Wholesale Funding Research Articles

Liquidity crisis, relationship lending and corporate finance

This paper investigates the consequences of the liquidity shocks in wholesale funding markets during the 2007–2009 financial crisis on bank lending and corporate financing. We show that banks that relied more heavily on wholesale funding contracted lending more severely than banks that relied more on insured deposits. We then examine the effects of loan contraction on the financial positions of publicly traded firms. We find that both during and after the crisis, the change in leverage of bank-dependent firms is less than that of firms with access to public debt markets. In addition, bank-dependent firms rely more on cash than net equity issuance to finance operations. We also find that firms with established bank lending relationships weather the crisis better. Such firms are able to attain higher levels of leverage during the crisis, add to their cash holdings, secure new bank credit, and achieve higher profitability as a result.

Bank business models, capital rules and structural separation policies

Purpose – The study examines the roles of capital rules, macro variables and bank business models in determining the safety of banks as measured by the “distance-to-default” (DTD) with the purpose of drawing implications for regulation of bank capital and business models. Design/methodology/approach – A panel regression study using pre- and post-crisis data for 108 US and European banks is used to explore the issue empirically. A new technique is also used to back out the amount of capital banks would have needed during the crisis to keep the “DTD” in the very safe zone. Findings – The simple leverage ratio has a strong relationship with “DTD”, while the Basel ratio does not. The most important business model features are derivatives and wholesale funding, which have a strong negative relationship with “DTD”. Trading and available-for-sale securities have a positive influence. Calculations show that it is not possible for any reasonable capital rule to compensate for the risks created by business model features encompassing large derivative-based activities. Bank separation policies are essential. Originality/value – The micro evidence-based analysis as an approach to bank regulation and business model requirements stands in contrast to the ad hoc way policy has been constructed before and after the crisis. The empirical evidence supports separation based on the balance sheet size of derivatives and a leverage ratio instead of the complex Basel risk-weighted capital approach. The current approaches to structural separation are criticised constructively, and some evidence-based suggestions for improving bank business models to reduce systemic risk are made.

From Merlin to Oz: The strange case of failed lending targets in the UK

ABSTRACTAs a response to the crisis in the British banking system and reduced lending, the British government established Project Merlin, a series of lending targets aimed at boosting lending to the British economy, and small and medium-sized enterprises (SMEs) in particular. Given the economic importance of the targets, however, this paper questions why the Merlin agreements were so ineffective. Three explanations are given: first, in light of the challenges in accessing wholesale funding for the largest UK-owned banks, there was a lack of capacity and incentive to lend more; second, the lack of decisive intervention by the British state to compel banks to lend was also a determinant; third, though, I argue that boosting actual lending figures was not the primary aim of Project Merlin. Instead, the targets were performative, rather than substantive. I argue that these three explanations have important implications for the varieties of capitalism (VoC) debate and the economic and political economic literature on foreign versus domestic bank ownership. To the first literature, the article explains the degree to which politics underpins the structure of even the UK's purportedly liberal market economy (LME), whilst to the second, it explores the limitations to political control over even domestically-owned banks.

Liquidity Safety Nets for Banks

Liquidity shocks are a core risk of the business model of commercial banks, which is founded on a liquidity mismatch between the banks' liabilities and assets. A substantial part of the banks' funding comes from short-term retail and wholesale funding, whilst a substantial part of the assets are long-term and illiquid loans. This is the source of the banks' profi ts, but also of their claim to fulfi l an important social role. Having argued that leaving the solution to this problem to the banks alone is unsafe, this article turns to examine three regulatory strategies for reducing the incidence of liquidity shocks or making banks more resilient to them. They are: regulating the level of banks' liquidity reserves, insuring the value of the banks' long-term assets and guaranteeing the discharge of the banks' short-term liabilities. The criteria of assessment are the least impact on the banks' social role of transforming short-term deposits into long-term loans, coupled with the least incentive for banks to take excessive risk, the least subsidy to banking and the least cost to the public purse. It is suggested that insuring the value of the banks' long-term assets emerges as the most attractive strategy.

