Bank Funding Structures and Risk: Evidence from the Global Financial Crisis

Bank Funding Structures and Risk: Evidence from the Global Financial Crisis. By Francisco Vazquez and Pablo Federico
IMF Working Paper WP/12/29
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012029
Jan, 2012

Summary: This paper analyzes the evolution of bank funding structures in the run up to the global financial crisis and studies the implications for financial stability, exploiting a bank-level dataset that covers about 11,000 banks in the U.S. and Europe during 2001–09. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with bank risk-taking. In the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border banks were more susceptible to solvency risk due to excessive leverage. The results support the proposed Basel III regulations on structural liquidity and leverage, but suggest that emphasis should be placed on the latter, particularly for the systemically-important institutions. Macroeconomic and monetary conditions are also shown to be related with the likelihood of bank failure, providing a case for the introduction of a macro-prudential approach to banking regulation.


Introduction

The global financial crisis raised questions on the adequacy of bank risk management practices and triggered a deep revision of the regulatory and supervisory frameworks governing bank liquidity risk and capital buffers. Regulatory initiatives at the international level included, inter alia, the introduction of liquidity standards for internationally-active banks, binding leverage ratios, and a revision of capital requirements under Basel III (BCBS 2009; and BCBS 2010 a, b).2 In addition to these micro-prudential measures, academics and policymakers argued for the introduction of a complementary macro-prudential framework to help safeguard financial stability at the systemic level (Hanson, Kashyap and Stein, 2010).

This regulatory response was implicitly based on two premises. First, the view that individual bank decisions regarding the size of their liquidity and capital buffers in the run up to the crisis were not commensurate with their risk-taking—and were therefore suboptimal from the social perspective. Second, the perception that the costs of bank failures spanned beyond the interests of their direct stakeholders due, for example, to supply-side effects in credit markets, or network externalities in the financial sector (Brunnermeier, 2009).

The widespread bank failures in the U.S. and Europe at the peak of the global financial crisis provided casual support to the first premise. Still, empirical work on the connection between bank liquidity and capital buffers and their subsequent probability of failure is incipient.  Background studies carried out in the context of Basel III proposals, which are based on aggregate data, concluded that stricter regulations on liquidity and leverage were likely to ameliorate the probability of systemic banking crises (BCBS, 2010b).3 In turn, studies based on micro data for U.S. banks also support the notion that banks with higher asset liquidity, stronger reliance on retail insured deposits, and larger capital buffers were less vulnerable to failure during the global financial crisis (Berger and Bouwman, 2010; Bologna, 2011).  Broadly consistent results are reported in Ratnovski and Huang (2009), based on data for large banks from the OECD.

This paper makes two contributions to previous work. First, it measures structural liquidity and leverage in bank balance sheets in a way consistent with the formulations of the Net Stable Funding Ratio (NSFR), and the leverage ratio (EQUITY) proposed in Basel III. Second, it explores for systematic differences in the relationship between structural liquidity, leverage, and subsequent probability of failure across bank types. In particular, we distinguish between large, internationally-active banks (henceforth Global banks), and (typically smaller) banks that focus on their domestic retail markets (henceforth Domestic banks).

This sample partition is suitable from the financial stability perspective. Global banks are systemically important and extremely challenging to resolve, due to the complexity of their business and legal structures, and because their operations span across borders, entailing differences in bank insolvency frameworks and difficult fiscal considerations. Furthermore, the relative role of liquidity and capital buffers for bank financial soundness is likely to differ systematically across these two types of banks. All else equal, Global banks benefit from the imperfect co-movement macroeconomic and monetary conditions across geographic regions (Griffith-Jones, Segoviano, and Spratt, 2002; Garcia-Herrero and Vazquez, 2007) and may exploit their internal capital markets to reshuffle liquidity and capital between business units.  In addition, Global banks tend to enjoy a more stable funding base than Domestic banks due to flight to safety, particularly during times of market distress. To the extent that these factors are incorporated in bank risk management decisions, optimal choices on structural liquidity and leverage are likely to differ across these two types of banks.

