The Banking Sector Under Financial Stability

Indranarain Ramlall

• Publisher: Emerald Publishing Limited
• Year: 2018
• ISBN:
  9781787696839
• Topic: Business
• Subtopic: Business General
• Index: Business

Many economies in the world are characterised by a bank-based financial system, that is, the financial intermediation process is mostly performed by banks. It is therefore critically important to undertake a fully-fledged analysis of the banking sector with respect to financial stability risks.
The Banking Sector Under Financial Stability considers the unique position of banks which by nature assume higher risks, but with a low equity to total assets ratio. It recognises that balance sheet analysis of banks becomes a key element in financial stability risk assessment and that the sources of banks' funding also pose risks to financial stability. The book also gives due consideration to the interactive forces which prevail among banks, macroeconomic states, asset prices, the household sector, and monetary policy. The differences between the US and the European Union are also covered at length, as are the various credit risk models pertinent for banks.
This book will prove valuable to central bankers, economists, and policy-makers who are involved in the field of financial stability, as well as researchers studying the field.

Chapter 1

Banks, Risks and Risk Management

1.1. Introduction

The objective of this book is to provide a thorough analysis of banking sector risks with respect to financial stability assessment. The word ‘bank’ originates from the Old Italian term ‘banca’, referring to the ‘bench’ people seeking loans from moneylenders used to sit on. A systematic approach is considered to be the best approach as it assists in avoiding undue risks on the financial system. Such a systematic approach requires a sound framework for the banking sector financial stability. Readers can scan the following website (http://www.relbanks.com) to glean information about the top 100 banks in the world. Beyond a certain critical point level, a bigger banking and financial system starts to act as a drag on economic growth and not a spur to it. Wolf (2014) stated that ‘Sounder banks do not necessarily generate faster growth in demand. Indeed, causality goes far more in the opposite direction’. After the US subprime crisis, banks are now considered to be well capitalised in the world following the building up of more stable deposits relative to the volatile wholesale deposits and enhanced liquidity states, all promulgated under the Basel III approach to liquidity-enhancing strategies under the Net Stable Funding Ratio and the Liquidity Coverage Ratio. Nonetheless, looming economic risks still prevail for the weaker banks in the world.

1.2. Difference Between a Bank and A Non-Financial Firm

The chief creditors of banks consist of depositors. The financial statements of a bank are not the same as that of a non-financial firm due to the following reasons:

• Bank’s funds are of a short-term nature.
• Banks constitute highly leveraged institutions which are endowed with low levels of equity. High leverage generates higher profits in the case that earnings are positive. Thus, since banks are inherently imbued with high financial leverage, then, in countries which have high-interest rate spreads, banks should be reaping larger levels of profits as to boost up their capital base, making them less vulnerability to financial stability shocks. Leverage emanates not only from the on-balance sheet but also from off-balance sheet items. Deregulation and innovation made the financial sector not only highly leveraged but also highly competitive. As per the Basel Committee on Banking Supervision (2015) under its Basel III Monitoring Report 2015, the aggregate leverage of big banks fell from 29 times Tier 1 capital in the first half of 2011 to 22 times in the first half of 2014.
• Banks have a low proportion of fixed assets which thereby lead to low operating leverage. Operating leverage can be defined as the proportion of fixed costs to total costs.
• Banks have a large chunk of their assets invested in loans and advances and investments, all carrying high-interest rate risk.
• A large part of the revenues of a bank often emanates from interests on advances and investments.
• In the case of profits, net interest income of a bank is akin to gross profit for a non-financial firm.
• Banks tend to have volatile asset values on the back of changes in interest rates and defaults of borrowers.

1.3. Banking Business Inherently Risky: Low-Profit Margin but High Leverage

The key metric for a bank balance sheet analysis pertains to its assets/equity ratio which constitutes an equity multiplier or leverage ratio. The banking business is inherently considered to be risky on the ground of low-profit margins but high leverage levels. The balance sheets of banks systematically show low levels of capital to liabilities ratio which is not often seen in any other type of business which falls outside the purview of the banking business. The leverage ratio constitutes the financial ratio which bears strong impact on default risk. To dampen procyclicality,¹ the authorities can also work upon the leverage ratio by increasing it. A microscopic analysis of leverage ratio is undertaken as follows.

