Financial Stability

Dossier

 

In short

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

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Badly Hurt? Natural Disasters and Direct Firm Effects

Felix Noth Oliver Rehbein

in: Finance Research Letters, forthcoming

Abstract

We investigate firm outcomes after a major flood in Germany in 2013. We robustly find that firms located in the disaster regions have significantly higher turnover, lower leverage, and higher cash in the period after 2013. We provide evidence that the effects stem from firms that already experienced a similar major disaster in 2002. Overall, our results document a positive net effect on firm performance in the direct aftermath of a natural disaster.

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How Do Banks React to Catastrophic Events? Evidence from Hurricane Katrina

Claudia Lambert Felix Noth U. Schuewer

in: Review of Finance, forthcoming

Abstract

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.

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Katrina und die Folgen: Sicherere Banken und positive Produktionseffekte

Felix Noth

in: Wirtschaft im Wandel, No. 4, 2018

Abstract

Welche Auswirkungen haben große Schocks wie Naturkatastrophen auf das Risiko von Banken, und welche realwirtschaftlichen Implikationen ergeben sich daraus? Diesen Fragen geht ein aktueller Beitrag unter IWH-Beteiligung nach, der die Auswirkungen des Wirbelsturms Katrina in den USA untersucht. Dabei finden die Autoren, dass vor allem eigenständige und besser kapitalisierte Banken auf das erhöhte Risiko reagieren, indem sie ihre Risikovorsorge in Form deutlich erhöhter Eigenkapitalpuffer nach oben fahren und den Anteil risikoreicher Aktiva in ihren Bilanzen verkleinern. Das geschieht allerdings nicht durch eine Verknappung des Kreditangebots, sondern potenziell durch Kreditverkäufe. Die Ergebnisse legen deshalb nahe, dass das Instrument der Verbriefung es betroffenen Banken ermöglicht, einerseits ihre Bilanzen sicherer zu machen und andererseits Unternehmen mit neuen Krediten zu versorgen. Dadurch profitieren auch die vom Schock betroffenen Regionen. Solche Regionen, die durch mehr eigenständige und besser kapitalisierte Banken gekennzeichnet sind, haben nach der Wirbelsturmsaison von 2005 deutlich höhere Produktionseffekte und geringere Arbeitslosenquoten.

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Market Power and Risk: Evidence from the U.S. Mortgage Market

Carola Müller Felix Noth

in: Economics Letters, 2018

Abstract

We use mortgage loan application data of the Home Mortgage Disclosure Act (HMDA) to shed light on the role of banks’ market power on their presumably insufficient risk screening activities in the U.S. mortgage market in the pre-crisis era. We find that banks with higher market power protect their charter value. The effect is stronger for banks that have more information about local markets.

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Regional Banking Instability and FOMC Voting

Stefan Eichler Tom Lähner Felix Noth

in: Journal of Banking & Finance, 2018

Abstract

This study analyzes if regionally affiliated Federal Open Market Committee (FOMC) members take their districts’ regional banking sector instability into account when they vote. Considering the period 1979–2010, we find that a deterioration in a district's bank health increases the probability that this district's representative in the FOMC votes to ease interest rates. According to member-specific characteristics, the effect of regional banking sector instability on FOMC voting behavior is most pronounced for Bank presidents (as opposed to Governors) and FOMC members who have career backgrounds in the financial industry or who represent a district with a large banking sector.

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