CAROLINE ROULET

The authors’ empirical evidence is used to show that there is no reasonable capital rule that can protect the financial system in the face of events like 2007–2008: large interconnected banks would need 4 times the amount of capital to avoid default without government aid. They argue that separating deposit-guaranteed banks from investment banking, while maintaining a leverage ratio, is the policy mix supported by empirical evidence. They suggest the best threshold for separation should be derivatives exposure (with no netting) at or above 10%. They compare their own legal separation proposal to the Volcker rule, the UK Vickers rule and to those European proposals that were quietly dropped to please banks. They rebut 5 criticisms of separation proposals and review the 2017 Mnuchin Treasury modification of the Volcker Rule.

High-yield corporate and leveraged loans have grown substantially over the past decade. However, the COVID-19 pandemic means downside risks are rising alongside expectations of severe negative impacts on corporate earnings and economic growth. The proportion of leveraged corporate debt exposed to such downside risks has become a key concern. This paper assesses the magnitude of indebtedness of leveraged non-financial companies and identifies the share of debt related to the riskiest firms. A stress test analysis examines the sensitivity of corporate debt to potential macroeconomic and financial shocks. The results show a sharp deterioration in the credit quality of firms, particularly in the United States and Emerging Market Economies (EMEs). Under stressed conditions, all these countries, China included, would experience a sharp rise in the number of firms considered at risk or distressed due to deteriorating cash flows and the inability to make interest payments, thereby becoming ...

We assess the advantage of using the net stable funding ratio as defined in the Basel III accords to detect bank distress. Considering US and European publicly traded commercial banks over the 2005-2009 period, we specify a Logit model which tests if the net stable funding ratio adds predictive value to models relying on liquidity ratios from the CAMELS approach to explain the bank probability of default. Our main results support the use of the net stable funding ratio. These findings shed light on the advantage to improve the definition of liquidity in order ameliorate the assessment of bank financial conditions.

The authors focus on causality in the narrow sense of place and time: the preconditions for the crisis were global, but it all started in the USA and traced back to 2004. They argue that structural features of the US, including the role of Fannie Mae and Freddie Mac and SEC regulatory changes, were instrumental in the sharp acceleration of leverage and mortgage-backed securities (MBS) origination. They ask why bank management was unable to contain excessive risk and use corporate governance indicators for key US banks, and examples from Europe, to explain the dangerous equity culture in play. They argue that corporate governance cannot substitute for sound rules concerning leverage and what banks do with respect to their business models—models that led to the ‘Lehman Moment’.

The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital buffer and liquidity for European and U.S. publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks do not strengthen their regulatory capital buffer when they face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009). However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks do actually strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as ...

The authors argue that the elephant in the room on bank risk is their business models which are largely untouched by reform. They contrast traditional deposit banking from models based on multiple collateralised counterparty agreements, where derivatives and structured products funded via securities transactions cause contagion risk—including adverse valuation shifts and/or defaults at various points in the hypothecation chains. Balance sheets of actual banks during the crisis and the size of derivatives transactions are used by the authors to illustrate these issues and they document bank losses which, despite all the support, are sobering. The authors argue that the underpricing of this risk (helped by credit ratings) was the core of the crisis and the AIG insurance debacle is shown to be one of its most dangerous events.

Liquidity creation is one of the pre-eminent functions of banks but it is also a major source of their vulnerability to shocks. Considering US and European publicly traded commercial banks from 2000 to 2008, we consider the new measures of liquidity defined in the Basel III accords to estimate a level of liquidity creation beyond which a bank may not able to meet its liquidity requirements. Besides, as financial innovation provides new ways for banks to manage their liquidity, we investigate how transformation risk is impacted by the concentrations on loans that are potentially securitisable and on short term, potentially unstable market funding. On the whole, we show that transformation risk decreases with a higher concentration on loans that are potentially securitisable. However, transformation risk increases when banks are more concentrated on short term market debts. Thus by better understanding what factors significantly impact transformation risk, it can help banks to improve...

The authors summarise the final version of Basel III, reducing thousands of pages to a necessary few. They argue that supervisors appear to believe the problem all along was just the need for greater granularity and more model-based sensitivity, rather than fundamental flaws in the framework itself (its one-size-fits-all and portfolio invariance assumptions; and contaminating bank risk models by linking them to regulatory capital charges). They opine that banks have defended their risky business models very well and thus the reform process is not over: separating investment banking and imposing a sufficient binding leverage ratio (LR) remain on the table. They suggest that such a pre-emptive approach is needed to deal with the underpricing of risk and are dismissive of mechanical modelling of stress scenarios to estimate capital requirements.