The impact of market power and funding strategy on bank-interest margins

This paper investigates the implications of market power and funding strategies for bank-interest margins, using a sample of 978 banks in 55 emerging and developing countries over an eight-year period, 2000–2007. We provide additional insight by examining the complex interlocking of three key variables that are important for regulators: the degree of market power, funding sources and bank performance. The results show that market power increases when banks use internal funding to diversify into non-interest income-generating activities. We also find that the high net-interest margins of banks in emerging and developing countries can be explained by the degree of market power, credit risk, and implicit interest payments. In addition, our results suggest that interest margins among banks with market power are significantly more sensitive to internally generated funds than they are to deposit and wholesale funding.

Structural Funding and Bank Failures

This paper investigates bank structural funding vis-a-vis bank failures. An empirical analysis is conducted on the defaults of commercial banks occurred in the United States between 2007 and 2009. The results highlight that structural funding position indeed plays a significant role in explaining the probability of bank defaults. A balanced funding position, with more deposits and a lower loans-deposits gap to be filled with wholesale funding, positively contributes to the resilience of the banks. Not all deposits are, however, the same: within deposit funding, the higher the reliance on the less-stable components the more likely a bank is to face distress. Results are robust to the sampling and modelling choices as well as to the variable specification used. While the empirical analysis focuses on the US and the loan-to-deposit ratio, the findings can be easily generalized to any banking system, and the relevant policy messages can be extended to the banking stability impacts of the Basel III structural funding regulation.

Main determinants of efficiency and implications on banking concentration in the European Union

This study aims to measure the main determinants influencing bank efficiency. We suggest that the bank efficiency ratio, obtained from the income statement, is positively related to the size of a bank in terms of total assets. However, we believe that such a relationship cannot be maintained for banks over a certain size. By the use of the regression analysis method, we analyze the link between bank efficiency and bank size, using a sample of 3952 banks in the European Union. Our results show that the efficiency ratio stops improving for banks with total assets over $25 billion. Previous literature, using different analysis techniques, does not reach an agreement on this point. Furthermore, our study identifies further variables which negatively affect the efficiency of banks, such as competition and lending diversification, or affect them positively, such as the wholesale funding ratio and income diversification. Our findings imply the need for different bank policies depending on total assets, in order to limit the size and activities of banks.

The Basel III Net Stable Funding Ratio and bank net interest margins

The Net Stable Funding Ratio (NSFR) is a new Basel III liquidity requirement designed to limit funding risk arising from maturity mismatches between bank assets and liabilities. This study explains the NSFR and estimates this ratio for banks in 15 countries. Banks below the ratio need to increase stable sources of funding and to reduce assets requiring funding. The most cost-effective strategies to meet the NSFR are to increase holdings of higher-rated securities and to extend the maturity of wholesale funding. These changes reduce net interest margins by 70–88 basis points on average, or around 40% of their year-end 2009 values. Universal banks with diversified funding sources and high trading assets are penalized most by the NSFR.

Liquidity Regulation, the Central Bank and the Money Market

As reliance on excessively short-term wholesale funding has been one of the major causes for the 2007-2009 financial crisis, recent advances in global liquidity regulation try to curb the excessive reliance on short-term wholesale funding without being clear on how such an approach will affect the overall equilibrium on money markets. In particular, liquidity regulation may interfere with the central bank's influence on short-term money market rates. This paper tries to fill the gap in understanding the interaction between the money market, the central bank, and the regulator. Importantly, it shows that the existence of a central bank can be welfare-improving when the market equilibrium is driven by collateral constraints and asymmetric information. Regulation can be welfare-improving in the presence of an externality and also in case of collateral constraints, but reduces activity on the unsecured market. This implies that in case of collateral constraints the regulator can lead to a complete crowding out of the unsecured market which leads to an increased central bank intermediation need.

