Periods Of Financial Distress Research Articles

An Analysis of the Potential Impact of Heightened Capital Requirements on Banks’ Cost of Capital

Critics of recent regulation to increase minimum bank capital requirements contend that this policy will increase the cost of doing business for banks. We investigate the potential impact of heightened capital requirements on banks’ cost of capital. In the cross-section, banks’ cost of equity, measured by the implied cost of capital (ICC), and banks’ cost of debt decline when equity capital increases. The negative association between capital and banks’ ICC is stronger after the onset of the financial crisis, consistent with prior work suggesting that equity is more valuable during periods of financial distress. The negative association between capital and banks’ cost of equity and debt, compensates for the difference in the costs of these sources of financing. As a consequence, the overall cost of capital remains unaltered when capital increases. Thus, our findings do not offer support the claim that additional equity has a negative impact on credit because equity increases banks’ cost of capital. An exception to these findings is found in the sample of large banks. There is no discernible association between capital and the costs of equity and debt of large banks and their WACC increases when they substitute debt with more expensive equity.

Capital Regulations and the Management of Credit Commitments during Crisis Times

Drawdowns on credit commitments by firms reduce a bank's regulatory capital ratio. Using the Austrian Credit Register, we provide novel evidence that during the 2008-09 financial crisis, capital-constrained banks managed this concern by substantially cutting partly or fully unused credit commitments. Controlling for a bank's capital position, we also find that greater liquidity problems induced banks to considerably cut such credit commitments during the crisis. These results suggest that banks actively manage both capital and liquidity risk caused by undrawn credit commitments in periods of financial distress, but thereby reduce liquidity provision to firms exactly when they need it most.

On the stability of stock-bond comovements across market conditions in the Eurozone periphery

We analyze the relationship between returns on equity and long-term government bonds in the crisis-hit Eurozone peripheral economies. In particular, we are interested in the stability of the relationship across differing market conditions and if long-term bonds act as a safe haven for equity investors during periods of financial distress. Employing a Markov-switching vector autoregression model with three regimes, we find that the stock-bond relationship varies across market conditions and across countries. Overall we observe increased comovement during the crisis regimes at the market level, with the relationship between the financial sectors and the domestic sovereign bond being its most important driver across countries.

An alternative approach to predicting bank credit risk in Europe with Google data

The aim of this paper is to construct an alternative approach based on a sentiment index to measure bank credit risk in European countries using an alternative approach instead of traditional measures. Specifically, we use Google data for a set of keywords related to bank credit risk to capture investor sentiment. The resulting index shows a great similarity to traditional indexes based on bank CDS. The out-of-sample analysis demonstrates that our sentiment index is helpful for predicting bank credit risk during periods of financial distress, since it enhances the accuracy of the estimations.

Discount Window Stigma and the Term Auction Facility

How should the lender of last resort provide liquidity to banks during periods of financial distress? During the 2008-2010 crisis, banks avoided borrowing from the Fed's long-standing discount window (DW), but actively participated in its special monetary program, the Term Auction Facility (TAF), although both programs had the same borrowing requirements. Using an adverse selection model with endogenous borrowing decisions, we explain why two programs suffer from different stigma and how the introduction of TAF incentivized banks' borrowing. Empirically, we combine several data sources to confirm our main theoretical predictions.

Board structure and financial distress in Brazilian firms

PurposeThe purpose of this paper is to investigate what board characteristics affect companies in periods of financial distress (FD) among non-financial Brazilian firms and examine which model best fits to predict FD.Design/methodology/approachThe sample comprises data from 2010 to 2016 of the non-financial Brazilian firms listed on the Brazilian Stock Exchange. To measure this relationship, a conditional logistic regression is performed.FindingsA U-shaped relationship between the size of the board of directors (BD) and FD is found in all models, indicating an optimal number of six members in the BD during the period of FD. However, board characteristics (related to composition and directors’ independence) are insufficient to align the shareholders’ interests and unsuitable for avoiding or even reducing FD in firms when other factors are neglected. Furthermore, the results reveal what variables provide the best-fitting models to predict FD.Originality/valueTo the best of the authors’ knowledge, this is the first study that investigates how the composition of the BD affects the FD likelihood in the Brazilian context. The findings are potentially of interest to researchers and practitioners since this paper contributes to the growing literature on the influence of corporate governance mechanisms in periods of FD and the understanding of its prediction models.

