Incentives For Banks Research Articles

Risk of window dressing: quarter-end spikes in the Japanese yen Libor-OIS spread

It is well documented in literature that funding conditions have been subject to the undue influence of distorted incentives of banks to lend and borrow at quarter ends under the Basel III regulatory framework. We investigate whether or not funding risk possibly also suffers the same. Using a state space model, we find quarter-end spikes in the Japanese yen Libor-OIS spread, which arguably reflect a higher funding risk premium at quarter ends, during the global financial crisis and in recent years. The phenomenon in the former episode suggests that quarter-end reporting under Basel II might already have had an effect on the functioning of funding markets, as banks found the capital ratio requirement sharply more binding or constraining. The spikes in the latter episode, which are attributable to the effect of the leverage ratio requirement under Basel III, are found to be negative, partly reflecting the scarcity of high-quality collaterals against the backdrop of a large-scale asset-purchase programme introduced by the Bank of Japan and partly a negative interest rate environment. The evidence adds to the argument in favour of supervisory practices that require banks to report/disclose their average leverage ratio for the quarter instead of their ratio for the last day of the quarter. Indeed, despite the currently proposed reform, the capital ratio remains quarter-end-based, so there could still be quarter-end spikes in funding risk premium in times of financial adversity.

Does the business model influence income smoothing? Evidence from European banks

PurposeThe purpose of this paper is to explore whether the business model (BM) influences bank income smoothing by considering two competing perspectives, the opportunistic and the information enhancement one. Additionally, the paper addresses the role of auditors’ involvement in national supervision and external governance.Design/methodology/approachIncome smoothing is measured by regressing loan loss provisions on unmanaged earnings, and the moderating role of country-level factors is tested employing three-way interactions. The sample consists of European banks observed from 2004 to 2015.FindingsResults indicate that the BM affects smoothing and that retail-funded banks exhibit smoother earnings due to informative reasons. National supervisors’ emphasis on audit is positively associated with smoothing by market-oriented banks, whereas external governance constrains smoothing in diversified-retail banks.Research limitations/implicationsEuropean reforms strengthening monitoring bodies could bring the unintended effect of inducing opportunistic behaviours in market-oriented BMs. However, this study employs indirect proxies for institutional factors and does not consider internal-governance issues.Practical implicationsEvidence sustains the IASB choice of the expected-loss approach for estimating credit losses as it could enhance the informativeness of retail-funded banks’ accounting numbers.Originality/valueThis paper contributes to the income smoothing literature by addressing the role of the BM as a whole in explaining smoothing propensity, not limiting the observation to partial features of the balance sheet. Moreover, it supports a counterintuitive argument, thepenalty hypothesis, assuming that stronger supervision increases bank incentives to manage earnings to avoid penalties.

State-controlled banks and income smoothing. Do politics matter?

This paper uses a new dataset to reassess the relationship between government ownership and income smoothing of commercial banks. We also evaluate how political connections affect the impact of government ownership on earnings management. We find that banks with more state-controlled shareholders located in developing countries tend to have more incentives to smooth income. The paper finds no significant difference in earnings manipulation between government-controlled and non-government banks in developed countries. Next, to investigate whether the income smoothing behavior of state-controlled banks is driven by political objectives, the paper tests whether this behavior widens during national election years; the results provide strong support for this conjecture. The magnitude of the income smoothing behavior also varies with different countries and electoral characteristics. These findings suggest that the political channel plays an important role in determining the income smoothing incentives of state-controlled banks, especially in developing countries.

Stealth Recapitalization and Bank Risk Taking: Evidence from TLTROs

I study the transmission of unconventional monetary policy through an increase in bank net worth. I examine the ECB’s Targeted Long Term Refinancing Operations (TLTROs), which provided interest rate subsidized loans to banks. First, I measure the rate subsidy and document that it results in equity gains for banks facing high borrowing costs in the private market, especially low capitalized banks. Second, using loan-level data from a sample of thirty-three European banks, I show that weakly capitalized banks receiving TLTRO funding subsequently decreased their risky lending. The effect spills-over to asset classes not targeted by TLTROs and is largest for banks receiving higher interest rate subsidies. In contrast to previous evidence, these results support that subsidized funding can boost bank net worth and offset risk-shifting incentives of banks, resulting in improved ex-post stability of the financial sector. The differences in results can be potentially attributed to differences in asset-side and liability-side recapitalizations as well as the different frictions (limited liability/regulatory scrutiny) faced by weakly capitalized banks in each setting.

