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Abdullah Al-Hassan, Imen Benmohamed, Aidyn Bibolov, Giovanni Ugazio, and Ms. Tian Zhang
The Gulf Cooperation Council region faced a significant economic toll from the COVID-19 pandemic and oil price shocks in 2020. Policymakers responded to the pandemic with decisive and broad measures to support households and businesses and mitigate the long-term impact on the economy. Financial vulnerabilities have been generally contained, reflecting ongoing policy support and the rebound in economic activity and oil prices, as well as banks entering the COVID-19 crisis with strong capital, liquidity, and profitability. The banking systems remained well-capitalized, but profitability and asset quality were adversely affected. Ongoing COVID-19 policy support could also obscure deterioration in asset quality. Policymakers need to continue to strike a balance between supporting recovery and mitigating risks to financial stability, including ensuring that banks’ buffers are adequate to withstand prolonged pandemic and withdrawal of COVID-related policy support measures. Addressing data gaps would help policymakers to further assess vulnerabilities and mitigate sectoral risks.
Mr. Ashok Vir Bhatia, Ms. Srobona Mitra, Mr. Shekhar Aiyar, Luiza Antoun de Almeida, Cristina Cuervo, Mr. Andre O Santos, and Tryggvi Gudmundsson
This note weighs the merits of a capital market union (CMU) for Europe, identifies major obstacles in its path, and recommends a set of carefully targeted policy actions. European capital markets are relatively small, resulting in strong bank-dependence, and are split sharply along national lines. Results include an uneven playing field in terms of corporate funding costs, the rationing out of collateral-constrained firms, and limited shock absorption. The benefits of integration center on expanding financial choice, ultimately to support capital formation and resilience. Capital market development and integration would support a healthy diversity in European finance. Proceeding methodically, the note identifies three key barriers to greater capital market integration in Europe: transparency, regulatory quality, and insolvency practices. Based on these findings, the note urges three policy priorities, focused on the three barriers. There is no roadblock—such steps should prove feasible without a new grand bargain.
Will Kerry
This paper measures the performance of different metrics in assessing banking system vulnerabilities. It finds that metrics based on equity market valuations of bank capital are better than regulatory capital ratios, and other metrics, in spotting banks that failed (bad apples). This paper proposes that these market-based ratios could be used as a surveillance tool to assess vulnerabilities in the banking sector. While the measures may provide a somewhat fuzzy signal, it is better to have a strategy for identifying bad apples, even if sometimes the apples turn out to be fine, than not being able to spot any bad apples before the barrel has been spoiled.
Mr. Daniel Garcia-Macia
High household wealth is often cited as a key strength of the Italian economy. Both in absolute terms and relative to income, the Italian household sector is wealthier than most euro area peers. A sizable fraction of this wealth is held by the rich and upper middle classes. This paper documents the changes in the Italian household sector’s financial wealth over the past two decades, by constructing the matrix of bilateral financial sectoral exposures. Households became increasingly exposed to the financial sector, which in turn was exposed to the highly indebted real and government sectors. The paper then simulates different financial shocks to gauge the ability of the household sector to absorb losses. Simple illustrative calculations are presented for a fall in the value of government bonds as well as for bank bail-ins versus bailouts.
Mr. Anil Ari
I propose a dynamic general equilibrium model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and slow recovery from crises. When banks' investment decisions are not contractible, depositors form expectations about bank risk-taking and demand a return on deposits according to their risk. This creates strategic complementarities and possibly multiple equilibria: in response to an increase in funding costs, banks may optimally choose to pursue risky portfolios that undermine their solvency prospects. In a bad equilibrium, high funding costs hinder the accumulation of bank net worth, leading to a persistent drop in investment and output. I bring the model to bear on the European sovereign debt crisis, in the course of which under-capitalized banks in defaultrisky countries experienced an increase in funding costs and raised their holdings of domestic government debt. The model is quantified using Portuguese data and accounts for macroeconomic dynamics in Portugal in 2010-2016. Policy interventions face a trade-off between alleviating banks' funding conditions and strengthening risk-taking incentives. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.
Christoph Aymanns, Carlos Caceres, Christina Daniel, and Miss Liliana B Schumacher
Understanding the interaction between bank solvency and funding cost is a crucial pre-requisite for stress-testing. In this paper we study the sensitivity of bank funding cost to solvency measures while controlling for various other measures of bank fundamentals. The analysis includes two measures of bank funding cost: (a) average funding cost and (b) interbank funding cost as a proxy of wholesale funding cost. The main findings are: (1) Solvency is negatively and significantly related to measures of funding cost, but the effect is small in magnitude. (2) On average, the relationship is stronger for interbank funding cost than for average funding cost. (3) During periods of stress interbank funding cost is more sensitive to solvency than in normal times. Finally, (4) the relationship between funding cost and solvency appears to be non-linear, with higher sensitivity of funding cost at lower levels of solvency.
Raja Almarzoqi, Samy Ben Naceur, and Alessandro Scopelliti
The paper analyzes the relationship between bank competition and stability, with a specific focus on the Middle East and North Africa. Price competition has a positive effect on bank liquidity, as it induces self-discipline incentives on banks for the choice of bank funding sources and for the holding of liquid assets. On the other hand, price competition may have a potentially negative impact on bank solvency and on the credit quality of the loan portfolio. More competitive banks may be less solvent if the potential increase in the equity base—due to capital adjustments—is not large enough to compensate for the reduction in bank profitability. Also, banks subject to stronger competitive pressures may have a higher rate of nonperforming loans, if the increase in the risk-taking incentives from the lender’s side overcomes the decrease in the credit risk from the borrower’s side. In both cases, country-specific policies for market entry conditions—and for bank regulation and supervision—may significantly affect the sign and the size of the relationship. The paper suggests policy reforms designed to improve market contestability and to increase the quality and independence of prudential supervision.
Mr. Manmohan Singh and Mr. Mohsan Bilal
This paper looks at some technical issues when using CDS data, and if these are incorporated, the analysis or regression results are likely to benefit. The paper endorses the use of stochastic recovery in CDS models when estimating probability of default (PD) and suggests that stochastic recovery may be a better harbinger of distress signals than fixed recovery. Similarly, PDs derived from CDS data are risk-neutral and may need to be adjusted when extrapolating to real world balance sheet and empirical data (e.g. estimating banks losses, etc). Another technical issue pertains to regressions trying to explain CDS spreads of sovereigns in peripheral Europe - the model specification should be cognizant of the under-collateralization aspects in the overall OTC derivatives market. One of the biggest drivers of CDS spreads in the region has been the CVA teams of the large banks that hedge their exposure stemming from derivative receivables due to non-posting of collateral by many sovereigns (and related entities).