Complex Banking Organizations Research Articles

Banks’ complexity-risk nexus and the role of regulation

We investigate the relationship between bank complexity and bank risk-taking using German banking data over the period 2005-2017. We find that more complex banking organizations tend to take on more risk, but that this complexity-risk nexus decreases over time. We study how regulatory tightenings inherent in this period, and addressing systemically important banks (SIBs) in general and complexity more specifically, alter banks’ choices of complexity and risk. Banks reduce their complexity in response to regulatory tightenings, as these increase the related regulatory costs. Surprisingly, for SIBs in particular, the reduction of regulatory costs is associated with an increase in diversification benefits. As a result, they are able to lower their idiosyncratic risk more than other banks. The overall complexity-risk nexus is lower after regulatory tightenings. Thus, our results indicate that post-crisis regulation is effective in reducing banks’ complexity-risk nexus.

Did Dodd–Frank miss the mark? Financial experts’ and regulators’ perspectives on resolution plans

‘Not credible’. This statement was included in joint press release by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation’s Board of Directors as part of the agencies joint summary statement of their reviews of the second round of resolution plans (RPs) submitted by 11 large banking organizations on 5 August 2014. The Dodd–Frank Wall Street Reform and Consumer Protection Act enhanced the powers bestowed on these agencies, to include oversight of the newly required, annual RPs, in an effort to reduce the risk posed when financial institutions become ‘too big to fail’, protect US taxpayers from the need for government bailouts, and protect consumers from abusive financial services practices. However, these initial RPs missed the mark. Moving beyond regulatory feedback, this article is the first to provide an empirical assessment of the perspectives of those expert closets to RPs: employees of the affected institutions that must submit RPs, who are responsible for their creation and maintenance, as well as of the federal regulators who oversee them. The latter emerge as far more sceptical than the former about the ability of RPs to protect US taxpayers. The main deficiencies relate to a lack of confidence that the government could avoid bailing out large institutions, regardless of the RPs; the lack of global authority; a lack of experience among regulators with unwinding large, complex banking organizations; and insufficient clarity in the regulatory guidelines.

JP Morgan's Trading Loss and Money Market Funds

The $2.0 billion plus derivatives trading loss announced by JP Morgan in May 2012 raises questions concerning the vast expansion of the federal safety net for banks that has resulted from government policies since the financial crisis, particularly with respect to the concentration of assets in the banking system due to the ballooning of FDIC insurance by $2.5 trillion. JP Morgan's loss raises questions concerning the ability of banking regulators to effectively supervise large, complex banking organizations and suggests that it is unwise for the Federal Reserve to discourage diversity in the financial system by seeking to incapacitate money market funds as safe and efficient alternatives to banks.

Market discipline in international banking regulation: Keeping the playing field level

The focus of this article is the debt market as a powerful disciplinarian source for large and complex banking organizations around the world. We empirically study the interactions between reinforcing banks’ market discipline and preserving a level playing field in international banking. Our approach consists of conducting cross-country comparisons of the secondary market prices sensitivity to market measures of bank risk (traditional and financial strength ratings). The results are generally consistent with the market discipline paradigm. However, much progress still needs to be made (especially in Japan and certain European countries) in order to make the level playing field principle compatible with the reinforcement of market discipline on an international level.

Market Discipline in International Banking Regulation: Keeping the Playing Field Level

The focus of this article is the debt market as a powerful disciplinarian source for large and complex banking organizations around the world. We empirically study the interactions between (1) reinforcing banks' market discipline and (2) preserving the 'level playing field' principle put forward by the Basel Committee since the adoption of the first Capital Adequacy Accord. Our approach consists of conducting cross-country comparisons of the secondary market prices sensitivity to market measures of bank risk (traditional & financial strength ratings). The final sample includes major internationally active banks headquartered in Canada, Europe, Japan, and the United States, over the 1995 - 2002 period. We find that: (i) the spread/rating relationship is statistically significant and comparable for the European and North American banks; (ii) the debt securities issued by the US banks are traded at higher spreads on average that those of their international competitors, probably due to conjectural government guarantees perceived in the European and Japanese banking sectors; (iii) in fact, the variable measuring this kind of guarantees is statistically significant in explaining spreads for the European banks, but insignificant for the North American banks; (iv) in accordance with the market discipline theory, the subordinated creditors are more sensitive than the senior ones to the risk profile of bank issuers; and finally (v), rating downgrades during the year significantly affect spread variability. All in all, although these results are generally consistent with the market discipline paradigm, they arouse serious reflections about the asymmetric transmission of market discipline in various national banking sectors. Much progress remains to be done (especially in Japan and certain European countries) in order to make the 'level playing field' principle compatible with the reinforcement of market discipline at international level.

Systemic Risk and Financial Consolidation: Are They Related?

Abstract The creation of a number of very large and sometimes increasingly complex financial institutions, resulting in part from the on-going consolidation of the financial system, has raised concerns that the degree of systemic risk in the financial system may have increased. We argue that firm inter-dependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. We analyze the dynamics of the stock return correlations of a sample of US large and complex banking organizations (LCBOs) over 1988–1999, and find a significant positive trend in stock return correlations. This finding is consistent with the view that the systemic risk potential in the financial sector appears to have increased over the last decade. In addition, we relate firms' return correlations to their consolidation activity by estimating measures of the consolidation elasticity of correlation. Consolidation at the sample LCBOs appears to have contributed to LCBOs inter-dependencies. However, consolidation elasticities of correlation exhibit substantial time variation, and likely declined in the latter part of the decade. Thus, factors other than consolidation have also been responsible for the upward trend in return correlations.

