In a nutshell
Following the outbreak of the financial crisis, no other requirement was higher on the political agenda than the stabilisation of the financial markets. IWH has conducted extensive research into the impact of these rescue packages and their political consequences.
Our experts on Financial Stability
Both the US and European governments launched a number of support and regulatory measures that were intended to meet the requirement for increased stability in the financial sector. But today, over eight years after the onset of the crisis, the impact of these actions is often in question: what was the effect of increasing banks' deposit protection, for example? Have they reduced the knock-on effects of crises, as governments hoped? Did the colossal acquisition of banking shares distort the market? Deposit protection schemes are a high-profile way of regulating a financial system. If a bank becomes insolvent, these systems guarantee that a certain amount of money will be paid out. This is intended to prevent large numbers of bank customers reclaiming their private deposits from the bank because they fear losing their assets. Actually, no bank is in a position to repay the amounts it holds to all its customers at once. Such a bank-run must therefore be prevented at all costs. But raising deposit protection in the US from USD 100,000 to USD 250,000 did not result in increased security. In fact, exactly the opposite occurred: banks began to operate in much more risky business areas. There is a simple reason for this: “If a bank successfully operates in high-risk areas, such as commercial property, it earns significantly more than in less risky areas. If it miscalculates, however, the deposit protection scheme automatically bears the bank's liability,” explains Felix Noth, Financial Market Expert at IWH. “In order to stabilise the financial system in the short-term, long-term increased risk incentives for banks are therefore accepted. And this can potentially lead to the next financial crisis.”
The usefulness of deposit protection schemes is mainly in question, because there has been a range of other measures aimed at stabilising floundering banks. Such as the Troubled Asset Relief Program (TARP) of 2008, for example, one of the largest stabilisation measures in the US, with a budget of USD 475 billion. IWH calculations for all US banks suggest, for example, that competition between those banks that received money from the TARP Program and those that did not benefit from TARP, did not suffer any long-term damage as a result of this rescue package. 112% of the funds paid out by the US Government to rescue the banks were also repaid – so American tax-payers even made a profit from rescuing the banks.
The financial crisis of recent years has primarily revealed the possible knock-on effects of various financial systems. It showed, for example, that the turmoil in Europe and the US had an impact on lending and regional employment in Latin and South American countries. But it's not only overseas funding that determines whether a bank is in foreign hands or not - its corporate structure also plays a part. Banks financed from overseas, for example, extended their loans to a much greater extent than those that belonged to overseas institutions – and therefore made a significantly greater contribution to stability.
Banks can have varying influences on systems in their native markets or in the whole of the EU. Although a single regulatory body in Europe would be desirable – how would this work? There are now many proposals for increased stability in the financial sector, ranging from a central EU Authority or national monitoring, to the separation of investment banking and deposit business. The establishment of the European banking union is a welcome first step. But current developments in the European financial market clearly show that there is still much work to be done.
Publications on "Financial Stability"
Delay Determinants of European Banking Union Implementation
in: European Journal of Political Economy, forthcoming
Most countries in the European Union (EU) delay the transposition of European Commission (EC) directives, which aim at reforming banking supervision, resolution, and deposit insurance. We compile a systematic overview of these delays to investigate if they result from strategic considerations of governments conditional on the state of their financial, regulatory, and political systems. Transposition delays pertaining to the three Banking Union directives differ considerably across the 28 EU members. Bivariate regression analyses suggest that existing national bank regulation and supervision drive delays the most. Political factors are less relevant. These results are qualitatively insensitive to alternative estimation methods and lag structures. Multivariate analyses highlight that well-stocked deposit insurance schemes speed-up the implementation of capital requirements, banking systems with many banks are slower in implementing new bank rescue and resolution rules, and countries with a more intensive sovereign-bank nexus delay the harmonization of EU deposit insurance more.
Cross-border Transmission of Emergency Liquidity
in: Journal of Banking & Finance, forthcoming
We show that emergency liquidity provision by the Federal Reserve transmitted to non-U.S. banking markets. Based on manually collected holding company structures, we identify banks in Germany with access to U.S. facilities. Using detailed interest rate data reported to the German central bank, we compare lending and borrowing rates of banks with and without such access. U.S. liquidity shocks cause a significant decrease in the short-term funding costs of the average German bank with access. This reduction is mitigated for banks with more vulnerable balance sheets prior to the inception of emergency liquidity. We also find a significant pass-through in terms of lower corporate credit rates charged for banks with the lowest pre-crisis leverage, US-dollar funding needs, and liquidity buffers. Spillover effects from U.S. emergency liquidity provision are generally confined to short-term rates.
Drivers of Systemic Risk: Do National and European Perspectives Differ?
in: Journal of International Money and Finance, 2019
With the establishment of the Banking Union, the European Central Bank has been granted the power to impose stricter regulations than the national regulator if systemic risks are not adequately addressed at the national level. We ask whether there is a cross-border externality in the sense that a bank’s systemic risk differs when applying a national versus a European perspective. On average, banks’ contribution to systemic risk is similar at the two regional levels, and so is the ranking of banks. Generally, larger banks and banks with a lower share of loans are more systemically important. The effects of these variables are qualitatively but not quantitatively similar at the national versus the European level.
How Do Banks React to Catastrophic Events? Evidence from Hurricane Katrina
in: Review of Finance, No. 1, 2019
This paper explores how banks react to an exogenous shock caused by Hurricane Katrina in 2005, and how the structure of the banking system affects economic development following the shock. Independent banks based in the disaster areas increase their risk-based capital ratios after the hurricane, while those that are part of a bank holding company on average do not. The effect on independent banks mainly comes from the subgroup of highly capitalized banks. These independent and highly capitalized banks increase their holdings in government securities and reduce their total loan exposures to non-financial firms, while also increasing new lending to these firms. With regard to local economic development, affected counties with a relatively large share of independent banks and relatively high average bank capital ratios show higher economic growth than other affected counties following the catastrophic event.
Too Connected to Fail? Inferring Network Ties from Price Co-movements
in: Journal of Business & Economic Statistics, No. 1, 2019
We use extreme value theory methods to infer conventionally unobservable connections between financial institutions from joint extreme movements in credit default swap spreads and equity returns. Estimated pairwise co-crash probabilities identify significant connections among up to 186 financial institutions prior to the crisis of 2007/2008. Financial institutions that were very central prior to the crisis were more likely to be bailed out during the crisis or receive the status of systemically important institutions. This result remains intact also after controlling for indicators of too-big-to-fail concerns, systemic, systematic, and idiosyncratic risks. Both credit default swap (CDS)-based and equity-based connections are significant predictors of bailouts. Supplementary materials for this article are available online.