Next Generation System-Wide Liquidity Stress Testing

A framework to run system-wide, balance sheet data-based liquidity stress tests is presented. The liquidity framework includes three elements: (a) a module to simulate the impact of bank run scenarios; (b) a module to assess risks arising from maturity transformation and rollover risks, implemented either in a simplified manner or as a fully-fledged cash flow-based approach; and (c) a framework to link liquidity and solvency risks. The framework also allows the simulation of how banks cope with upcoming regulatory changes (Basel III), and accommodates differences in data availability. A case study shows the impact of a "Lehman" type event for stylized banks. 

Bank liquidity was traditionally viewed as of equal importance to their solvency. Liquidity risks are inherent in maturity transformation, i.e., the usual long-term maturity profile of banks’ assets and short-term maturities of liabilities. Banks have commonly relied on retail deposits, and, to some degree, long-term wholesale funding as supposedly stable sources of funding. Yet, attention to liquidity risk diminished in recent decades, was symbolized by the absence of consideration of liquidity risk in the 1988 Basel I framework (Goodhart, 2008).

The global financial crisis has clearly shown that neglecting liquidity risk comes at a substantial price. Over the last decade, large banks d became increasingly reliant on shortterm wholesale funding (especially in interbanking markets) to finance their rapid asset growth. At the same time, funding from non-deposit sources (such as commercial paper placed with money market mutual funds) soared. With the unfolding of the global financial crisis, when uncertainties about the solvency of certain banks emerged, various types of wholesale funding market segments froze, resulting in funding or liquidity challenges for many banks.3 In the light of this experience, there is now a widespread consensus that banks’ extensive reliance on deep and broad unsecured money markets pre-crisis is to be avoided (and in current market conditions there is no appetite for that anyway). Creating substantial liquidity buffers across the board is the explicit aim of a number of regulatory responses to the crisis, such as the CEBS Guidelines on liquidity buffers (CEBS 2009b) as well as the forthcoming Basel III liquidity standards, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

The liquidity stress testing framework presented herein was developed in the context of recent Financial Sector Assessment Programs (FSAPs)4 and IMF technical assistance especially in Eastern Europe, extending the seminal work of Čihák (2007), and drawing upon work at the Austrian National Bank (OeNB). While developing the framework, five key facts were accounted for: (i) the availability of data varies widely; (ii) liquidity risk has several dimensions and assessing banks’ resilience vis-à-vis funding risks requires multi-dimensional analysis; (iii) designing and calibrating scenarios is more challenging than for solvency risks, mainly as liquidity crises are relatively rare and originate from different sources; (iv) there is a close link between solvency and liquidity risks; and (v) while the paper and tool present some economic benchmark scenarios, but these scenarios and economic and behavioral assumptions used for the tests should depend on bank- and country-specific circumstances, and current circumsta ces (i.e., the level of stress), among others. More generally speaking, the presented liquidity stress testing framework herein does not substitute for sound economics in designing the tests.

The answer to these multiple dimensions is a framework that is an Excel-based, easy-to-use balance sheet type liquidity stress testing tool that allows running bottom-up tests for hundreds of banks: First, the tool can be used to run some basic tests in circumstances where data is very limited to broad asset and liability items. Likewise, a cash flow based module allows running detailed liquidity analysis like those carried out by banks for the internal purposes but again can be adapted to a more limited data environment. Second, the framework includes three broad dimensions (based on four modules) that allow for complementary views on liquidity risks, including the link to solvency risks. Third, the paper provides benchmark scenarios based on historical evidence on the one hand and common scenarios used by FSAP missions on the other. Fourth, the framework allows assessing the link between liquidity and solvency, albeit additional effort is needed in this context, including work that captures dynamic aspects of this relationship and spillover effects such as dynamically examining the link from liquidity to solvency concerns. As such, the framework is meant to provide users with the possibility to run a meaningful system-wide liquidity stress test within a relatively short period of time, but can also be used for monitoring purposes.

It is vital to bear in mind that the key benefit of system-wide stress tests is to benchmark banks against one another, i.e. to run peer comparisons and thereby assess their relative vulnerability to different shocks. Whether and how a shock materializes depends on the various factors, with behavioral aspects increasingly playing an essential role. Hence, it is also acknowledged that regular liquidity stress testing is not a panacea for a qualitative judgment by policy-makers in order to complement findings even from well-designed liquidity stress tests.

While cash flow data reporting, for instance, will become mandatory in the European Capital Requirements Directive (CRD) IV regulation, it is (for now) still rarely available at regulatory/ supervisory institutions so we follow a two-pronged approach, distinguishing between implied cash flow tests and a “real” cash flow approach, thereby seeking to lift liquidity tests to a next generation level.The framework consists of three elements:

(i) Stress testing funding liquidity based on an implied cash flow approach, with two different components: (a) a tool to simulate bank-run type scenarios while accounting for fire sales of liquid assets and/ or central bank liquidity provision subject to eligible collateral and haircuts; and (b) a liquidity gap analysis module that matches assets and liabilities for different maturity buckets under different stress assumptions, including rollover risk; the tool also allows for calculating (simplified) Basel III liquidity ratios.

