Posted by: mulrickillion | February 1, 2012

Bank Funding Structures and Risk: Evidence from the Global Financial Crisis

By Francisco Vazquez and Pablo Federico

International Monetary Fund (IMF), Working Paper No. 12/29, January 2012 —

Summary: This paper analyzes the evolution of bank funding structures in the run up to the global financial crisis and studies the implications for financial stability, exploiting a bank-level dataset that covers about 11,000 banks in the U.S. and Europe during 2001–09. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with bank risk-taking. In the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border banks were more susceptible to solvency risk due to excessive leverage. The results support the proposed Basel III regulations on structural liquidity and leverage, but suggest that emphasis should be placed on the latter, particularly for the systemically-important institutions. Macroeconomic and monetary conditions are also shown to be related with the likelihood of bank failure, providing a case for the introduction of a macro-prudential approach to banking regulation.

[An excerpt from the Working Paper reads]:

The global financial crisis raised questions on the adequacy of bank risk management practices and triggered a deep revision of the regulatory and supervisory frameworks governing bank liquidity risk and capital buffers. Regulatory initiatives at the international level included, inter alia, the introduction of liquidity standards for internationally-active banks, binding leverage ratios, and a revision of capital requirements under Basel III (BCBS 2009; and BCBS 2010 a, b). In addition to these micro-prudential measures, academics and policymakers argued for the introduction of a complementary macro-prudential framework to help safeguard financial stability at the systemic level (Hanson, Kashyap and Stein, 2010).

This regulatory response was implicitly based on two premises. First, the view that individual bank decisions regarding the size of their liquidity and capital buffers in the run up to the crisis were not commensurate with their risk-taking—and were therefore suboptimal from the social perspective. Second, the perception that the costs of bank failures spanned beyond the interests of their direct stakeholders due, for example, to supply-side effects in credit markets, or network externalities in the financial sector (Brunnermeier, 2009).

The widespread bank failures in the U.S. and Europe at the peak of the global financial crisis provided casual support to the first premise. Still, empirical work on the connection between bank liquidity and capital buffers and their subsequent probability of failure is incipient. Background studies carried out in the context of Basel III proposals, which are based on aggregate data, concluded that stricter regulations on liquidity and leverage were likely to ameliorate the probability of systemic banking crises (BCBS, 2010b). In turn, studies based on micro data for U.S. banks also support the notion that banks with higher asset liquidity, stronger reliance on retail insured deposits, and larger capital buffers were less vulnerable to failure during the global financial crisis (Berger and Bouwman, 2010; Bologna, 2011). Broadly consistent results are reported in Ratnovski and Huang (2009), based on data for large banks from the OECD. . . .

>>Read the full Working Paper here (wp1229.pdf).

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