Systemic risk and financial consolidation: Are they related?

The creation of a number of very large and sometimes increasingly complex financial institutions, resulting in part from the on-going consolidation of the financial system, has raised concerns that the degree of systemic risk in the financial system may have increased. We argue that firm inter-dependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. We analyze the dynamics of the stock return correlations of a sample of US large and complex banking organizations (LCBOs) over 1988–1999, and find a significant positive trend in stock return correlations. This finding is consistent with the view that the systemic risk potential in the financial sector appears to have increased over the last decade. In addition, we relate firms' return correlations to their consolidation activity by estimating measures of the consolidation elasticity of correlation. Consolidation at the sample LCBOs appears to have contributed to LCBOs inter-dependencies. However, consolidation elasticities of correlation exhibit substantial time variation, and likely declined in the latter part of the decade. Thus, factors other than consolidation have also been responsible for the upward trend in return correlations.

Systemic Risk and Financial Consolidation: Are they Related?

We argue that firm interdependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. We find a positive trend in stock return correlations net of diversification effects for a sample of U.S. Large and Complex Banking Organizations over 1988-99. This finding suggests that the systemic risk potential in the financial sector may have increased. In addition, we find a positive consolidation elasticity of correlations. However, such elasticity exhibits substantial time variation and likely declined in the latter part of the decade. Thus, factors other than consolidation have also been responsible for the upward trend in return correlations.

Systemic Risk and Financial Consolidation: Are They Related?

The creation of a number of very large and sometimes increasingly complex financial institutions, resulting in part from the on-going consolidation of the financial system, has raised concerns that the degree of systemic risk in the financial system may have increased. We argue that firm interdependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. We analyze the dynamics of the stock return correlations of a sample of U.S. large and complex banking organizations (LCBOs) over 1988-1999, and find a significant positive trend in stock return correlations. In addition, we relate firms' return correlations to their consolidation activity. Consolidation at the sample LCBOs appears to have contributed to LCBOs interdependencies. However, consolidation elasticities of correlation exhibit substantial time variation, and likely declined in the latter part of the decade. Thus, factors other than consolidation have also been responsible for the upward trend in return correlations.

REFORMING BANK CAPITAL REGULATION: USING SUBORDINATED DEBT TO ENHANCE MARKET AND SUPERVISORY DISCIPLINE

In 1988 the Basel Capital Accord introduced minimum risk‐weighted capital requirements for internationally active banks. In recent years there has been a growing realization that there are significant problems with the capital guidelines. As financial firms have become more sophisticated and complex they have effectively arbitraged the requirements and have become so good at it that the regulations have essentially ceased being a safety and soundness issue for supervisors and have become more of a compliance issue. Indeed, the Basel Committee is now evaluating reforms to the capital accord and is considering various means to improve the risk‐capital relationship and to increase the role of market discipline. The authors argue that many of the problems that currently exist can be addressed, and some additional benefits not previously possible under the current capital guidelines can be realized, by increasing the role of subordinated debt in the bank capital structure. The authors discuss the potential benefits and offer a capital reform proposal that would improve both market and supervisory oversight. This should lead to more prudent risk management behavior by the larger, more complex banking organizations, resulting in a safer industry with less potential for systemic problems.

Systematic Risk and Financial Consolidation: Are They Related?

The creation of a number of very large and sometimes increasingly complex financial institutions, resulting in part from the on-going consolidation of the financial system, has raised concerns that the degree of systemic risk in the financial system may have increased. We argue that firm interdependencies, as measured by correlations of stock returns, provide an indicator of systemic risk potential. We analyze the dynamics of the stock return correlations of a sample of U.S. large and complex banking organizations (LCBOs) over 1988-1999, and find a significant positive trend in stock return correlations. In addition, we relate firms' return correlations to their consolidation activity. Consolidation at the sample LCBOs appears to have contributed to LCBOs interdependencies. However, consolidation elasticities of correlation exhibit substantial time variation, and likely declined in the latter part of the decade. Thus, factors other than consolidation have also been responsible for the upward trend in return correlations.

Supervision of Large Complex Banking Organizations

The long-term trends of consolidation and innovation in the U.S. banking system have intensified over the past decade. A small number of banking organizations now hold a larger portion of the banking system's assets, and, at the same time, their activities have become more complex. As a result, the Federal Reserve has altered its approach to the supervision of the largest, most complex banking organizations (LCBOs). This new approach focuses on the most important risks facing U.S. banking organizations and the ways in which these risks are managed. This article discusses the Federal Reserve's risk-focused supervision program as applied to LCBOs.

Credit risk modeling and internal capital allocation processes: implications for a models-based regulatory bank capital standard

This paper surveys the current state-of-the-art in credit risk modeling at large U.S. banks. Within this context, the paper examines the near-term feasibility of an internal models approach to setting formal regulatory capital requirements for banks, as a replacement for the 1988 Basle Accord. Such an overhaul of the international capital standards would require, in our view, specific attention to several deficiencies in current modeling practices, including questions relating to model specification, parameter estimation, and model validation procedures. The paper also discusses possible uses of internal risk models for setting regulatory capital requirements against selected credit instruments and/or improving examination guidance dealing with the capital adequacy of large, complex banking organizations.