(ii) Cash flow-based liquidity tests—running this module ideally requires detailed data on contractual cash flows for different maturity buckets and behavioral data based on banks’ financial/funding plans. If the latter are not available, the tool can be run on contractual cash-flows only and behavioral flows can be modeled based on the stress test assumptions. The calibrated scenarios then denote roll-over assumptions for contractual cash-outflows and cash-inflows. The former focus on funding risk and the latter take into account the banks’ objective to maintain its franchise value even under stress. In addition, market funding risk can be captured through haircuts. Accordingly, the module allows for an intuitive view of each banks’ liquidity risk bearing capacity in the form of the cumulated counterbalancing capacity at the end of each maturity bucket. In addition to stress testing, the module is also meant to be used for liquidity monitoring purposes, for which behavioral cash-flows are particularly informative.

(iii) Tests linking solvency and liquidity risk—the tool allows linking liquidity and solvency risk from three complementary perspectives. The assumptions are crucial for these tests and require sound judgment by the stress tester. First, the module allows simulating the increase in funding costs from a change in solvency, indicated by a change in a bank’s (implied) rating. Second, the tool enables simulating the partial or full closure of funding markets (both long and short-term) depending on the level of capitalization with or without considering solvency stress. Third, it allows examining the potential impact of concentration in funding and a name crisis (e.g., from parent banks) on banks’ liquidity positions.

The output of the tests provides failure and pass rates (in terms of the number of banks and total assets, respectively), and the estimated funding shortfalls for each bank as well as at the system level (or group of banks tested). For instance for the fully-fledged cash flow test, (cumulative) funding gaps and the corresponding (cumulative) counterbalancing capacity for each maturity bucket are provided after haircuts and roll over rates for each bank and the

IMF. Author/Editor:Schmieder, Christian; Hesse,Heiko; Neudorfer, Benjamin; Puhr, Claus; Schmitz, Stefan W.Working Paper No. 12/3

Next Generation System-Wide Liquidity Stress Testing x

Bank of Japan’s Quantitative and Credit Easing: Are They Now More Effective?

This paper asks whether the BoJ’s recent experience with unconventional monetary easing has been effective in supporting economic activity and inflation. Using a structural VAR model, the paper finds some evidence that BoJ’s monetary policy measures during 1998-2010 have had an impact on economic activity but less so on inflation. These results are stronger than those in earlier studies looking at the quantitative easing period up to 2006 and may reflect more effective credit channel as a result of improvements in the banking and corporate sectors. Nevertheless, the relative contribution of monetary policy measures to the variation in output and inflation is rather small.

Japan has had a long experience with quantitative easing, dating back to 2001. Following a period of zero interest rate policy (ZIRP) during 1999–2000, the Bank of Japan (BoJ) introduced quantitative easing in March 2001. Under this policy, the BoJ used purchases of Japanese Government Bonds (JGBs) as the main instrument to reach their operating target of current account balances (CAB) held by financial institutions at the BoJ (bank reserves). The BoJ exited quantitative easing in March 2006, amid signs that the economy was emerging from deflation. Following the global financial crisis, the BoJ increased the pace of its JGB purchases and adopted a number of unconventional measures to promote financial stability. In October 2010, the BoJ introduced its Comprehensive Monetary Easing (CME) policy to respond to the re-emergence of deflation and a slowing recovery. One key measure was an asset purchase program involving government securities as well as private assets (see Ueda 2011 for a detailed description).

Research on the effectiveness of earlier quantitative easing has yielded mixed results, with most pointing to limited effects on economic activity. While most papers found evidence that quantitative easing helped reduce yields, its effect on economic activity and inflation was found to be small. The reasons cited included a dysfunctional banking sector, which impaired the credit channel, and weak demand for loans during a period when corporates were deleveraging. The situation since then, however, has improved, with a strengthening of banks’ balance sheets and restructuring of the corporate sector after the banking crisis of the late 1990s.

This paper revisits the question of whether quantitative easing and other unconventional monetary easing measures in Japan are now more effective given improvements in the banking and corporate sectors. Specifically, this paper assesses the impact of monetary easing on economic activity and inflation extending the period of analysis to 2010 to include the easing measures after the Lehman collapse. The paper finds that there is some evidence that monetary easing has supported economic activity and to a lesser extent inflation. Nevertheless, relative to all other economic variables included in the VARs a small portion of the variation in output and inflation is explained by the shocks to monetary policy variables.

IMF. Author/Editor:Berkmen, Pelin. Working Paper No. 12/2

Bank of Japan’s Quantitative and Credit Easing: Are They Now More Effective?

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Foreign Banks: Trends, Impact and Financial Stability

This paper introduces a comprehensive database on bank ownership for 137 countries over 1995-2009, and reviews foreign bank behavior and impact. It documents substantial increases in foreign bank presence, with many more home and host countries. Current market shares of foreign banks average 20 percent in OECD countries and 50 percent elsewhere. Foreign banks have higher capital and more liquidity, but lower profitability than domestic banks do. Only in developing countries is foreign bank presence negatively related with domestic credit creation. During the global crisis foreign banks reduced credit more compared to domestic banks, except when they dominated the host banking systems.

Although interrupted by the recent financial crisis, the past two decades have seen an unprecedented degree of globalization, especially in financial services. Not only have crossborder bank (and other capital) flows increased dramatically, but also many banks, from both advanced and developing countries, have ventured abroad and established presence in other countries. Although there are exceptions and regional differences, few countries have been left out from this trend of increasing financial integration. As a result, foreign banks have become important in domestic financial intermediation. For example, in terms of loans, deposits and profits, current market shares of foreign banks average 20 percent in OECD countries and close to 50 percent in emerging markets and developing countries.