Measuring Systemic Risk on the Indonesia’s Banking System

Inter-connectedness is one important aspect in measuring the degree of systemic risk arising in the banking system. In this paper, this aspect besides the degree of commonality and volatility are measured using Principal Component Analysis (PCA), dynamic Granger causality tests and a Markov regime switching model. These measures can be used as leading indicators to detect pressures in the financial system, in particular the banking system. There is evidence that the inter-connectedness level together with degree of commonality and volatility among banks escalate substantially during the financial distress. It implies that less systemically important banks could become more important in the financial system during the abnormal times. Therefore, the list of systemically important banks as regulated in the Law on Prevention and Mitigation of Financial System Crisis (UU PPKSK) should be updated more frequently during the period of financial distress.

Predicting Default Risk under Asymmetric Binary Link Functions

In this paper we propose the use of an asymmetric binary link function to extend the proportional hazard model for predicting loan default. The rationale behind this approach is that the symmetry assumption, that has been widely used in the literature, could be considered as quite restrictive, especially during periods of financial distress. In our approach we allow for a flexible level of asymmetry in the probability of default by the use of the skewed logit distribution. This enable us to estimate the actual level of asymmetry that is associated with the data at hand. We implement our approach to both simulated data and a rich micro dataset of consumer loan accounts. Our results provide clear cut evidence that ignoring the actual level of asymmetry leads to seriously biased estimates of the slope coefficients, inaccurate marginal effects of the covariates of the model, and overestimation of the probability of default. Regarding the predictive power of the covariates of the model, we have found that loan specific covariates, contain considerably more information about the loan default than macroeconomic covariates, which are often used in practice to carry out macroprudential stress testing.

Capital Regulations and the Management of Credit Commitments During Crisis Times

Drawdowns on credit commitments by firms reduce a bank's regulatory capital ratio. Using the Austrian Credit Register, we provide novel evidence that during the 2008-09 financial crisis, capital-constrained banks managed this concern by substantially cutting partly or fully unused credit commitments. Controlling for a bank's capital position, we also find that greater liquidity problems induced banks to considerably cut such credit commitments during the crisis. These results suggest that banks actively manage both capital and liquidity risk caused by undrawn credit commitments in periods of financial distress, but thereby reduce liquidity provision to firms exactly when they need it most.

The Nonlinear Dynamics of Corporate Bond Spreads: Regime-Dependent Effects of Their Determinants

This paper studies the behavior of corporate bond spreads during different market regimes between 2004 and 2016. Applying a Markov-switching vector autoregressive (MS-VAR) model, we document that the dynamic impact of spread determinants varies substantially with market conditions. In periods of high volatility, systematic credit risk - rather than interest rate movements - contributes to driving up spreads. Moreover, while market-wide liquidity risk is not priced when volatility is low, it becomes a crucial factor during stress periods. Our results challenge the notion that spreads predominantly capture credit risk and suggest it must be reassessed during periods of financial distress.

VOLATILITY MEASURES, LIQUIDITY AND CREDIT LOSS PROVISIONS DURING PERIODS OF FINANCIAL DISTRESS

In this paper, we investigate the role of liquidity in banks lending activity and how liquidity provision is related to bank’s credit risk and others market-based risk measures, such as bank’s implied volatility skew from options traded on the market and realized volatility from futures contract on LIBOR, during periods of global financial distress. Credit risk is given by the ratio between loan loss reserves and total assets and we find that losses from lending activity force banks to build up new liquidity provisions only during the period of financial distress. Liquidity ratio is given by the sum of cash and short-term assets over total assets and we discovered that credit risk reduces liquidity ratio only in bad times, as this demand for liquid asset is suddenly switched on and the more reserves from loan losses the bank has, the more it cleans its balance sheet from long-term commitments in order to replenish its cash and short-term securities. When we control for market-based risk measures, we evidence that both implied volatility skew and LIBOR’s realized volatility are negatively related with the liquidity ratio and are useful in predicting a distress in bank’s liquidity holdings.