Increase in leverage ratio = Increase in

To increase equity or capital, a bank has two possible ways: either to directly add up new capital or to forgo dividend payments (retained earnings). The leverage ratio can further be split as follows.

This implies that

has to fall down in order to increase the leverage ratio. To initiate a decline in

, either A has to rise or L has to fall.

The table summarises the liability structure of US Bank Holding Companies as of 31 December 2009. The table is based on the data from the FR Y-9C reports that Bank Holding Companies are required to file with the Federal Reserve. It is clear that US banks operate under a high leverage ratio (Table 1.1).

Table 1.1: Liability Structure of US Bank Holding Companies, 2009.

	$Trillion	% of Assets
Assets	15.927	100.0
Liabilities
Deposits	7.502	47.1
Short-term wholesale funding
Repurchase agreements and federal funds purchased	1.658	10.4
Other short-term wholesale funding	0.880	5.5
Trading liabilities	0.736	4.6
Total	3.274	20.6
Long-term funding
Long-term wholesale funding	1.718	10.8
Subordinated debt and trust preferred	0.416	2.6
Total	2.134	13.4
Other liabilities	1.570	9.9
Total liabilities	14.480	90.9
Equity
Common stock	1.309	8.2
Preferred stock	0.137	0.9
Total equity	1.446	9.1

Source: Hanson, Kashyap, and Stein (2011).

1.4. Banking Sector and Financial Stability

In recent years, rising research interest has shown a strong relationship between the banking sector and financial stability by virtue of the fact that a financial crisis is usually related to a bank panic or a bank run. The underlying rationale relates to the fact that depositors can hardly monitor as to how banks use their money so much so that strong information asymmetry prevails as to the use of depositors’ money for generating sound profits but at a comfortable level of risk assumed by the bank. Once a bank is subject to a crisis condition, this unleashes strong systemic risks as to impact on the function of other banks because risk-averse people queue up to retrieve their deposited money. Such a state of affairs is automatically reflected through high levels of risks to banks as they all operate under the ‘law of large numbers’ whereby in a single day, no all depositors will withdraw their money. Intriguingly, the self-fulfilling prophecy works well in such cases as people who believe that all depositors will queue up tomorrow and thus today go to retrieve their money, ironically inciting massive withdrawals.

Most economies in the world tend to exhibit a bank-based financial system so that banking sector stability constitutes a key ingredient to financial stability. Jokipii and Monnin (2013) found a positive relationship between banking sector stability and real output growth. They defined banking sector instability as the probability of the banking sector becoming insolvent within the next quarter. Hogart, Reis, and Saporta (2002), Kroszner, Laeven, and Klingebiel (2007) and Dell’Ariccia, Detragiache, and Rajan (2008) all pointed out that banking crises can generate substantial economic slowdown. Laeven and Valencia (2010) stated that ‘The economic cost of the new crises is on average much larger than that of past crises, both in terms of output losses and increases in public debt. The median output loss (computed as deviations of actual output from its trend) is 25% of GDP in recent crises, compared to a historical median of 20% of GDP, while the median increase in public debt (over the three year period following the start of the crisis) is 24% of GDP in recent crises, compared to a historical median of 16% of GDP’. They attributed such increase in impacts to larger shocks, the increasing size of the financial system and also to the concentration of the crises in high-income countries. However, analysing the effect of the banking crises may also depend on the type of economy under scrutiny. Devereux and Dwyer (2016) found that prior economic conditions helped to predict output losses for developed economies while having a stock market and deposit insurance helped to predict output losses in the case of low-income economies.

Binary and continuous variables prevail to capture banking sector instability. Under the binary variable, a crisis is defined based on the definition of threshold values – a crisis manifests in the case that the selected threshold value is being exceeded. Under a continuous variable, a crisis is defined as the banking sector’s probability of default. The focus has been laid not only as to when a crisis pops out but also as to when a crisis ends. Laeven and Valencia (2012) defined the end of a banking crisis as ‘real GDP growth and real credit growth are positive for at least two consecutive years’. Interestingly, banking sector risks may creep into currency crises. For instance, Lang (2013) pointed out that ...