Given the importance of foreign banks in many countries, understanding the motivations of foreign banks to enter a particular host country, the mode by which they do so, and the impact they have on financial sector development and lending stability has become essential. These questions have become even more prominent as a result of the financial crisis. Although much research has been conducted, many questions remain unanswered, however, partly because data availability has been limited.

This paper contributes to the literature on foreign banking in two ways. It introduces a new and comprehensive database on bank ownership, including the home country of foreign banks, covering 137 countries from 1995 to 2009. And, using this extensive database, it provides salient facts on trends in foreign ownership, compares foreign and domestic bank characteristics, and analyzes the relationship between foreign bank presence and financial development and the impact of foreign banks on lending stability during the recent crisis.

Before the crisis, the general consensus was that the benefits of foreign banks greatly outweigh costs in many dimensions. Particularly, it was generally considered that foreign banks add to domestic competition, increase access to financial services, enhance financial and economic performance of their borrowers, and bring greater financial stability (Clarke, Cull, Martinez Peria and Sanchez, 2003, Claessens, 2006, Chopra, 2007, and Cull and Martinez Peria, 2011). Generally, lower costs of financial intermediation (measured by margins, spreads, overheads) and lower profitability are documented with greater foreign bank presence (Claessens, Demirguc-Kunt, and Huizinga, 2001 and related studies, e.g., Mian, 2003, Berger, Clarke, Cull, Klapper and Udell, 2005). Also, evidence exists of better quality financial intermediation, e.g., lower loan-loss provisioning with more foreign entry (Martinez-Peria and Mody, 2004). Likely a number of factors are behind these effects of foreign banks, such as the introduction of new, more diverse products, greater use of up-todate technologies, and know-how spillovers (e.g., as people learn new skills from foreign banks, they migrate over time to domestic banks). In addition, foreign banks likely pressured governments to improve regulation and supervision, increase transparency, and more generally catalyze domestic reform (Levine 1996, Dobson, 2005, and Mishkin, 2006).

The effects of the entry of foreign banks on development and efficiency appear to depend though on some conditions. Limited general development and barriers can hinder the effectiveness of foreign banks (Garcia-Herrero and Martinez Peria, 2005; Demirguc-Kunt,Laeven and Levine, 2004). Also, the relative size of foreign banks’ presence seems to matter.

With more limited entry (as a share of the total host banking system), fewer spillovers seem to arise, suggesting some threshold effect (Claessens and Lee, 2003). In terms of individual bank characteristics, it seems that larger foreign banks are associated with greater effects on access to financial services for small and medium-sized enterprises, perhaps as they are more committed to the market, while smaller banks are more niche players (Clarke et al. 2005). Furthermore, the health of both the home and the local host bank operation seem to matter, with healthier banks showing better credit growth (Dages, Goldberg and Kinney, 2000; see also Haber and Musacchio, 2005 and De Haas and Van Lelyveld, 2006).

While the entry of foreign banks is generally thought to have favorable effects on the development of host banking systems, including through increased credit extension, some studies find more ambiguous results. Some show that foreign banks “cherry pick” borrowers (Detragiache, Gupta, and Tressel, 2008; Beck and Martinez Peria, 2007). This can undermine overall access to financial services, since cherry picking worsens the remaining credit pool, and lower financial development, especially in low-income countries where relationship lending is important. Indeed, Detragiache, Tressel and Gupta (2008) show the presence of foreign banks in low-income countries to be associated with less credit being extended. At the same time, a number of studies show that (funding) shocks to parent banks can be transmitted to their foreign subsidiaries with negative consequences for their lending (Peek and Rosengren (1999, 2000); Acharya and Schnabl (2010), Chava and Purnandam (2011); Cetorelli and Goldberg, 2011). Since the onset of the global financial crisis, more studies have also pointed out the risks of foreign banking for financial stability. De Haas, Korniyenko, Loukoianova and Pivovarsk (2011) and Popov and Udell (2010) find for emerging European countries that foreign subsidiaries reduced their lending more compared to domestic banks. De Haas and Van Lelyveld (2011), comparing loan growth of foreign subsidiaries of large multinational banking groups with large domestic banks, find similar results.

Some though find that global banks support their foreign affiliates during times of financial stress through internal capital markets (De Haas and Van Lelyveld, 2006 and 2010; and Barba-Navaretti, Calzolari, Levi and Pozzolo, 2010). Ongena, Peydro Alcalde and Van Horen (2011) find that, while foreign banks reduced lending more than local domestic banks did, they did not compared to domestic banks that had financed their lending boom through borrowing from international capital markets. In addition, De Haas and Van Horen (2011) show that during the global crisis foreign banks continued to lend to those countries that were geographically close and with whom they have established long-term lending relationships, suggesting that foreign banks do differentiate between countries during times of stress.

The crisis also highlighted that, while foreign banks play important roles in the global financial system and affect domestic financial systems, access to financial services, and consequent economic performance, many aspects are not yet well understood, in part due to lack of data. Many studies to date have only used short time periods and a limited number of countries, and hardly any have investigated bilateral ownerships. These three aspects are important to consider, however. A long time period is necessary to properly disentangle effects of cyclical developments and structural changes. A broad spectrum of countries needs to be studied as the causes and effects of foreign bank presence might differ with respect to the importance of foreign banks in the host country or (home and host) development and business and institutional environments. And bilateral patterns need to be studied given the interplay between home and host countries features in entry decisions (Galindo, Micco and Serra 2003, and Claessens and Van Horen, 2010) and between (cultural and institutional) distance and performance (Claessens and Van Horen, 2011).

