empirical evidence rejects both propositions. Funding structures remained relatively stable during the crisis. Intertemporal variation in aggregate funding costs can be explained by shifts in policy rates. Variation in the spread in funding costs between failed and nonfailed banks ,at the time that failure rates peaked, can be explained almost entirely by differences in solvency risk.

Credit Ratings in China: Evidence from the Upgrades in the Banking Sector

We observe 180 upgrades, in contrast to two downgrades, among 657 Chinese banks during 2015-2017. Evidence shows that the upgrades were results of compromised rating standard rather than improvements to bank fundamentals. Investors reacted negatively to the upgrades, especially those granted by non-incumbent credit rating agencies (CRAs), suggesting that they were able to discover information. However, investors responded positively to the upgrades that led to regulatory benefits, implying that rating-contingent regulations play a central role in aligning the interests of issuer, investor and CRA for rating inflation---myopia induces investors to accept biased upgrading as incentive for regulatory arbitrage prevails; single-rating reporting policy and insufficient issuer-CRA contact disclosure play important accessary roles, while investor monitoring and agency reputation effect are absent.

Do High Deposit Interest Rates Signal Bank Default? Evidence from the Russian Retail Deposit Market

In recent years the Russian banking system has witnessed numerous bank license withdrawals. Many of the failed banks had significant volumes of retail deposits in their liabilities, thus, transmitting the default burden to the Deposit Insurance Agency and ultimately to the taxpayers. In their attempt to stay in the market banks may try to attract the depositor funds even more intensively when the failure is not far away. The main assumption of this paper is that banks raise additional funds through inflated deposit interest rates – the overstatement strategy – before leaving the market. We use unique data on Russian bank deposit interest rates for deposits of different maturities in 2015–2016 combined with data about bank fundamentals coming from their financial statements. The results suggest that if a bank offers too generous interest rates for deposits for 180-365 days this can be a signal of a significantly higher probability of license withdrawal in 3 quarters. In their attempt to urgently attract funds when moving closer to default banks assign the highest rates for the longest-term deposits, with the maturity over one year. The interest rates higher than the market average dramatically increase the probability of a bank failure in 2 quarters.

Do Lower Returns on Bank Stocks Suggest Lower Cost of Capital? An Explanation for the Low Risk Anomaly and the Loan Growth Effect

Banks with higher equity risk and faster loan growth have lower abnormal stock returns. By disentangling ex ante cost of capital from cash flow and discount rate news in bank stock returns, we show that the lower returns do not suggest lower cost of capital. The underperformance of banks with higher equity risk is explained by the poorer cash flow news. The underperformance of banks with faster loan growth is due to both the cash flow and the discount rate news components. Overall, the evidence points to the nontrivial role of investors’ inefficient forecasts of expected bank risk and fundamentals.

Disciplina de mercado en el sistema bancario centroamericano

This article empirically tests the market discipline hypothesis in the Central American banking system. Whether the riskier banks (with the worst bank fundamentals) pay higher interest rates and attract fewer amounts of deposits. We use dynamic panel data models and the generalized method of moments (SYS GMM) estimator, and a sample of 30 banks from six Central American countries over the years 2008-2012. In contrast to most of the previous empirical literature, particularly in developed countries, in Central America we did not find evidence for market discipline. The results are robust to different indicators of the bank fundamentals, to the effect of the internal demand for funding by banks, and to other econometric methods. These findings indicate weakness in the disclosure policy of banking information.

BANK RUN AND STABILITY OF ISLAMIC BANKING IN INDONESIA

Bank run is an important economic phenomenon which increasingly occurred in in modern banking system and potentially threatened banking stability as it could trigger a banking crisis. However, most studies related to bank run focus on the occurrence of bank run in conventional banking system. Very few of them discuss the bank run phenomenon under Islamic banking system or dual banking system where Islamic banks jointly operating with conventional banks. Therefore, this study attempts to analyze the determinants of bank run in the Indonesian Islamic banking industry by employing primary data from 256 customers of Indonesia Islamic banks in 2015 and by utilizing factor analysis and descriptive statistics. In theory, Islamic banks tend to be more resilient towards any macroeconomic or financial shocks as compared to conventional banks due to the nature of its asset-based and risk-sharing arrangement. However, the result exhibits that both psychological and fundamental factors (i.e. macroeconomics and bank fundamentals) strongly influence the behaviors of Islamic banking depositors to withdraw their funds, which might trigger the occurrence of bank runs in the country. Insider information, macroeconomic condition and bank fundamental factors are also shown to have the highest impacts among all variables. Hence, in the context of banking stability, the finding implies that Islamic banks are not completely immune to the impacts of macroeconomic shocks or financial crisis. As a country with a dual banking system, Indonesia had experienced several bank runs since 1990s. Therefore, the findings of the study should provide the policy makers important insight into research based-policy in order to attain financial stability as one of the main economic goals of the country.Keywords: Bank run, Islamic bank, Factor analysis, IndonesiaJEL Classification: C83, G21, G28

Depositors Discipline through Interest Costs during Good and Bad Times: the Role of the Guarantor of Last Resort1

We investigate whether the public sector’s ability as the guarantor of last resort (GLR) to help banks or to guarantee banks’ liabilities affects the sensitivity of interest costs to bank fundamentals. We use a global bank sample and find that the sensitivity is an increasing function of GLR risk, regardless of the method applied to describe this risk. Therefore, our results indicate that increased levels of GLR risk might foster market monitoring by depositors.