The paper exploits a bank-level dataset that covers about 11,000 U.S. and European banks during 2001-09. This sample coverage allows us to study bank dynamics leading to, and during, the global financial crisis. As a by-product, we document the evolution of structural liquidity and leverage in the pre-crisis period, and highlight some patterns across bank types to motivate further research. Contrary to expectations, the average structural liquidity in bank balance sheets in the run up to the global financial crisis (as measured by a proxy of the NSFR) was close to the target values proposed in Basel III recommendations.4 However, we find a wide dispersion in structural liquidity across banks. A mild (albeit sustained) increase in structural liquidity mismatches in the run up to the crisis was driven by banks located at the lower extreme of the distribution. Pre-crisis leverage was also widely uneven across banks, with the Global banks displaying thinner capital buffers and wider gaps between leverage ratios and Basel capital to risk-weighted assets.

In line with alleged deficiencies in bank risk management practices, we find that banks with weaker structural liquidity and banks with higher leverage ratios in the run up to the crisis were more vulnerable to failure, after controlling for their pre-crisis risk-taking. However, the average effects of stronger structural liquidity and capital buffers on the likelihood of bank failure are not large. On the other hand, there is evidence of substantial threshold effects, and the benefits of stronger buffers appear substantial for the banks located at the lower extremes of the distributions. In addition, we find systematic differences in the relative importance of liquidity and leverage for financial fragility across groups of banks. Global banks were more susceptible to failure on excessive leverage, while Domestic banks were more susceptible to failure on weak structural liquidity (i.e., excessive liquidity transformation) and overreliance on short-term wholesale funding. 

In the estimations, we include bank-level controls for pre-crisis risk taking, and for countryspecific macroeconomic conditions (i.e., common to all banks incorporated in a given country). The use of controls for pre-crisis risk-taking is critical to this study. To the extent that banks perform active risk management, higher risk-taking would tend to be associated with stronger liquidity and capital buffers, introducing a bias to the results. In fact, we find that banks engaging in more aggressive risk taking in the run-up to the crisis—as measured by the rate of growth of their credit portfolios and by their pre-crisis distance to default— were more likely to fail afterward. Macroeconomic conditions in the pre-crisis period are also found to affect bank probabilities of default, suggesting that banks may have failed to internalize risks stemming from overheated economic activity and exuberant asset prices.

All in all, these results provide support to the proposed regulations on liquidity and capital, as well as to the introduction of a macro-prudential approach to bank regulation. From the financial stability perspective, however, the evidence indicates that regulations on capital— particularly for the larger banking groups—are likely to be more relevant.

Concluding remarks

Overall, the findings of this paper provide broad support to Basel III initiatives on structural liquidity and leverage, and show the complementary nature of these two areas. Banks with weaker structural liquidity and higher leverage before the global financial crisis were more vulnerable to subsequent failure. The results are driven by banks in the lower extremes of the distributions, suggesting the presence of threshold effects. In fact, the marginal stability gains associated with stronger liquidity and capital cushions do not appear to be large for the average bank, but seem substantial for the weaker institutions.

At the same time, there is evidence of systematic differences across bank types. The smaller banks were more susceptible to failure on liquidity problems, while the large cross-border banking groups typically failed on insufficient capital buffers. This difference is crucial from the financial stability perspective, and implies that regulatory and supervisory emphasis should be placed on ensuring that the capital buffers of the systemically important banks are commensurate with their risk-taking.

The evidence also indicates that bank risk-taking in the run-up to the crisis was associated with increased financial vulnerability, suggesting that bank decisions regarding the associated liquidity and capital buffers were not commensurate with the underlying risks, resulting in excessive hazard to their business continuity. Country-specific macroeconomic conditions also played a role in the likelihood of subsequent bank failure, implying that banks failed to properly internalize the associated risks in their individual decision-making processes. Thus, while more intrusive regulations entail efficiency costs, the results point to associated gains in terms of financial stability that have to be pondered. This also supports the introduction of a macro-prudential framework as a complement to traditional, microprudential approach. In this regard, further work is needed to deepen the understanding of the role of the macroeconomic environment on financial stability.