This paper introduces an extensive database on that contains information on the ownership of 5377 banks in 137 countries from 111 home countries. For each bank, ownership, domestic versus foreign, is determined for each year the bank was active over the period 1995 to 2009, with all changes in ownership (from domestic to foreign and foreign to domestic) and all exits recorded. Important to investigate the factors behind the spread and impact of foreign banks, the home country of the main investor of each bank is identified. Using this database, the paper illustrates salient trends in foreign bank presence over the past two decades. It shows that, albeit interrupted by the global financial crisis, foreign bank presence has increased substantially in most countries, sometimes from none to foreign banks holding 67 percent market share (in terms of numbers) in a single decade. Also many more home countries have become active as investors, with several emerging countries becoming important “exporters.” Substantial differences still exist, though, with foreign bank presence ranging from zero to 100 percent. And foreign ownership is still mostly regional, with this pattern becoming stronger over time.

Taking stock as of end 2007, i.e., just before the crisis, the paper shows that in terms of loans, deposits and profits, foreign banks capture on average about 20 percent of market shares in OECD countries and close to 50 percent in emerging markets and developing countries. Interesting, in those countries with over 50 percent foreign banks in numbers, foreign banks tend to play an important part in financial intermediation. In contrast, when less important in numbers, foreign banks tend to be niche players.

The paper then studies balance sheet and performance characteristics of domestic and foreign banks, and the relationships between foreign bank presence and financial sector development and stability. In terms of balance sheets, the paper finds that foreign banks generally have higher capital adequacy and better liquidity positions. They also engage relatively less in traditional lending businesses. In terms of performance, maybe surprising, foreign banks underperform domestic banks in emerging markets and developing countries, but do not perform differently in high-income countries. Differences reflect in part variations in business strategies between foreign and domestic banks and host country circumstances. Particularly, performance may differ because foreign banks have more conservative portfolios and operate with less ease in some countries than domestic banks do.

In terms of the relations between foreign bank presence and financial sector development, patterns differ by host country. Specifically, in middle-income and high-income countries, foreign bank presence tends to have an insignificant relationship with credit extended. In low-income countries, however, foreign bank presence is associated with less credit extended. In terms of financial stability, we find that foreign banks generally reduced their domestic credit during 2009 more than domestic banks did. Foreign banks did enhance the stability of domestic financial systems though in countries with majority foreign bank presence since their credit growth declined there less than that of domestic banks. The crisis continues to affect banks in many ways. Faced with large losses and capital shortfalls, many banks in advanced countries are undergoing major restructurings, either voluntary or as conditions of government recapitalizations. Furthermore, banks need to comply with stricter regulations, such as Basel III and other measures triggered by the crisis. And all banks are responding to changing global economic patterns, including the economic slowdown in advanced countries and the increased economic importance of emerging markets. While many advanced countries’ banks are less likely to be active investors in the near future, banks from emerging markets, being in much better financial positions, are likely to step into the void, increasing their relative importance as foreign investors, especially within their geographical regions.

The paper itself is structured as follows. Section 2 provides an extensive description of the construction of the database. Section 3 starts with an overview of the main trends in foreign banking. It then reviews the trends in regionalization in foreign bank presence. Section 4 examines the importance of foreign banks in the host country banking system, the balance sheets and performance of foreign banks relative to domestic banks and provides some evidence on the relationship between foreign bank presence and financial sector development. Section 5 studies the impact of foreign bank ownership on lending stability during the global financial crisis. Section 6 discusses the future of foreign banking, including the rising importance of emerging market foreign banks. Section 7 concludes.

IMF. Author/Editor:Claessens, Stijn; Horen, Neeltje van

Foreign Banks: Trends, Impact and Financial Stability

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Colombia Second-tier Government Banks and Firm Performance Micro-Evidence

Government-owned development banks play the crucial role of channeling public funds to productive activities that, even if promising, may be rationed from credit access and may not flourish in the absence of such credit. Particularly interesting is the case of second-tier public banks. Rather than lending directly to firms, these banks lend resources to financial intermediaries (first-tier), which eventually lend the resources to firms. In this setting, secondtier banks not only expand credit supply by making more resources available, but may also provide resources at low costs and with flexible conditions that the intermediaries may then pass on to the final recipients of loans. Their activity is, therefore, expected to relax the constraints that prevent some firms from accessing credit, either because it is not available at all or because it is not available at costs that these firms can afford.

Such credit by second-tier development banks has potential advantages when compared with direct public lending and other forms of direct public support to business. First, second-tier credit is aimed at addressing market failures that limit access to credit, particularly for micro, small, and medium-sized enterprises (MSMEs). Second, because commercial banks and other private financial institutions eventually take on default risks, one could expect them to

adequately evaluate the quality of different projects and to separate those that are potentially profitable from those that are not. Resources should thus be more likely assigned to better uses than when governments provide direct support to businesses, sometimes assigning it on the basis of lobbying by potential beneficiaries. In fact, studies have found no effects or even negative

effects on economic performance when government-owned banks lend directly. Previous analyses also show evidence that such effects may relate to allocation of direct government loans according to political criteria.