Can Short Sellers Inform Bank Supervision?

We investigate the timeliness and accuracy of supervisory information and short seller signals to assess whether short sellers have the potential to inform bank supervision. We find that short interest in bank equity increases prior to supervisory ratings downgrades but does not decrease prior supervisory ratings upgrades. Our tests of the relative forecasting accuracy of short seller signals and supervisory ratings indicate short sellers accurately assess the changes for both deteriorating and improving bank fundamentals, but do not focus on the same fundamental variables as regulators. Our results indicate that short seller signals have the potential to complement bank supervision in monitoring bank risk.

The Determinants of Global Bank Credit-Default-Swap Spreads

Using a sample of 161 global banks in 23 countries, we examine the applicability of structural models and bank fundamentals to price global bank credit risk. First, we find that variables predicted by structural models (leverage, volatility, and risk-free rate) are significantly associated with bank CDS spreads. Second, some CAMELS indicators, including asset quality, cost efficiency, and sensitivity to market risk, contain incremental information for bank CDS prices. Moreover, leverage and asset quality have had a stronger impact on bank CDS since the onset of the recent financial crisis. Banks in countries with lower stock market volatility and/or more financial conglomerates restrictions tend to have lower CDS spreads. Deposit insurance appears to have an adverse effect on CDS spreads, indicating a moral hazard problem. Keywords: bank credit default swaps, structural models, CAMELS, global banks

Do Depositors Punish Banks for 'Bad' Behavior? Market Discipline in Argentina, Chile, and Mexico

A study of the banking industries of Argentina, Chile, and Mexico in the 1980s and 1990s finds that across countries and across deposit insurance schemes, market discipline exists even among small insured depositors - who punish risky banks by withdrawing their deposits. Bank fundamentals are at least as important as other factors affecting deposit behavior. Peria and Schmukler examine the banking industries of Argentina, Chile, and Mexico to see if market discipline existed there in the 1980s and 1990s. Using a set of bank panel data, they test for the presence of market discipline by studying whether depositors punish risky banks by withdrawing their deposits. They find that across countries and across deposit insurance schemes, market discipline exists even among small insured depositors-who punish risky banks by withdrawing their deposits. Standardized coefficients and variance decomposition of deposits indicate that bank fundamentals are at least as important as other factors affecting deposits. GMM estimates confirm that the results are robust to the potential endo-geneity of bank fundamentals. This paper - a joint product of Finance, Development Research Group and the Office of the Chief Economist, Latin America and Carribean Region - is part of a larger effort in the Bank to study banking issues affecting developing countries. The study was funded by the LAC Regional Studies Program and by the Bank's Research Support Budget under research project Deposit Insurance Design and Use (RPO 682-90). The authors may be contacted at mmartinezperia@worldbank.org or sschmukler@worldbank.org.

Bank Solvency and Funding Cost

Understanding the interaction between bank solvency and funding cost is a crucial pre-requisite for stress-testing. In this paper we study the sensitivity of bank funding cost to solvency measures while controlling for various other measures of bank fundamentals. The analysis includes two measures of bank funding cost: (a) average funding cost and (b) interbank funding cost as a proxy of wholesale funding cost. The main findings are: (1) Solvency is negatively and significantly related to measures of funding cost, but the effect is small in magnitude. (2) On average, the relationship is stronger for interbank funding cost than for average funding cost. (3) During periods of stress interbank funding cost is more sensitive to solvency than in normal times. Finally, (4) the relationship between funding cost and solvency appears to be non-linear, with higher sensitivity of funding cost at lower levels of solvency.

Exposure to interbank market and risk-taking by Mexican banks

Banks can avoid bank runs and panic using the interbank market as a type of coinsurance. Moreover, because of the possibility of losing financial assets, they theoretically have incentives to monitor their peers, borrowing in this market. This paper examines whether bank risks are explained by their exposure to the interbank market. The market discipline hypothesis suggests that bankers are well equipped to monitor their peers, and the interbank borrowing is par excellence an uninsured deposit. Consequently, banks with a larger exposure to the interbank market should present strong bank fundamentals. Using a sample of 37 Mexican banks, from December 2008 to September 2012, and dynamic panel models based on the SYS GMM estimator, I did not find evidence in favor of the market discipline hypothesis. These results are robust to different indicators of bank risk and exposure to interbank markets. This is a wake-up call for policymakers, who should restore market discipline in interbank operations, following the disclosure policy in Basel III.