The authors argue that settling the issue of what reforms are required must be based on empirical evidence. They first set out the key bank risks, including those associated with collateralised agreements at the heart of complexity and interdependence problems. They point out that in normal times these risk positions mostly cancel out (one’s loss being another’s gain), but when risk is mispriced these positions become pro-cyclical, correlated and concentrated activities involving chains of counterparties that create interconnectedness risk. The authors choose bank distance-to-default (DTD) data as their dependent variable and show that 4 business model features have a much stronger impact on risk than any capital rule: the size of (un-netted) derivatives, the extent wholesale securities financing, the availability of liquid assets and a measure of interdependence.

The authors argue that four issues will condition how globalisation evolves over coming decades: (i) the management of financial risk in advanced countries; (ii) the long-term asset return implications of distorted policy; (iii) the outcome of China’s ambitious attempt to build a vast alternative economic region (the Belt and Road) based on principles opposed to those prevailing in advanced countries; and (iv) the building financial risks in China. They point out that China has taken a longer-term strategic view but relies less on markets and sound governance. They conclude that how this plays out will depend on which part of the world turns out to have the least coherent approach. Extreme outcomes will be likely if things do not go well in either of these parts of the world.

The authors argue that the Basel capital rules not only were unable to contain the pressures building from globalisation, but they actually contributed leverage via off-bank-balance-sheet activity and the use of derivatives. The authors provide insights on the history of securitisation and how it works; and the history of derivatives and how the main derivative contracts operate. They then turn to how innovations with these instruments were used to exploit regulatory and tax arbitrage opportunities as banks ‘gamed’ the system to maximise their return on equity. The authors point out that finance is a system of promises and that it is the inability of regulators to treat promises in the same way that gives the banks endless opportunities to shift them around to create unacceptable risk.

Over the past two decades, governments worldwide have continued to liberalise restrictions on international investment with only occasional relapses. Yet, FDI liberalisation remains an unfinished agenda in various parts of the world and across sectors. This paper sheds light on their potential costs in terms of foregone investments. Applying an augmented gravity model, covering 60 advanced and emerging countries over the period 1997–2016, it estimates the elasticity of bilateral FDI positions and cross-border M&A activity to FDI restrictions as measured by the OECD FDI Regulatory Restrictiveness Index. Results suggest that reforms liberalising FDI restrictions by about 10% as measured by the Index could increase bilateral FDI in stocks by 2.1% on average. Effects are greater for FDI in the services sector, but even manufacturing sectors – which are typically open to FDI – are negatively affected by countries’ overall restrictiveness. Foreign equity limitations and FDI screening poli...

Over the past two decades, Asian economies have experienced rapid capital market growth and profound changes in the structure of their financial systems. This paper analyses key developments in advanced and emerging Asian economies since the global financial crisis, focusing on market intermediation of sovereign and corporate debt, equity market development, and the growth of alternative finance and structured products. This enables a forward-looking assessment of the extent to which developments in the medium term may contribute to rising risks in the stability of financial intermediation and sustainable long-term growth with a view to informing policy discussions on economic opportunities and associated risks.

The authors explain globalisation and provide an interesting history of its various stages—including reasons why emerging countries turned away from the advanced nations as a model for economic development. Turning to recent decades, they counterpose two very different parts of the world economy that have begun to butt-up against each other. Topics such as the China saving glut, exchange rate management and foreign buying of US securities, subsidies to state-owned enterprises (SOEs), rising Chinese import penetration following WTO entry and the creative destruction technological responses of large companies are brought together as key preconditions for the 2008 crisis. With new empirical evidence, they link these developments to the hollowing out of jobs, low inflation, the price of US treasuries, mortgages rates and asset price inflation.

Abstract Using data on commercial banks in Europe, this paper analyses the impact of the new Basel III capital and liquidity regulation on bank lending following the 2008 financial crisis. On the whole, capital ratios have significant and negative impacts on large European bank-retail-and-other-lending-growth in a context of deleveraging and “credit crunch” in Europe over the post-2008 financial crisis period. Additionally, liquidity indicators have positive but perverse effects on bank-lending-growth, which supports the need to consider heterogeneous banks’ characteristics and behaviours when implementing new regulatory policies.

