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Banking Under Stress

Paper Session

Sunday, Jan. 5, 2020 10:15 AM - 12:15 PM (PDT)

Marriott Marquis, Torrey Pines 1
Hosted By: American Economic Association
  • Chair: Yuliya Demyanyk, University of Illinois-Chicago

Bank Adjustment

Natasha Sarin
,
University of Pennsylvania
Emily Williams
,
Harvard Business School

Abstract

Profits in the banking industry are remarkably stable. Absent the financial crisis, in the last three decades banks’ return on assets (ROA) is consistently around 1 percent. This means that the net income that banks are able to generate is essentially unchanged over time despite major changes in the competitive landscape of banking, technology, and of course massive swings in the interest rate environment. This is a surprising fact. Our prior is that competition decreases profit margins and that technology makes firms more efficient. And since 1990, as interest rates have trended downward, banks’ net interest margin (NIM) has decreased by nearly one-third, yet ROA remains constant. This is because at this same time, banks’ non-interest expense (NIE) has fallen one-for-one with net interest margins. The result is a stable ROA despite wide fluctuations in interest rates that, without contemporaneous decrease in banks’ non-interest expense, would have substantially decreased banks’ profits. We show empirically that in the face of a shock to income banks respond by decreasing non-interest expense, resulting in stable ROA. We demonstrate that without this adjustment, banking industry profits would have been substantially decreased by the interest rate declines of the recent epoch.

Bankruptcy Resolution: Misery or Strategy

Jairaj Gupta
,
University of Birmingham
Mariachiara Barzotto
,
University of Bath

Abstract

In this study we explore the explanatory power of a set of covariates relating to firm, judicial, case, geographic, and macroeconomic characteristics in explaining the likelihood of successful bankruptcy resolution. Based upon our analysis, we propose an eight-factor multivariate Probit model that best explains bankruptcy resolution. Subsequently, we investigate the effect of strategic behaviour (proxied by financial benefits) on firms’ likelihood of emerging from bankruptcy, and whether financial benefits are endogenous to the emergence likelihood. Test results confirm that firms start acting strategically from one up to four years before filing for bankruptcy in the presence of (repeated) adverse event(s).

Bank Resolution Regimes and Systemic Risk

Deyan Radev
,
University of Bonn
Thorsten Beck
,
City University of London
Isabel Schnabel
,
University of Bonn

Abstract

Using a novel and comprehensive database on bank resolution regimes in 22 member countries of the Financial Stability Board, we analyze how systemic risk at bank level changes in response to system-wide and bank-specific shocks, depending on the prevailing bank resolution regimes. We find that systemic risk increases more for banks in countries with more comprehensive bank resolution frameworks after negative system-wide shocks, such as Lehman Brothers' default, while it decreases more after positive system-wide shocks, such as Draghi's "Whatever it takes" speech. In contrast, systemic risk increases less in countries with more comprehensive bank resolution regimes in the case of bank-specific negative shocks, such as Deutsche Bank's loss announcement in 2016. These results suggest that bank resolution rules are effective in dealing with bank-specific shocks, while they may exacerbate the effect of system-wide shocks.

Origins of Too Big to Fail: Commercial Bank Stock Returns and the Banking Reforms of the 1930s

Gary Richardson
,
University of California-Irvine
Brian Yang
,
San Francisco State University

Abstract

Too-big-to-fail incentives began to distort incentives of large commercial banks in the United States following the banking reforms of the mid-1930s. We document this phenomenon using a difference-in-differences estimation strategy and new data on commercial-bank stock returns and balance sheets for the years 1926 through 1976. Our data illuminate stock returns of depository institutions. From the mid-1920s through the mid-1930s, when resolution procedures for failed banks treated institutions similarly regardless of their size, we find that risk-adjusted returns differed little between large and small banks. The banking reforms of the 1930s, which authorized federal financial assistance for failing banks and insured bank deposits, introduced discretionary interventions for struggling intermediaries. Large banks were more likely to receive assistance and less likely to be liquidated than smaller institutions. After the introduction of resolution procedures favoring large institutions, the cost of capital at large commercial banks fell substantially relative to smaller banks, even after controlling for standard risk-factors and other factors that influenced the returns of banks of different types. The change does not coincide with changes in banks’ economies of scale and other alternative explanations for modern size anomalies in bank stock returns. Our results validate methods used to estimate too-big-to-fail distortions across counties with modern data. They also reveal specific policies that contributed to the rise of these distortions in the United States.

Overcoming Borrowing Stigma: The Design of Lending-of-Last-Resort Policies

Yunzhi Hu
,
University of North Carolina-Chapel Hill
Hanzhe Zhang
,
Michigan State University

Abstract

How should the government effectively provide liquidity to banks during periods of financial distress? During the most recent financial crisis, banks avoided borrowing from the Fed's Discount Window (DW) but bid more in its Term Auction Facility (TAF), although both programs share similar requirements on participation. Moreover, some banks paid higher interest rates in the auction than the concurrent discount rate. Using a model with endogenous borrowing stigma, we explain how the combination of the DW and the TAF increased banks' borrowings and willingnesses to pay for loans from the Fed. Using micro-level data on DW borrowing and TAF bidding from 2007 to 2010, we confirm our theoretical predictions about the pre-borrowing and post-borrowing conditions of banks in different facilities. Finally, we discuss the design of lending-of-last-resort policies.

Stressed Banks

Diane Pierret
,
University of Lausanne
Roberto Steri
,
University of Luxembourg

Abstract

We investigate the risk taking incentives of "stressed banks" ---the banks that are subject to annual regulatory stress tests in the U.S. since 2011. We document that stress tests effectively prevent excessive risk taking by bringing additional scrutiny on the investment portfolios of stressed banks. Higher capital requirements are not a substitute for regulatory scrutiny to promote prudent lending. However, the correction in regulatory capital charges originating from stress tests effectively reduces risky lending. Overall, our results highlight the importance of regulatory scrutiny of bank portfolios in parallel to setting more stringent capital requirements.
JEL Classifications
  • G2 - Financial Institutions and Services