Bank fundamentals, economic conditions, and bank failures in East Asian countries

In this study, a fixed effect panel logit regression model and a split population survival time model are used to investigate the impact of bank fundamentals and economic conditions on bank failures and survival time from 1999 to 2011 in 11 East Asian markets. The empirical results show that strong bank fundamentals, including capital adequacy, asset quality, management, and profitability and liquidity, as well as desirable economic conditions measured by GDP growth rates, inflation rates, and real interest rates, reduce the failure probability of East Asian banks. In addition, the survival time of banks is primarily described by the measures of economic conditions, and the bank fundamentals exerted marginal effects.

The Determinants of Global Bank Credit-Default-Swap Spreads

Using a sample of 161 global banks in 23 countries, we examine the applicability of market-based structural models and accounting-based bank fundamentals to price global bank credit risk. First, we find that variables predicted by structural models are significantly associated with bank CDS spreads. Second, some CAMELS indicators contain incremental information for bank CDS prices. We find no evidence in favor of one model over the other, while the combined structural and CAMELS model performs better than each individual model. Moreover, leverage and asset quality have had a stronger impact on bank CDS since the onset of the recent financial crisis. Banks in countries with lower stock market volatility, fewer entry barriers, and/or more financial conglomerate restrictions tend to have lower credit risk. Deposit insurance appears to have an adverse effect on bank CDS spreads, indicating a moral hazard problem.

Bank Fundamentals, Executive Compensation and Public Perception of Banks in Australia

Public perception of banks in Australia is relatively poor compared to firms in other major services sectors. This study explores a number of potential sources of negative public opinion. We find that bank profits are similar to firms in other sectors after adjustment for firm size. Average bank executive remuneration as a proportion of total staff costs are also lower than those in other sectors. Finally, Australian banks not only pay a higher average effective tax rate than their counterparts in OECD countries but are also closest to their statutory corporate tax rates. Our findings therefore suggest that poor public perception of banks is based on the flawed claims of generating excessive profits, overpaying bank executives, and underpaying taxes and is not justified.

Understanding Bank-Run Contagion

We study experimental coordination games to examine through which transmission channels and under which information conditions a panic-based depositor run at one bank may trigger a panic-based depositor run at another bank. We find that withdrawals at one bank trigger withdrawals at another bank by increasing players’ beliefs that other depositors in their own bank will withdraw, making them more likely to withdraw as well. Observed withdrawals only affect depositors’ beliefs, and are thus contagious when they form an informative signal about bank fundamentals. Data, as supplemental material, are available at http://dx.doi.org/10.1287/mnsc.2015.2416 . This paper was accepted by Amit Seru, finance.

Depositors’ Perception of “Too-Big-to-Fail”*

We exploit the exogenous shock to the Brazilian banking system caused by the international turmoil of 2008 and find evidence that the run to systemically important banks is better explained by the perception of a too-big-to-fail policy than by bank fundamentals. We infer that the extra inflow of deposits received by systemically important banks during crises gives them an important competitive advantage. Our analysis also indicates that a bank’s share of funding from institutional investors affects the nonfinancial firms’ and institutional investors’ decision to run.

Can Bank Boards Prevent Misconduct?

We study whether two key functions of bank boards, monitoring and advising, are effective in preventing misconduct in banks. We use regulatory enforcement actions issued against US banks to identify banks that engage in misconduct. We rely on metrics related to the social connections of directors to measure board monitoring and advising. Board monitoring is defined as the fraction of directors who are appointed before the current CEO takes office. Board advising is calculated based on the total connections that board directors establish with directors of other boards. We find that both board monitoring and advising are effective in preventing misconduct by banks. Further analysis reveals that while better monitoring by boards prevents all categories of misconduct, better advising prevents misconduct of a technical nature. Our results are robust to a number of CEO-, board-, firm-specific controls as well as a two-stage instrumental variables (IV) analysis that circumvents endogeneity concern. Finally, we find a positive relation between the announcement returns and our board measures, implying that effective boards are associated with less severe misconduct. We study three mechanisms that explain the results. First, we find that effective boards are associated with safer bank fundamentals. Second, effective boards increase the likelihood of misconduct detection. Third, effective board monitoring is associated with higher penalties imposed on the CEO if misconduct is revealed. Our paper offers novel insights on how to structure boards to prevent bank misconduct. First, the results of our study imply that the advisory function of boards deserves more attention as part of the governance process. Second, we show that conventional board measures such as board independence and financial expertise have no measurable effect bank misconduct being committed or detected. By contrast, the board metrics related to monitoring and advising we study in this paper are important predictors of misconduct. Thus, governance metrics revolving around CEO connections warrant more attention from regulators, investors and governance activists.