What is the relationship between a markets-based measure of leverage and banks’ funding costs?

Kieran Dent, Sinem Hacioglu Hoke and Apostolos Panagiotopoulos

The Great Financial Crisis demonstrated an important feedback loop between banks’ capitalisation and funding costs. As banks’ capitalisation declined, banks’ wholesale creditors responded by demanding higher interest rates to lend to them. In turn, higher funding costs dented banks’ profitability, further weakening their capitalisation. Quantifying the relationship between funding costs and market-based measures of leverage – a proxy for bank solvency – is key to understand how banks might fare in a future stress situation – for instance as part of regulatory stress tests.

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Do banks need belts and braces?

Marcus Buckmann, Paula Gallego Marquez, Mariana Gimpelewicz and Sujit Kapadia

Bank failures are very costly for society. Following the 2007/2008 global financial crisis, international regulators introduced a package of new banking regulations, known as Basel III. This includes a wider range of capital and liquidity requirements to protect banks from different risks. But could the additional complexity be unnecessary or even increase risks, as some have argued? In a recent staff working paper, we assess the value of multiple regulatory requirements by examining how different combinations of metrics might have helped prior to the 2007/2008 crisis in gauging banks that subsequently failed. Our results generally support the case for a small portfolio of different regulatory metrics: having belts and braces (or suspenders) can strengthen the resilience of the banking system.

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Covid-19 briefing: pandemics, natural disasters and banks’ balance sheets

Neeltje van Horen

The Covid-19 (Covid) pandemic is a major shock to the economy but unlike traditional crises or credit crunches, its origin is exogenous to the financial sector. The economy’s ability to recover from the impact of the pandemic will however depend in part on the availability of credit. This raises the question how banks absorb a large shock which originates from outside the financial sector. To answer this question this post reviews the literature on how previous pandemics and natural disasters in the developed world affected banks’ balance sheets. One key message stands out: banks that are more rooted in their market are much more likely to continue lending when faced with the economic fallout from such shock.

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2020 hindsight: what can supervisors learn from the collapse of Barings Bank 25 years on?

Ben Dubow

This year marks 25 years since the failure of Barings Bank. On Sunday 26 February 1995, the 200-year old merchant bank blew up thanks to derivatives trading, which it believed was both risk-free and highly profitable. It was neither of these things. The firm’s star trader was illicitly pursuing a strategy akin to ‘picking up pennies in front of a steam-roller‘. The steamroller arrived in the form the Kobe earthquake. The star trader’s losses ballooned and he doubled up on his bets, unsuccessfully. Barings went bankrupt. The episode captured the public imagination, and helped lead to the creation of a new regulator in the UK. 

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Separating deposit-taking from investment banking: new evidence on an old question

Matthieu Chavaz and David Elliott

On 16 June 1933, as the nationwide banking crisis was reaching a new peak, freshly elected US President Franklin D. Roosevelt put his signature at the bottom of a 37-page document: the Glass-Steagall Act. Eight decades later, the debate still rages on: should retail and investment banking be separated, as Glass-Steagall required? In a recent paper, we shed new light on the consequences of this type of regulation by examining the recent UK ‘ring-fencing’ legislation. We show that ring-fencing has an important impact on banking groups’ funding structures, and find that this incentivises banks to rebalance their activities towards retail mortgage lending and away from capital markets, with important knock-on effects for competition and risk-taking across the wider banking system.

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Montagu Norman and the transformation of the Bank

Chris Swinson

This post contributes to our occasional series of guest posts by external researchers who have used the Bank of England’s archives for their work on subjects outside traditional central banking topics.

In 1944, the Bank of England’s historian, John Clapham, looked back at the ways in which the Bank had changed since 1914 and remarked:

‘ . . . it would not be fantastic to argue that the Bank in 1944 was further . . . from 1914 than 1914 was from 1714.’

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Financial shocks, reopening the case

David Gauthier

Since the tumultuous events of 2007, much work has suggested that financial shocks are the main driver of economic fluctuations. In a recent paper, I propose a novel strategy to identify financial disturbances. I use the evolution of loan finance relative to bond finance to proxy for firms’ credit conditions and single out the shocks born in the financial sector. I apply and test the method for the US economy. I obtain three key results. First, financial shocks account for around a third of the US business cycle. Second, these shocks occur around precise events such as the Japanese crisis and the Great Recession. Third, the financial shocks I obtain are predictive of the corporate bond spread.

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The leverage ratio: a balance between risk and safety

Jonathan Smith

What was the root cause of the financial crisis? Ask any economist or banker and undoubtedly they will at some point mention leverage (see e.g. here, here and here). Yet when a capital requirement based on leverage — the leverage ratio requirement — was introduced, fierce criticism followed (see e.g. here and here). Drawing on the insights from a working paper, and thinking about the main criticism — that a leverage ratio requirement could cause excessive risk-taking — this seems not to have been the case.

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Setting boundaries: finding thresholds in bank regulation

Zahid Amadxarif, Paula Gallego Marquez and Nic Garbarino

“We’ve done a lot to lower prudential barriers to entry into the banking sector […] but have we done enough to lower the equivalent barriers to growth?” asked PRA CEO Sam Woods in a recent speech. To make regulation proportionate, policymakers adapt regulatory requirements to the risks posed by each firm. But regulators face a trade-off between addressing systemic risks in a proportionate way and limiting regulatory complexity. New thresholds can create complexity and cliff-edge effects that can discourage healthy firms from growing. We identify regulatory thresholds for UK banks and building societies using textual analysis on a new dataset that contains the universe of prudential rules.

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How do lenders adjust their property valuations after extreme weather events?

Nicola Garbarino and Benjamin Guin

Policymakers have put forward proposals to ensure that banks do not underestimate long-term risks from climate change. To examine how lenders account for extreme weather, we compare matched repeat mortgage and property transactions around a severe flood event in England in 2013-14. We find that lender valuations do not ‘mark-to-market’ against local price declines. As a result valuations are biased upwards. We also show that lenders do not offset this valuation bias by adjusting interest rates or loan amounts. Overall, these results suggest that lenders do not track closely the impact of extreme weather ex-post.

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