Pricing factors in multiple-term structures from interbank rates

This article analyzes the reward for the risk embedded in interbank derivatives, seeking to characterize the size and economic sources of the components of this risk premium in interbank spread quotes. The basis swap (BS) spreads – floating-to-floating interest rate swaps – are employed as a vehicle used by investors to express their views concerning the risk of borrowing on the interbank market. Our results show that the size of the risk premium ranges from 20 to 60 basis points, depending on the tenor, during periods of financial distress. Moreover, the evolution of this risk premium increases dramatically after August 2007, primarily due to the evolution of credit variables such as sovereign and financial sector risks. Finally, we also document important sources of commonality between risk premiums at different tenors. An analysis of the determinants of risk premia reveal that investors’ compensation relates to financial sector credit and liquidity uncertainty, and risk aversion.

A multiplex financial network approach to policy evaluation: the case of euro area Quantitative Easing

Over the last decades, both advanced and emerging economies have experienced astriking increase in the intra-financial activity across different asset classes and increasingly complex contract types, leading to a far more complex financial system. Until the 2007-2008 crisis, the increased financial intensity and complexity was believed beneficial in making the financial system more resilient and less vulnerable to shocks. However, in 2007-2008, the advanced economies suffered the biggest financial crisis since the 1930s, followed by a severe post-crisis recession, questioning the adequacy of traditional tools in predicting, explaining, and responding to periods of financial distress. In particular, the effect of complex interconnections among financial actors on financial stability has been widely acknowledged. A recent debate focused on the effects of unconventional policies aimed at achieving both price and financial stability. Among these unconventional policies, Quantitative Easing (QE, i.e., the large-scale asset purchase programme conducted by a central bank upon the creation of new money) has been recently implemented by the European Central Bank (ECB). In this context, two questions deserve more attention in the literature. First, to what extent, the resources provided to the banking system through QE are transmitted to the real economy. Second, to what extent, the QE may also alter the pattern of intra-financial exposures and what are the implications in terms of financial stability. Here, we address these two questions by developing a methodology to map the multilayer macro-network of financial exposures among institutional sectors across financial instruments (i.e., loans and deposits, debt securities, and equity), and we illustrate our approach on recently available data. We then test the effect of the implementation of ECB’s QE on the time evolution of the financial linkages in the multilayer macro-network of the euro area, as well as the effect on macroeconomic variables, such as consumption, investment, unemployment, growth, and inflation.

Pengaruh Rasio Keuangan Terhadap Financial Distress Pada Perusahaan Manufaktur Yang Terdaftar Di Bursa Efek Indonesia Periode 2009-2013

The purpose of this study is to determine the financial ratios partial effect on financial distress in manufacturing companies prior to the period of financial distress (t-n). Financial distress is defined as a late stage of corporate decline that precedes more cataclysmic events such as bankruptcy or liquidation. Analysis of financial ratios is performed to determine the ratio that affect the probability of financial distress. The method used is the purposive sampling method. Data analysis techniques logistic regression. Hypothesis testing is done in three periods, that is the period of one year before the financial distress (t-1), a two-year period before the financial distress (t-2) and a three-year period before the financial distress (t-3). Results indicate that the independent variables have a partial effect on manufacture company. The period t-1, ratio TL/TA and NI/TA affect financial distress. The period t-2, ratio NI/EQ affect financial distress. The period t-3, ratio TL/TA and NI/TA affect financial distress.

Monetary Policy across Space and Time

Many major macroeconomic events have occurred across multiple countries. This Economic Brief looks at similarities and differences among the euro area, the United Kingdom, and the United States and finds that macroeconomic variables tend to become more interconnected during periods of financial distress. Movements in monetary policy are highly correlated across all three regions. In addition, inflation and unemployment become less responsive to monetary policy shocks over time.