Bank capital buffers in a dynamic model

AbstractWe estimate a dynamic structural banking model to examine the interaction between risk‐weighted capital adequacy and unweighted leverage requirements, their differential impact on bank lending, and equity buffer accumulation in excess of regulatory minima. Tighter risk‐weighted capital requirements reduce loan supplies and lead to an endogenous fall in bank profitability, reducing bank incentives to accumulate equity buffers and, therefore, increasing the incidence of bank failure. Alternatively, tighter leverage requirements increase lending, preserve bank charter value, and incentives to accumulate equity buffers leading to lower bank failure rates.

中国影子银行的经济学分析：发展驱动因素 (Economics of China’s Shadow Banking: Driving Growth Factors)

Chinese Abstract: 近年来，中国影子银行的迅速发展吸引了学术界和政策制订者的广泛关注。在传统的银行表内贷款和债券投资之外，存量高达50万亿元的影子银行如何发展起来？本文系统性回顾了影子银行自2002年以来的发展历程，认为其本质上是地方政府融资平台和房地产企业的融资工具，来自这两类企业的旺盛融资需求为影子银行发展提供了根本动力。为影子银行发展助力的是商业银行降低交易费用的动机，把表内业务挪到表外、内部交易外部化，资金成本高了一些，但显著降低了制度成本，从而降低了总交易费用。此外，监管政策对影子银行的发展也有影响。我们据此建立了局部均衡理论模型，并解出影子银行的存量方程和价格方程，首次采用李文喆（2019）测算的翔实的影子银行总量数据进行了实证检验。经工具变量法、广义矩估计、向量自回归等方法检验，发现本文的解释框架在较高的显著性下成立，模型解释力较强。 English Abstract: In recent years, the spectacular expansion of China’s shadow banking attracts broad attention from both academia and policy makers. Beyond traditional on-balance sheet bank loans and bond investment, how did shadow banking develop to a scale as high as RMB 5 trillion yuan? This paper systematically reviews development of shadow banking since 2002, and comes to conclude that shadow banking essentially is the financing vehicle of local government and real estate enterprises. Financing needs of these two types of enterprises are the essential driving factor of shadow banking growth. Incentive of commercial banks to lower transaction costs is also very important. Although shifting business off balance sheet, and externalizing internal transactions elevate funding cost, they substantially lower institutional cost and reduce total transaction cost. Besides, during this process, regulation policy also exerts influences. Based on the above analysis, we build partial equilibrium theoretical model and solve to obtain stock and price equations of shadow banking. For the first time, we utilize detailed aggregate data of China’s shadow banking from Li (2019) to conduct empirical tests of above analysis. The results from Instrumental Variable method, Generalized Method of Moments, and Vector Autoregression show that this explanatory framework stands at high significance level, and has strong explanatory power. Note: Downloadable document is in Chinese. An updated version of this paper was published in Chinese academic journal 'Economist' in March 2021.

Overnight block trades in the Korean stock market

AbstractWe examine the characteristics of overnight block trades in the Korean stock market from 2004 to 2015. We find that the discount on the offering price is negatively related to the number and return volatility of shares, the offering price is higher for firm‐commitment contracts than for best‐effort contracts, the discount level is lower for larger deal values under best‐effort contracts, commission fee rates and fees are more pronounced under firm‐commitment contracts, and a deal's uncertainty is related to the firm's contract choice. The incentives of sellers and investment banks are aligned unless sellers face an informational disadvantage.

Securitization as a response to monetary policy

AbstractThis paper studies how monetary easing provides incentives for banks to take risk and issue mortgage‐backed securities (MBS) and, because MBS have the “lemon” property, why MBS buyers are willing to purchase high‐risk securities at high prices. Banks need equity to attract deposits. Monetary easing reduces this need, and banks leverage up and reduce their monitoring efforts. The internal need for liquidity and risk sharing motivates banks to issue MBS. Security buyers understand the moral hazard problem that banks face but are willing to purchase bank securities at high prices because monetary easing would also reduce their cost of funds.

Pricing of Islamic deposit insurance

We present an Islamic deposit insurance model with both government and private insurers. We show that government insurer provides strong incentives for banks to take excessive systematic risks, and private insurers can eliminate such incentives by charging a higher fee.