Despite the potential gains from credit by second-tier development banks, little is known about their actual impact. This study is aimed at partially filling that gap by analyzing the impacts of lending activity of Bancoldex, the Colombian second-tier development bank, on the performance of manufacturing firms over the last decade. A companion paper studies Bancoldex’s impacts on the characteristics of credit used at the firm level (Eslava, Maffioli, and

Meléndez, 2011).

First established in 1992 to promote exports, Bancoldex became the Colombia’s development bank in 2003, taking over general development policy responsibilities that were previously held by the development agency IFI (now nonexistent). Bancoldex’s activities concentrate on second-tier lending: all of its credit resources are channeled through other financial or nonfinancial intermediaries.

To explore the effects of loans funded by Bancoldex on firm performance, we use microlevel data for all manufacturing establishments with 10 or more employees from 1997 through 2007 matched with data on Bancoldex credit recipients from 2000 through 2007. This allows us to study the effects of different types of Bancoldex loans on different aspects of firm performance.

After correcting for selection biases, we find that using Bancoldex loans increases firms’ output, employment, investment, and productivity. Moreover, these effects grow with increases in amounts borrowed. While loans intended for long-term purposes are found to have positive impacts on output, investment, and productivity, short-term loans help improve performance in

other dimensions, particularly with respect to exports.

Our study is, to the extent of our knowledge, the first econometric assessment of the impact of credit from second-tier development banks on firm performance. Our findings contribute to the understanding of how different ways of channeling public resources to the business sector can have different effects. In contrast to the negative or inconclusive findings of previous studies on the impact of direct lending by the government, our results suggest that second-tier banking can foster productive activities, especially if resources are targeted to funding long-term projects that may otherwise be hard to finance in a tight financial market.

The paper is organized as follows. Section 2 describes Bancoldex and its financing activity. Section 3 reviews previous studies on the subject. Section 4 introduces the data used in our evaluation, and Section 5 discusses our empirical approach. Section 6 presents the results of our study, while Section 7 discusses those results in the light of the existing literature and

concludes this paper.

Marcela Eslava. Alessandro Maffioli. Marcela Meléndez. Capital Markets and Financial Institutions Division (IFD/CMF). IDB WORKING PAPER SERIES No. IDB-WP-294. Inter-American Development Bank. January 2012

Colombia Second-tier Government Banks and Firm Performance Micro-Evidence

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Banking flows and financial crisis.financial interconnectedness and basel III effects

This paper examines the factors that determine banking flows from advanced economies to emerging markets. In addition to the usual determinants of capital flows in terms of global push and local pull factors, it examines the role of bilateral factors, such as growth differentials and economic size, as well as contagion factors and measures of the depth in financial interconnectedness between lenders and borrowers.

The analysis finds profound differences across regions. In particular, in spite of the severe impact of the global financial crisis, banking flows in emerging Europe stand out as a more stable region than is the case in other developing regions. Assuming that the determinants of banking flows remain unchanged in the presence of structural changes, the authors use these results to explore the short-term implications of Basel III capital regulations on banking flows to emerging markets.

I. Introduction

The global financial crisis has led to a range of reform proposals concerning the regulatory framework governing the banking sector with a view to enhancing its resilience. Agreement has already been reached on some aspects of these new rules, which are collectively referred to as Basel III (Appendix 1). The proposed new regulations cover both micro-prudential or firm-specific measures, as well as macro-prudential measures aimed at strengthening the resilience of the banking system as a whole by addressing the pro-cyclicality of banking and limiting the risks arising from the interconnectedness among financial institutions.

One of the cornerstones of the proposed reforms relates to strengthening the level and quality of the capital base through an increase in the minimum common equity requirement from 2.0 percent to 4.5 percent of assets and the introduction of a capital conservation buffer of 2.5 percent of assets. Within the proposed macro-prudential reforms, agreement has also been reached on the introduction of counter-cyclical capital buffers. To contain the excessive buildup of leverage, agreement has also been reached on introducing an internationally harmonized leverage ratio threshold that could serve as a backstop to the capital measure and on a new global minimum liquidity standard.

Although the proposed reforms are expected to generate substantial benefits (namely, by reducing the frequency and intensity of banking crises), concerns have been raised that, in the short term, the costs of moving to higher capital ratios may lead banks to raise their lending rates and reduce lending.1 In particular, if these regulations are implemented over a short period of time, there could be a consequent drag on the economic recovery in countries adopting these regulations as well as in those emerging markets closely dependent on global banking flows.

Against this background, this paper examines the determinants of banking flows from advanced economies to emerging markets. It focuses primarily on the nature of the financial linkages between these countries after controlling for global push and local pull factors, as well as aggregate bilateral linkages. These results are then used to assess the possible impact on emerging markets of the regulatory changes under Basel III. We focus primarily on the financial flows channel; that is, the impact on banking flows through both direct and indirect lending.

World Bank.Author:Ghosh,,Swati R.;Sugawara,Naotaka; Zalduendo,Juan.Document Date:  2011/08/01.Document Type: Policy Research Working Paper.Report Number: WPS5769.Volume No:1 of 1

Banking flows and financial crisis.financial interconnectedness and basel III effects

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Colombia.Support to FINDETER.Financiera Desarrollo Territorial

To finance the trip of four Finderter staff to Mexico D.F (MX) to visit BANOBRAS and SOCIEDAD HIPOTECARIA banks in order to know the experience and the best practices of infrastructure banks.

