The deferred recognition of COVID-induced losses at banks in many countries has reignited the debate on regulatory forbearance. This paper presents a model where the public's own political pressure drives regulatory policy astray, because the public is poorly informed. Using probabilistic game stages, the model parameterizes how time consistent policy is. The interaction between political motivations and time consistency is novel and complex: increased policy credibility can entice the politically-motivated regulator to act in the public's best interest, or instead repel it from doing so. Considering several regulatory instruments, the paper probes the nexus of political pressure, perverse bank incentives and time inconsistent policy.
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. Hamid R Tabarraei, Hamed Ghiaie, and Asghar Shahmoradi
The structural model in this paper proposes a micro-founded framework that incorporates an
active banking sector with an oil-producing sector. The primary goal of adding a banking
sector is to examine the role of an interbank market on shocks, introduce a national
development fund and study its link to the banking sector and the government. The
government and the national development fund directly play key roles in the propagation of
the oil shock. In contrast, the banking sector and the labor market, through perfect
substitution between the oil and non-oil sectors, have major indirect impacts in spreading
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.
Ms. Sally Chen, Minsuk Kim, Marijn Otte, Kevin Wiseman, and Ms. Aleksandra Zdzienicka
Balance sheet recessions have been a drag on activity after the Global Financial Crisis, underscoring the important role of balance sheet adjustment for resuming sustained growth. In this paper we examine private sector deleveraging experiences across 36 advanced and emerging economies countries since 1960. We consider the common features and divergent experiences of deleveraging episodes across countries, and analyze empirically the impact of different aspects of deleveraging during the bust phase of leverage cycles on subsequent medium-term growth. The results suggest that larger and quicker unwinding of non-financial sector debt overhangs is associated with sizable medium-term output gains, and that policies should focus on facilitating up-front balance sheet adjustment.
Central counterparties (CCPs) can offer significant benefits to a market. However, CCPs are also highly interconnected with financial institutions and markets and therefore too important to fail. The increased volumes cleared through CCPs and their increasing global scope, in particular in the OTC derivatives market, make it even more important that systemic risks related to CCPs are managed. This paper argues that the current set of international policy measures does partly address these risks, but that alternative policy measures are needed to reduce remaining systemic risks. For example, the paper recommends network analysis to be conducted by CCPs and authorities to gauge potential losses and suggests a common international approach to central bank services to help reduce the dependency of CCPs on services provided by commercial banks.
International Monetary Fund. Monetary and Capital Markets Department
This paper discusses findings of the Detailed Assessment of Observance of the Insurance Core Principles on Denmark. Insurance regulation in Denmark has a good level of compliance with the Insurance Core Principles. A particular strength of the Danish Financial Supervisory Authority’s approach is its close focus on key risks in the sector and its readiness to require action by companies to address vulnerabilities. Regular, even daily monitoring of market risk sensitivities is carried out on life insurers’ balance sheets. In nonlife insurance, regular testing of a number of key performance ratios helps to highlight potential weaknesses and to support early intervention. There is comprehensive oversight of the reinsurance programs of the nonlife companies in particular.
Depositor preference and collateralization of borrowing may reduce the cost of settling the conflicts among creditors that arises in case of resolution or bankruptcy. This net benefit, which may be capitalized into the value of the bank rather than affect creditors’ expected returns, should result in lower overall funding costs and thus a lower probability of distress despite increasing encumbrance of the bank’s balance sheet. The benefit is maximized when resolution is initiated early enough for preferred depositors to remain fully protected.
The recent financial crisis drew unprecedented attention to the stress testing of financial institutions. On one hand, stress tests were criticized for having missed many of the vulnerabilities that led to the crisis. On the other, after the onset of the crisis, they were given a new role as crisis management tools to guide bank recapitalization and help restore confidence. This spurred an intense debate on the models, underlying assumptions, and uses of stress tests. Current stress testing practices, however, are not based on a systematic and comprehensive set of principles but have emerged from trial-and-error and often reflect constraints in human, technical, and data capabilities.