Monetary Policy Exposure of Banks and Loan Contracting

The bank lending channel states that tight monetary policy impairs the loan supply of banks to borrowers. However, banks and their borrowers enter into binding long-term loan contract agreements, limiting the ability of banks to decrease loan supply. This raises the question of whether banks take ex ante actions to gain flexibility to reduce their lending when needed. In this paper, I exploit banks’ heterogeneity of exposure to monetary policy and show that banks with higher exposure write stricter covenants in their loan contracts. This practice of writing stricter covenants increases the probability of covenant violation, and hence enables banks to decrease loan amounts to their existing borrowers during times of monetary policy tightening. The results are robust after controlling for endogenous bank-borrower matching, by having a within borrower estimation or using bank mergers as an instrument. Consistent with the increased incentive and ability of banks, the effect is stronger for long-term lines of credit originated to financially constrained firms during times of high monetary policy uncertainty. These findings show how banks preserve flexibility against future contingencies, and highlight the role of a specific feature of financial contracting in the transmission of monetary policy to the economy through banks.

Interactions between Bank Levies and Corporate Taxes: How is the Bank Leverage Affected?

Regulatory bank levies set incentives for banks to reduce leverage. At the same time, corporate income taxation makes funding through debt more attractive. In this paper, we explore how regulatory levies affect bank capital structure, depending on corporate income taxation. Based on bank balance sheet data from 2006 to 2014 for a panel of EU-banks, our analysis yields three main results: The introduction of bank levies leads to lower leverage as liabilities become more expensive. This effect is weaker the more elevated corporate income taxes are. In countries charging very high corporate income taxes, the incentives of bank levies to reduce leverage turn ineffective. Thus, bank levies can counteract the debt bias of taxation only partially. JEL Classification: G21, G28, L51

Reasons for the Demise of Interest: Savings Glut and Secular Stagnation or Central Bank Policy?

In this paper we compare the Keynesian, neoclassical and Austrian explanations for low interest rates and sluggish growth. From a Keynesian and neoclassical perspective low interest rates are attributed to ageing societies, which save more for the future (global savings glut). Low growth is linked to slowing population growth and a declining marginal efficiency of investment as well as to declining fixed capital investment due to digitalization (secular stagnation). In contrast, from the perspective of Austrian business cycle theory, interest rates were step by step decreased by central banks to stimulate growth. This paralyzed investment and growth in the long term. We show that the ability of banks to extend credit ex nihilo and the need of time to produce capital invalidates the IS identity assumed in the Keynesian theory to hold permanently. Furthermore, we find no empirical evidence for the global savings glut and secular stagnation hypotheses. Instead, low growth can be explained by the emergence of quasi “soft budget constraints” as a result of low interest rates, which reduce the incentive for banks and enterprises to strive for efficiency.

The Evolution of Banking Regulation Since the Financial Crisis: A Critical Assessment

Following the 2008 financial crisis a major process of regulatory reform of the banking industry took place with the aim of increasing the resilience of the financial system. More specifically, the regulatory changes introduced after the financial crisis were aimed at pursuing three main objectives: (i) improve the resilience of individual banks, thereby reducing the risk of financial institutions to fail, (ii) improve the resilience of the financial system as a whole, limiting the risk of spillovers to the broader economy that would be triggered by the failure of large financial institutions, and (iii) reduce the risk for taxpayers to bear the cost of future banking crisis. Starting from an exam of the main weaknesses of the banking regulatory framework highlighted by the financial crisis, this paper provides a detailed analysis of the Basel 3 reform, its main goals, timing and technical features. It then examines the more recent revisions of the Basel 3 framework - often called “Basel 4” - and the new requirements associated to bank resolution policies, i.e. the “total loss absorbing capacity” (TLAC) and the “minimum required eligible liabilities” (MREL). These regulatory reforms are then critically discussed, both though the analysis of their impact on the banking industry, and with recourse to the available empirical evidence. This evidence shows that the banking industry did register a significant increase in the amount and quality of equity capital, mostly achieved through capital increases, and in liquidity. This led to a decrease in the probability of future large banks defaults and in the incentive for banks to take on excessive risks. Also, by introducing bail in mechanisms for banks’ liabilities, these reforms reduced the likelihood of future crisis being supported by taxpayers via government bail outs. However, a number of threats are still being faced by the banking industry. These include profitability, a necessary condition for a bank to be sustainable over time, the sovereign-banks “doom loop”, and the possibility of future recessions, as banks’ safety and soundness is inevitably linked to the state of the economy.