IDB.CO-T1261: Support to FINDETER - Financiera Desarrollo Territorial

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Credit Growth and Bank Soundness: Fast and Furious?

Episodes of rapid growth in bank credit to the private sector are rather frequent events(Terrones, 2004; Barajas et al., 2007). In the business cycle context, financial accelerator mechanisms can explain such episodes relatively well: favorable investment opportunities and vigorous economic activity push asset prices up, which in turn increase the creditworthiness of borrowers and let them borrow more against higher values of collateral.

Hence, credit is procyclical and grows in tandem with income. In addition, countries move up the ladder in terms of financial development, generating an upward trend in credit-to-GDP ratio. Several factors driving financial development can push the growth rate of credit far above the growth rate of income. For instance, financial deregulation (including lifting of capital account restrictions), increased competition, and financial innovation could cultivate credit booms, i.e., episodes of above-trend growth in credit-to-GDP ratio.

While increased credit availability often spurs economic growth helping savings to be channeled into investment, rapid credit growth also raises concerns about prudential risks. Prudential risks, defined as threats to financial stability stemming from the financial position of banks, can emerge both at the micro and macro levels. At the micro level, fast expansion of loan portfolios may lead to capacity constraints (to manage risks, gather information, or assess quality of applications) starting to bind and new loans being originated without adequate screening and risk management (Berger and Udell, 2004).

At the macro level, expansion may involve strategic competition concerns whereby banks take on more risks or financial institutions become more interconnected and the system, as a whole, becomes riskier. Or, it may involve reliance on the same asset classes and marginal loans, i.e., loans made to borrowers that are riskier and potentially more exposed to shocks that may be correlatedacross borrowers. For instance, in the run-up to the recent global financial crisis, several studies identify the mortgage credit boom in the U.S. as one of the culprits because it increased the exposure of the financial system to a single shock, that is, a fall in house prices (see, for instance, Dell’Ariccia, Igan, and Laeven, 2008). Hence, rapid credit growth episodes can decrease loan quality, increase systemic risk, and deteriorate bank soundness.

This posited relationship between credit growth and bank soundness is a dynamic one. In other words, credit growth affects and is affected by bank soundness. While most theoretical models predict a negative relation running from credit growth to bank soundness (see Dell’Ariccia and Marquez, 2006, and references therein), the sign of the feedback effect is ambiguous. It could be the case that bank soundness feeds positively into credit growth because sounder banks have more capacity (to manage risks or to deploy additional employees) and they can expand faster than others. Or, the feedback effect may be negative because less sound banks become more aggressive and take more risks as they bet all their resources in a last effort to survive.

This paper examines the risks associated with rapid credit growth taking into account the role of bank soundness as a determinant of credit growth. The econometric analysis is based on a simultaneous equation framework, where credit growth and bank soundness are modeled as depending on lagged values of each other and various macroeconomic and bank-specific factors. Thus, the analysis tests two hypotheses about the risks associated with rapid credit growth. The first is that rapid credit growth weakens banks. The second is that credit grows more rapidly in sounder/less sound banks.

World Bank. Author/Editor:Igan, Deniz;Pinheiro, Marcelo.December 01, 2011.Working Paper No. 11/278

Credit Growth and Bank Soundness: Fast and Furious?

The Relative Volatility of Commodity Prices: A Reappraisal

Are the international prices of primary commodities more volatile than those of manufactured goods? This question has important implications for macroeconomic and development policies, and the conventional wisdom expressed in academic and policy circles is that they are. The policy literature is replete with prescriptions for economies to cope with the volatility of commodity prices, ranging from prescribed investments in financial hedging instruments such as commodity futures to fiscal stabilization rules to help reduce the pass through of commodity price volatility into domestic economies. A recent example is the World Bank’s 4 billion dollar contribution to a joint fund launched in June 21, 2011 with J.P.

Morgan to help developing countries invest in commodity-price hedging instruments.In fact, the concern over the impact of commodity price volatility on developing countries has also led the World Bank to argue that economic diversification away from commodities should be a priority for these countries even if this requires industrial policies. Indeed, there are good reasons to expect that commodity prices are relatively volatile. One is that commodities, by definition, are goods that retain their qualities over time, which allows economic agents to use them as financial assets. This might be the case, for example, of gold and other commodities whose prices tend to rise amidst global financial uncertainty.

Caballero et al. (2008), for example, argued that the volatility of commodity prices could be due to the lack of a global safe asset (besides the U.S. Treasury bills). An earlier literature argued that commodity price volatility was fueled by stockpiling policies to secure access to food or fuel during times of relative scarcity (Deaton and Laroque 1992). These mechanisms add price volatility because of unavoidable asymmetric stockpiling rules; that is, the stockpile of commodities cannot be negative. Yet another potential explanation is the lumpiness of exploration investments in mining, which results in inelastic supply in the short run (Deaton and Laroque 2003). Finally, more traditional economic analysis of the effects of random demand shocks on homogeneous (i.e., commodities) and differentiated goods (i.e., manufactured products) also suggests that the resulting price volatility of the latter would tend to be lower as producers of differentiated products could maximize profits by reducing supply in response to negative demand shocks.