Office Market Interconnectedness and Systemic Risk Exposure

We empirically examine how systemic risk in the banking sector leads to correlated risk in office markets of global financial centers. In so doing, we compute an aggregated measure of systemic risk in financial centers as the cumulated expected capital shortfall of local financial institutions. Our identification strategy is based on a double counterfactual approach by comparing normal with financial distress periods as well as office with retail markets. We find that office market interconnectedness arises from systemic risk during financial turmoil periods. Office market performance in a financial center is affected by returns of systemically linked financial center office markets only during a systemic banking crisis. In contrast, there is no evidence of correlated risk during normal times and among the within-city counterfactual retail sector. The decline in office market returns during a banking crisis is larger in financial centers compared to non-financial centers.

Financial regimes and uncertainty shocks

Credit markets are an important link in the propagation of economic uncertainty. We study the nexus between the two using a nonlinear VAR where uncertainty is captured by the volatility of the economy’s structural shocks and its transmission mechanism is allowed to change in periods of financial distress. We find that, in the USA, uncertainty shocks have recessionary effects at all times, but their impact on output is six times larger when the economy is going through a financial crisis. Uncertainty accounts for one percentage point of the contraction in industrial production observed in the Great Recession.

Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

The time-variation in asset correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the magnitude of market movements, hence volatility. However, recent research finds that the size of markets fluctuations is not necessarily the primary driver for the time-variation in correlations, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Our findings show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations; and potentially help improve the effectiveness of risk management strategies during periods of financial distress.

Does Liquidity Risk Explain the Time-Variation in Asset Correlations? Evidence from Stocks, Bonds and Commodities

The time-variation in asset correlations have broad implications in asset pricing, portfolio management and hedging. Numerous studies in the literature have found that the change in correlations is mainly related to the magnitude of market movements, hence volatility. However, recent research finds that the size of markets fluctuations is not necessarily the primary driver for the time-variation in correlations, but that the effect of market movements is amplified in times of high financial distress, characterised by low liquidity. This paper seeks to investigate the effect of liquidity on time-varying correlations among different asset classes, namely stocks, corporate bonds and commodities. Our findings show that liquidity indeed has a significant effect on the time-variation in asset correlations, particularly in the case of how bond returns comove with other asset classes. We observe that higher liquidity risk is associated with lower correlation of bond returns with stocks as well as commodities. Our findings suggest that measures of liquidity risk can improve models of correlations; and potentially help improve the effectiveness of risk management strategies during periods of financial distress.

Determinants of risk reporting by Portuguese and Spanish non-finance companies

PurposeThis paper aims to assess the risk reporting practices extent to which firm’s and corporate governance characteristics explain risk-related disclosures (RRD) motivations across two European Latin countries (Portugal and Spain). Moreover, drawn on elements of agency, legitimacy, resources-based perspectives and institutional theory, this study also intends to assess whether the influence of corporate governance mechanisms on risk reporting is mediated by strategic/institutional legitimacy interests.Design/methodology/approachFrom a sample of 60 non-finance Portuguese and Spanish companies with securities traded on the Euronext Lisbon stock exchange market and on the Madrid stock exchange market, respectively, at December, 2011, the Corporate Governance reports and the “risk/risk management” sections of the Management reports included on consolidated annual reports for 2011 were manually content analysed, according to prior literature. Further, multiple linear regressions were used to assess the potential relationships between corporate governance mechanisms and risk reporting. The paper’s theoretical framework draws on elements of agency, legitimacy, resources-based perspectives and institutional theory. To understand the risk reporting practices of Portuguese and Spanish non-finance listed companies, the paper conducts a content analysis of 60 consolidated annual reports for 2011.FindingsResults indicate that visible companies, operating in a country with a weaker legal environment, and during periods of financial distress disclose more discretionary RRD, basically to contextualize their negative outcomes. Some corporate governance mechanisms were crucial to improve risk information.Originality/valueThe paper goes beyond prior literature work and assesses whether the theoretical framework grounded on agency, legitimacy, resources-based perspective and institutional theory is suitable in explaining RRD in an under-researched setting (European Latin countries, such as Portugal and Spain, with low agency costs and different corporate governance models). Moreover, the analysis embraces a wider and homogeneous range of internal and external corporate governance mechanisms and uses a period in which both countries were severely affected by a sovereign debt crisis with negative impacts on company’s liquidity and financial risks. A research setting like this has not been studied hitherto.