Bank Resolution and the Structure of Global Banks

We study the resolution of global banks by national regulators. Single-point-of-entry (SPOE) resolution, where loss-absorbing capital is shared across jurisdictions, is efficient but faces implementation constraints. First, when expected transfers across jurisdictions are too asymmetric, national regulators fail to set up SPOE resolution ex ante. Second, when required ex-post transfers are too large, national regulators ring-fence assets instead of cooperating in SPOE resolution. In this case, a multiple-point-of- entry (MPOE) resolution, where loss-absorbing capital is pre-assigned, is more robust. Our analysis highlights a fundamental link between efficient bank resolution, the operational structures, risks, and incentives of global banks.

How changes in market conditions affect screening activity, credit risk, and the lending behaviour of banks

ABSTRACTThe global financial crisis dramatically transformed the market conditions in the banking industry. We construct a theoretical model of spatial competition that considers the differential information between lenders and loan applicants to explore how changes in the market structure affect the lending behaviour of banks and their incentives to invest in screening and how this, in turn, affects the level of credit risk in the economy. Our findings reveal that enhanced competition reduces lending cost thus encouraging the entry of new customers in credit markets. Also, that the transportation cost that loan applicants are required to pay to reach the bank of their interest shrinks with respect to the degree of competition. We further lend support to the view that stiffer competition has an increasing impact on the level of credit risk. Notably, we find that competition strengthens the incentives of banks to engage in screening activity and that screening serves as a protection mechanism that can provide banks with a shield against bad loans. Overall, when market conditions are substantially distorted, this has a dilutive impact on the incentives mechanism of banks to screen their applicants. We provide empirical evidence which is consistent with the conceptual underpinnings of our theoretical model and the obtained findings.

Interactions between Regulatory and Corporate Taxes: How Is Bank Leverage Affected?

Regulatory bank levies set incentives for banks to reduce leverage. At the same time, corporate income taxation makes funding through debt more attractive. In this paper, we explore how regulatory levies affect bank capital structure, depending on corporate income taxation. Based on bank balance sheet data from 2006 to 2014 for a panel of EU-banks, our analysis yields three main results: The introduction of bank levies leads to lower leverage as liabilities become more expensive. This effect is weaker the more elevated corporate income taxes are. In countries charging very high corporate income taxes, the incentives of bank levies to reduce leverage turn ineffective. Thus, bank levies can counteract the debt bias of taxation only.

Competition for traders and risk

AbstractPerverse incentives for banks' traders have played a role in the financial crisis. We study how labor market competition interacts with the structure of compensation to result in excessive risk taking. In a model with trader moral hazard and adverse selection on trader abilities, we demonstrate how banks optimally induce top traders to take more risk as competition on the labor market intensifies, even if banks internalize the costs of negative outcomes. Distorting risk‐taking incentives allows banks to reduce the surplus offered to low‐ability traders. We find that increasing bank capital requirements does not unambiguously reduce risk taking by top traders.

GOVERNMENT DEBT AND BANKING FRAGILITY: THE SPREADING OF STRATEGIC UNCERTAINTY

AbstractThis article studies the interaction of government debt and financial markets. This interaction, termed a “diabolic loop,” is driven by government choice to bail out banks and the resulting incentives for banks to hold government debt instead of self‐insure through equity buffers. We highlight the role of bank equity issuance in determining whether the “diabolic loop” is a Nash equilibrium of the interaction between banks and the government. When equity is issued, no diabolic loop exists. In equilibrium, banks' rational expectations of a bailout ensure that no equity is issued and the sovereign‐bank loop is operative.

To screen or not to screen? Let the competition decide

We develop a model of spatial competition to explore how changes in the market structure affect the incentives of banks to screen loan applicants. We take a post-crisis perspective that treats the number of banks as exogenous. Our findings reveal that the relaxation of competition distorts banks’ incentives to invest in screening.

Pitfalls in systemic-risk scoring

Abstract In this paper, we identify several shortcomings in the systemic-risk scoring methodology currently used to identify and regulate Systemically Important Financial Institutions (SIFIs). Using newly-disclosed regulatory data for 119 US and international banks, we show that the current scoring methodology severely distorts the allocation of regulatory capital among banks. We then propose and implement a methodology that corrects for these shortcomings and increases incentives for banks to reduce their risk contributions.