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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Playing with fire: banks’ distressed sales under solvency and liquidity constraints

Caterina Lepore and Jamie Coen

Many commentators on the global financial crisis identified ‘fire sales’ as one of the key mechanisms by which shocks to banks were amplified and transmitted across the wider financial system. When firms in distress sell assets held by other institutions at discounted prices, losses can spread through the financial system as prices fall, amplifying the initial stress. In a working paper published last year, we explored this mechanism by presenting a new model of fire sales. In doing so, we answer the following questions: Which types of financial shocks combine to produce fire sales? How can banks optimally liquidate their portfolios when forced to do so? How big a risk are bank fire sales?

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Covid-19 Briefing: Corporate Balance Sheets

Neeltje van Horen

Faced with unprecedented declines in corporate revenue, the Covid-19 shock represents a loss of cash flow of indeterminate duration for many firms. It is too early to tell how exactly firms will be affected by this crisis and how scarring it will be, but the crisis will likely have a significant impact on most corporates. This post reviews the literature on factors affecting firms’ ability to withstand the Covid-19 shock and what large corporates did to shore up their finances.

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Housing consumption and investment: evidence from the Help to Buy scheme

Matteo Benetton, Philippe Bracke, João F Cocco and Nicola Garbarino

Academics have made the case for mortgage products with equity features, so that gains and losses due to fluctuations in house values are shared between the household and an outside investor. In theory, the equity component expands the set of affordable properties, without increasing household debt, and default risk. These products have not become mainstream, but in a recent paper, we study a large UK experiment with equity-based housing finance — the Help To Buy Equity Loan scheme. We find that equity loans are mainly used to overcome credit constraints, rather than to reduce investment risk. Unconstrained household prefer mortgage debt over equity loans, suggesting optimism about house price risk. Equity loans could still contribute to house price inflation: we don’t find evidence that houses purchased with equity loans are overpriced, but an assessment of the aggregate effects is beyond the scope of the paper.

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How to see it coming: predicting bank distress with machine learning

Joel Suss and Henry Treitel

The need to see it coming

The great American baseball sage, Yogi Berra, is thought to have once remarked: ‘It’s tough to make predictions, especially about the future’. That is certainly true, but thankfully the accelerating development and deployment of machine learning methodologies in recent years is making prediction easier and easier. That is good news for many sectors and activities, including microprudential regulation. In this post, we show how machine learning can be applied to help regulators. In particular, we outline our recent research that develops an early warning system of bank distress, demonstrating the improved performance of machine learning techniques relative to traditional approaches.

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Tracking foreign capital

Christiane Kneer and Alexander Raabe

Capital flows are fickle. In the UK, the largest and most volatile component of inflows from foreign investors are so-called ‘other investment flows’ – the foreign capital which flows into banks and other financial institutions. But where do these funds ultimately go and which sectors are particularly exposed to fickle capital inflows? Do capital inflows allow domestic firms to borrow more? Or does capital from abroad ultimately finance mortgages of UK households? Some of the foreign capital could also get passed on to the financial sector or flow back abroad.

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Bitesize: How much did PPI subsidise personal loan rates pre-crisis?

David Seaward

The Payment Protection Insurance (PPI) mis-selling scandal has rumbled on for years. But how did PPI impact loan margins pre-crisis?

This post argues that income from cross-selling PPI substantially offset lenders’ margins on personal loans between 2004 and 2009, and compares the pre-crisis PPI-adjusted margin to loan spreads today.

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New banking regulation: is it affecting the clearing of derivatives?

Jonathan Smith and Gerardo Ferrara

Just like the beginning of an unforeseen family argument, two key tenets of the post-crisis reforms have unexpectedly started to butt heads: the leverage ratio capital requirement and the mandatory requirement to centrally clear certain over-the-counter (OTC) derivatives.

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Give me more! Higher Capital Requirements and Loan Collateralisation

Sudipto Karmakar

How do banks adjust when faced with a sudden rise in capital requirements? The most frequent response, in the theoretical literature, is that they reduce lending or “deleverage” (see, e.g., Aiyagari and Gertler (1999); Gertler and Kiyotaki (2010). This is particularly true in crisis episodes when raising equity can be costly. However, in a new paper co-authored with Hans Degryse and Artashes Karapetyan, I show this is only part of the story. Banks may also ask borrowers to provide more collateral; collateralised exposures carry lower risk weights on average and hence enhance capital ratios. This requirement can adversely affect young and new borrowers that typically lack collateral to pledge and are also unlikely to have longstanding banking relationships.

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