However, there are also good reasons to expect a higher volatility of differentiated manufactured goods. Product innovation and differentiation itself might contribute to price volatility by producing frequent shifts in residual demand for existing varieties. Indeed, the trade literature has acknowledged the wide dispersion in unit values of within narrowly defined product categories in the United States import data at the 10-digit level of the Harmonized System (HS) (Schott 2004). Also, the demand for differentiated products might be more unstable with respect to household and aggregate income shocks than that for basic commodities. For instance, the demand for fuel and food might decline proportionately less than the demand for automobiles or electronics when incomes fall.

World Bank. Author/Editor: Arezki, Rabah ; Lederman, Daniel; Zhao, Hongyan.December 01, 2011.Working Paper No. 11/279

The Relative Volatility of Commodity Prices: A Reappraisal.

Knowledgeable bankers? the demand for research in World Bank operations

In trying to understand the impact of development aid, much attention has been given to the role played by the circumstances of recipient countries, notably whether their policy environment and governance are conducive to high social returns from aid.

The literature has given less attention to the role played by the staff and managers in donor organizations. In the case of the World Bank, there have been concerns about the Bank’s ―lending culture,‖ which tends to reward operational staff for the volume of their lending, with (it is argued) too little weight given to the quality of lending.

In one of the few studies of aid effectiveness to look at these issues, Denizer, Kaufmann and Kraay (2011) confirm that the ―macro‖ variables concerning recipient countries are relevant to the (subjectively but independently assessed) quality of the Bank’s development projects. But they also find that the bulk of the variance in the quality of the Bank’s lending operations is within countries rather than between them. The quality of the staff in charge of projects on the donor’s side matters at least as much as the policy environment on the recipient’s side.

The knowledge of operational staff within donor agencies is likely to be important to the quality of development aid. There is evidence that the stock of prior analytic work by the Bank on a recipient country is a strong predictor of the subsequent quality of its lending operations to that country (Deininger, Squire and Basu, 1998; Wane, 2004) and that the quality of prior analytic work matters to the quality of its projects (Fardoust and Flanagan, 2011). The stock of practitioners’ knowledge depends on their demand for knowledge, as well as its supply. Thus the incentives for learning within aid organizations have been identified as one factor in the quality of development aid (Wane, 2004; Ravallion, 2011). The generation of relevant knowledge and its diffusion within donor agencies is a poorly understood factor in development effectiveness.

While research is clearly a key element of knowledge generation and innovation, any large and complex organization like the World Bank will face challenges in assuring that relevant basic research is both produced and used.4 As the literature on organizations has emphasized, a key factor is the ability to exploit the internal division of labor to support innovation (Hage, 1999). The role of a designated ―research department‖ in bringing together internal research capabilities and in absorbing new external information to assure innovation has long been recognized in the literature (following, in particular, Cohen and Levinthal, 1990). But having such a department does not guarantee that practitioners will have the incentive to learn from research, and that the research produced will serve their needs. In practice, there may well be frictions within an organization that inhibit learning even when the incentive is there.

The World Bank (WB) has a department dedicated to research, the Development Research Group (DECRG), within the Development Economics Vice-Presidency (DEC), as well as researchers scattered across other units. Research accounts for roughly 1% of Bank staff; there are about 75 full-time research staff in DECRG and probably another 25 or so full-time equivalent researchers outside DECRG.

DECRG spans all sectors of the Bank’s work. Its research is almost invariably empirical and typically draws on economics as the primary discipline, though increasingly drawing on insights from other social sciences. By objective criteria, the scale and quality of its research on development exceeds that of virtually all other international agencies and universities. DECRG aims in part to serve the needs of its operational units, which provide development lending and policy advice to developing countries.

However, we know very little about the demand for Bank research among the Bank’s operational staff. How familiar are they with research? How much do they rely on it for their work? How do the answers to these questions vary across units and sectors of the Bank? We know even less about the incentives for learning among the Bank’s operational staff. Those incentives depend crucially on the value attached to WB research by staff for their work. Do the Bank’s practitioners value research for their work, and (if so) does this incentive to learn translate into greater familiarity and use of the Bank’s research?

This paper tries to throw new light on the demand for research by development practitioners within the World Bank. A key empirical question is how operational staff are mapped into the four groups identified in the following table. If the Bank’s operational staff highly value research for their work, and the research done within the Bank is relevant to their needs and accessible to them, then the bulk of staff will fall into the category ―functionally well-informed.‖ For this group, the incentive to learn comes with acquired knowledge. There may also be staff who are well-informed about research, but not because it matters to their work; they are ―independently well-informed.‖ And some value research for their work but face hurdles in accessing it, so their familiarity is low; these are the ―frustrated uninformed.‖ The remainder comprise those who do not see any value to research for their work, and so do not seek it out; they can be said to be ―happily uninformed.

The paper uses a specially commissioned survey of the World Bank’s senior operational staff to determine how they are mapped to these four groups. The paper’s analysis of these data aims to better understand the demand for research by the Bank’s practitioners—reflecting both their incentives to learn and the responsiveness of the supply of research to their needs.

World Bank.Author: Ravallion, Martin.Document Date: 2011/12/01.Document Type:Policy Research Working Paper.Report Number: WPS5892. Volume No:1 of 1.

Knowledgeable bankers? the demand for research in World Bank operations

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Russian Federation.Targeted Detailed Assessment of Observance of Basel Core Principles for Effective Banking Supervision

A targeted assessment of the Basel Core Principles for Effective Banking Supervision (BCP) was conducted which revealed some improvement since the 2007 assessment. The principles reviewed covered the following risk areas: major acquisitions, capital adequacy, risk management process, credit risks and provisions, exposure to related parties, abuse of financial services, remedial actions and consolidated supervision.