Deposit market competition, wholesale funding, and bank risk

Empirical research on the effect of bank competition on bank risk has so far produced very inconclusive results. In this paper we revisit this long-standing debate and propose a new empirical approach that is concentrated on the relationship between deposit market competition and bank risk. This approach closely follows the traditional theoretical views of the competition and risk relationship and is focused on testing the classical moral hazard problem of the bank: deposit market competition raises the optimal risk choice of the bank by raising the costs of bank liabilities. Since banks can substitute between retail and wholesale funding, we relate deposit market competition to wholesale market conditions and examine their joint effect on the risk of bank assets. The analysis is based on a unique, comprehensive dataset, which combines retail deposit rate data with data on bank characteristics and data on local deposit market features for a sample of 589 US banks. Our results support the notion of a risk-enhancing effect of deposit market competition.

Multiple bank regulators and risk taking

The potential for banks to arbitrage between regulators exists both in the US, with its multiple federal banking regulators, and in Europe, due to multinational banking. This paper models multiple regulators that have an agency bias, which can give rise to a “race to the bottom”. The model is used to analyze the interaction between the regulatory equilibrium and several salient pre-crisis features: rising bank leverage; wholesale funding with asymmetric information; and increasing supervisional costs to disentangling bank asset exposures. Each of these raises bank risk taking on its own, but regulatory competition is shown to be an amplification mechanism.

Balance Sheet Strength and Bank Lending During the Global Financial Crisis

We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. In particular, we exploit variation in banks’ wholesale funding reliance and their capital levels in 2007Q2 to estimate the impact of bank liquidity shocks in 2007-2008 on the supply of large corporate loans and real economic outcomes. We find that banks with ex-ante stronger balance sheets were better able to maintain lending during the global financial crisis. Banks that were more dependent on market funding reduced the supply of credit more than other banks during the crisis but higher levels of better-quality capital mitigated this effect. Reduced credit supply translated into lower economic activity for firms borrowing from thinly-capitalized banks, suggesting there was limited scope for credit substitution across lenders or debt markets. These findings indicate that strong financial intermediary balance sheets are key for the recovery of credit and economic performance after large financial sector shocks. They also support regulatory steps to boost high-quality capital buffers under the Basel III framework.

The Geography of Risk Capital and Limits to Arbitrage

We use the relative pricing of pairs of emerging market (EM) sovereign bonds issued in both dollars and euros to study capital markets frictions during periods of financial distress. While there is no evidence of mispricing before 2007, during the 2007–2008 crisis we document a persistent anomaly that resulted in segmented EM bond markets. The sign of mispricing varies cross-sectionally, depending on the domestic currency of funding banks, and its magnitude depends on the degree of fragility in wholesale funding markets. Neither liquidity nor short-selling constraints can account for this anomaly. We document the impact of non-conventional policy interventions.

From optimisation to resilience: The changing nature of the risk reward conversation as seen through Westpac's capital and liquidity management policies

This paper describes three insights into the use of risk-measurement models that further enhance the risk-management processes at Westpac: (1) Optimisation opportunities apparently on offer from advanced Basel II models led to the formalisation of a robust challenge process for risk models and the recognition that risk-model outcomes are best thought of as hypotheses that should be continually tested; (2) The recognition that stress testing would not capture ‘unknown unknowns’ strengthened consideration of unquantifiable risks; (3) Finally, the experience from the global financial crisis that continual access to wholesale funding markets could not be assumed deepened the understanding of the role risk models play in maintaining market confidence. Each of these insights tilted the emphasis in discussions at Westpac about enhanced risk measurement from optimisation to resilience.