The objective of this thesis is to analyze the advantages of adding liquidity standards in the current banking regulatory framework to strengthen bank stability. Chapter 1 reviews the existing literature and presents stylized facts focusing on the extent of banks’ liquidity creation and maturity transformation risk. The chapter also investigates the sensitivity of maturity transformation risk to several factors depending on banks’ business models. The findings raise several challenges for both banks and regulators to improve the profile of banks’ maturity transformation risk. Chapter 2 examines whether the introduction of a liquidity measure as defined in the Basel III accords can contribute to improve the prediction of bank financial distress. The results show that the Basel III net stable funding ratio adds predictive value to models relying on liquidity ratios from the CAMELS approach to explain bank default probability. The findings support the need to improve the definition of liquidity to predict bank financial distress. Chapter 3 investigates the relationship between bank capital buffer and liquidity. The purpose is to examine whether banks maintain or strengthen their capital buffer when they face lower liquidity. The empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, the findings raise challenges for regulators with regard to the need to further L’objectif de cette these est d’analyser les avantages de completer le cadre reglementaire par des contraintes sur la gestion de la liquidite afin de renforcer la stabilite financiere des banques. Dans le chapitre 1, nous effectuons une revue de la litterature et presentons des faits stylises pour mettre en evidence l’ampleur de la creation de liquidite et l’exposition des banques au risque de transformation. Nous considerons egalement la sensibilite du risque de transformation a differents facteurs en fonction de l’orientation des activites des banques. Nos resultats suggerent de nombreuses reflexions pour les banques et les regulateurs afin d’ameliorer le profil d’exposition des firmes bancaires a ce risque. Dans le chapitre 2, nous examinons dans quelle mesure l’introduction de ratios de liquidite comme definis par les accords de Bâle III contribue a ameliorer la prediction de la deterioration de la situation financiere des banques. Nous montrons que le « net stable funding ratio » comme defini par les accords de Bâle III ameliore le pouvoir explicatif des modeles incluant uniquement les ratios de liquidites CAMELS pour expliquer la probabilite de defaut des banques. Dans le chapitre 3, nous etudions la relation entre l’exces de capital et la liquidite des banques. Nous examinons dans quelle mesure les banques maintiennent ou renforcent leur exces de capital lorsque qu’elles sont davantage exposees au risque de liquidite. Nos resultats mettent en evidence le besoin d’instaurer des exigences pour maintenir des ratios minimum de liquidite en plus de celles sur les ratios de capitaux, comme preconise par le Comite de Bâle. Nos resultats suggerent differentes questions relatives au besoin de mieux clarifier comment definir et mesurer l’illiquidite des banques et aussi comment considerer les tres grandes banques qui se comportent differemment des plus petites.

The first references to macroprudential policy were in closed meetings, such as in the Cooke Committee in 1979,2 which was the forerunner of the Basel Committee of Banking Supervisors (BCBS). The chairman noted that microprudential issues were being interfaced with macroprudential issues. The concern was about bank lending globally in the face of high oil prices. He attempted to draw the boundary of supervisory interest as not in the macroeconomic problems per se but how the latter had (and could) lead to bank problems that are not treatable with microregulation. Lamfalussy around the same time explained that macroprudential issues are problems that bear on the market as a whole, and may not be obvious in individual banks at the microprudential level. The first public appearances of the term were in the Euro-currency Standing Committee report and in the Cross Report of the Bank for International Settlements (BIS) (1986), where it merits an entire chapter. The introduction to the report launches into bank risks that are related to innovations, capital markets banking, derivatives, securitization, large bank off-balance-sheet responses to investment banks, liquidity risk and the underpricing of risk. These developments might cause concerns — such as technology failures, the evaporation of liquidity in a crisis situation, and problems with counterparty risk that could have macroconsequences and negative feedback loops on the macroeconomy.

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 creat...

This paper looks at the urgent and ongoing need to change the business models of global systemically important banks — particularly those that dominate the OTC derivatives markets which carry massive counterparty risk via collateralisation practices. It explores the three main lessons of the financial crisis: too big to fail, excess leverage and conflicts of interest. While regulatory reforms have been plentiful, none have adequately addressed the main source of the problems which lie in the very nature of the business models of large interconnected banks.