Although the CBR continues to improve its supervisory process and issue recommendations to banks on monitoring and managing risks, it lacks the supervisory framework to support enforcement of those recommendations and that inhibits improvement in BCP compliance. CP-9 on problem assets and provisioning was upgraded to largely compliant but CP-11 on exposure to related parties was downgraded to materially noncompliant.

International Monetary Fund.November 29,2011.Country Report No. 11/336

Russian Federation:Targeted Detailed Assessment of Observance of Basel Core Principles for Effective Banking Supervisiond

Cyprus.Selected Issues Paper

The most salient risks come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy, are most heavily exposed to significant haircuts on Greek government bonds, and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. Risks from other financial institutions operating in Cyprus should not be overlooked, but they are not the main focus of this report.

Cyprus banks face capital needs estimated at €3.6 billion on a preliminary basis by the EBA. Cyprus banks would need this much of a buffer against losses on
sovereign debt holdings in order to reach a core Tier 1 capital ratio of 9 percent. In the event of additional shocks such as acceleration in the pace of NPL formation, capital needs could increase.

It is unclear how banks will raise necessary capital. They are expected to de-lever balance sheets, issue contingent convertible securities, retain profits and cut costs. If these sources prove inadequate, they would need the support from the government or external sources.

The system appears capable of absorbing moderate funding shocks at the aggregate level, but individual banks could face pressures. In the event of rapid and persistent loss of deposits, liquidity buffers would eventually be depleted.        

This paper was prepared based on the information available at the time it was completed on November 4, 2011. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Cyprus or the Executive Board of the IMF. The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information. © 2011 International Monetary Fund November 2011. IMF Country Report No. 11/332

Cyprus.Selected Issues Paper

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OECD.Banks in the balance

©OECD Observer No 286 Q3 2011.Whether or not you believe they have been reformed enough, few institutions have received as much attention during the current economic crisis as banks.

But how much money do they really control and how can their behaviour affect our economies so much?

Total assets of the largest banks as a share of GDP increased rapidly in major OECD countries in the years leading up to the financial crisis, says Bank Competition and Financial Stability. In contrast, in emerging economies, which were affected by the crisis to a lesser degree, the asset-to-GDP ratio was stable. In the case of China, the ratio actually decreased ahead of the financial crisis.

The proportional increase in assets of the largest French and British banks is particularly noticeable in the late 1990s and 2000s, with the three biggest British banks holding assets worth almost 340% of the UK’s GDP on the eve of the global financial crisis and 260% for the French big three. In 1995, the figure for both countries was less than 80%.

Some of the competitive practices in the banking system (or lack thereof) may have exacerbated the crisis, according to the report, while the authors warn that some government policies–for instance, enforced mergers–may have adverse consequences for competition.

See www.oecd.org/finance

 

The Eurozone Crisis: How Banks and Sovereigns Came to be Joined at the Hip

We use the rise and dispersion of sovereign spreads to tell the story of the emergence and escalation of financial tensions within the eurozone. This process evolved through three stages. Following the onset of the Subprime crisis in July 2007, spreads rose but mainly due to common global factors. The rescue of Bear Stearns in March 2008 marked the start of a distinctively European banking crisis.

During this key phase, sovereign spreads tended to rise with the growing demand for support by weakening domestic financial sectors, especially in countries with lower growth prospects and higher debt burdens.

As the constraint of continued fiscal commitments became clearer, and coinciding with the nationalization of Anglo Irish in January 2009, the separation between the sovereign and the financial sector disappeared.

Author/Editor: Mody,Ashoka;Sandri,Damiano.Authorized for Distribution: November 01, 2011.Series:Working Paper No. 11/269
This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

The Eurozone Crisis: How Banks and Sovereigns Came to be Joined at the Hip

Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information

This paper proposes and demonstrates a methodology for modeling correlated systemic solvency and liquidity risks for a banking system. Using a forward looking simulation of many risk factors applied to detailed balance sheets for a 10 bank stylized United States banking system, we analyze correlated market and credit risk and estimate the probability that multiple banks will fail or experience liquidity runs simultaneously.

Significant systemic risk factors are shown to include financial and economic environment regime shifts to stressful conditions, poor initial loan credit quality, loan portfolio sector and regional concentrations, bank creditors’ sensitivity to and uncertainties regarding solvency risk, and inadequate capital. Systemic banking system solvency risk is driven by the correlated defaults of many borrowers, other market risks, and inter-bank defaults. Liquidity runs are modeled as a response to elevated solvency risk and uncertainties and are shown to increase correlated bank failures.

Potential bank funding outflows and contractions in lending with significant real economic impacts are estimated. Increases in equity capital levels needed to reduce bank solvency and liquidity risk levels to a target confidence level are also estimated to range from 3 percent to 20 percent of assets. For a future environment that replicates the 1987-2006 volatilities and correlations, we find only a small risk of U.S. bank failures focused on thinly capitalized and regionally concentrated smaller banks. For the 2007-2010 financial environment calibration we find substantially elevated solvency and liquidity risks for all banks and the banking system.

IMF.Author/Editor: Schumacher, Liliana ; Barnhill, Theodore M. Authorized for Distribution: November 01, 2011.Working Paper No. 11/263
This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information