Business models of banks, leverage and the distance-to-default

This study models the distance-to-default (DTD) of a large sample of banks with the aim of shedding light on policy and regulatory issues. The determinants of the distance-to-default in a panel sample of 94 banks over the period 2004 to 2011, controlling for the market beta of each bank, includes house prices, relative size, simple leverage, derivatives gross market value of exposure, trading assets, wholesale funding and cross-border revenue. The Basel Tier 1 ratio finds no support as a predictor of default risk. The un-weighted leverage ratio, on the other hand, finds strong support. At the macro level house prices are a powerful predictor of the DTD. At the business model level, the results appear to be consistent with an approach to policy that focuses on the apparent importance of the “size-derivativesleverage- wholesale funding nexus” in influencing the DTD of banks. While these results are preliminary, it is encouraging that the out-of-sample predictive power of the model improves systematically as each year of new observations is added. The results are also consistent with some central bank involvement in the supervision process, given the importance of the asset price cycle, identified in this study.

Wholesale bank funding, capital requirements and credit rationing

This paper analyzes how different types of bank funding affect the extent to which banks ration credit to borrowers, and the impact that capital requirements have on that rationing. Using an extension of the standard Stiglitz–Weiss model of credit rationing, unsecured wholesale finance is shown to amplify the credit market impact of capital requirements as compared to funding by retail depositors. Unsecured finance surged in the pre-crisis years, but is increasingly replaced by secured funding. The collateralization of wholesale funding is found to expand the extent of credit rationing.

Bank wholesale funding and credit procyclicality: Evidence from Korea

Credit procyclicality has recently been the focus of considerable attention, but what fuels the often excessive credit growth is rarely questioned. We investigate the relationship between the composition of banks? liabilities and their credit procyclicality. After examining the macroeconomic context where banks rely increasingly on wholesale funding (WSF), we estimate the effect of WSF on the banks? credit growth using quarterly panel data for the commercial banks of Korea from 2000 to 2011. We find that a higher sensitivity of banks? WSF to the business cycle leads to an excessive response of credit growth to the business cycle, even with a low share of WSF on bank liabilities. On the other hand, we find that overseas WSF has a more marked effect on credit procyclicality, which may additionally exacerbate the financial fragility of export-led emerging economies.

Uncertainty and Bank Wholesale Funding

In this paper we relate a bank's choice between retail and wholesale liabilities to real economic uncertainty and the resulting volatility of bank loan volumes. We argue that since the volume of retail deposits is slow and costly to adjust to shocks in the volume of bank assets, banks facing more intense uncertainty and more volatile loan demand tend to employ more wholesale liabilities rather than retail deposits. We empirically confirm this argument using a unique dataset constructed from the weekly reports of the 122 largest U.S. commercial banks. The high frequency of the data allows us to employ dynamic identification schemes. Given the evidence presented in this paper we argue that regulatory measures targeting a cap on wholesale funding would limit funding uncertainty but will increase the exposure to asset-side shocks.

Balance Sheet Strength and Bank Lending During the Global Financial Crisis

We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. Using data from the syndicated loan market, we exploit variation in banks’ reliance on wholesale funding and their structural liquidity positions in 2007Q2 to estimate the impact of exposure to market freezes during 2007–08 on the supply of bank credit. We find that banks with strong balance sheets were better able to maintain lending during the crisis. In particular, banks that were ex-ante more dependent on market funding and had lower structural liquidity reduced the supply of credit more than other banks. However, higher and better-quality capital mitigated this effect. Our results suggest that strong bank balance sheets are key for the recovery of credit following crises, and provide support for regulatory proposals under the Basel III framework.

Balance Sheet Strength and Bank Lending During the Global Financial Crisis

We examine the role of bank balance sheet strength in the transmission of financial sector shocks to the real economy. Using data from the syndicated loan market, we exploit variation in banks' reliance on wholesale funding and their structural liquidity positions in 2007Q2 to estimate the impact of exposure to market freezes during 2007-08 on the supply of bank credit. We find that banks with strong balance sheets were better able to maintain lending during the crisis. In particular, banks that were ex ante more dependent on market funding and had lower structural liquidity reduced the supply of credit more than other banks. However, higher levels of better-quality capital mitigated this effect. Our results suggest that strong bank balance sheets are key for the recovery of credit following crises, and provide support for regulatory proposals under the Basel III framework.