George G. Kaufman

Bank contagion: A review of the theory and evidence

Contagion is a term used to describe the spillover of the effects of shocks from one or more firms to others, l It is widely considered to be both more likely to occur in banking than in other industries and to be more serious when it does occur. Bank (depository institution) contagion is of particular concern if adverse shocks, such as the failure or near-failure of one or more banks, are transmitted in domino fashion not only to other banks and the banking system as a whole, but beyond to the entire financial system and the macroeconomy. The risk of widespread failure contagion is often referred to as systemic risk. The potentially damaging aspects of bank failure contagion were among the major factors that led Gerald Corrigan, Former President of the Federal Reserve Bank of New York, among others, to conclude that banks and banking are unique and require government regulation (Corrigan, 1982, p. 9; Corrigan, 1987, p. 5; Corrigan, 1991-92, pp. 1-5). He argued that:

The Appropriate Role of Bank Regulation

The appropriate role of bank regulation, or whether banks should be regulated at all, has long been a matter of controversy. Banks are the oldest and largest financial institution. Their liabilities serve as money, which distinguishes them from non-financial firms, for which government regulation is generally less pervasive and more limited. We believe that most of the arguments that are frequently used to support special regulation for banks are not supported by either theory or empirical evidence. We also argue that banks should be regulated prudentially only to reduce the negative externalities resulting from government-imposed deposit insurance. Banks are believed to be inherently unstable because they are structurally fragile. The perceived fragility stems from their maintaining low ratios of cash reserves to assets (fractional reserves) and capital to assets (high leverage) relative to their high short-term debt. But such fragility does not imply instability if depositors and bankers are aware of it and act appropriately. This appears to have been the case in most countries. In the United States, the bank failure rate was lower than that for non-banks from I 865 until the establishment in I9I3 of the Federal Reserve System. This occurred despite restrictions that prevented banks from diversifying geographically through branching. Ironically, the failure rate increased only after the establishment of a central bank that was intended to reduce the severity of bank crises. Before the United States had a central bank, banks themselves established private clearing houses, resembling the private central banks in other countries, to provide both prudential supervision and prevent abrupt local declines in the assets that served as bank reserves and money. Nevertheless, we take as given not only a government central bank, but also government-operated deposit insurance. Thus, we do not disagree greatly with Dowds defence of free or laissez faire banking, but focus instead on how banks should be regulated in an existing non-laissez faire structure to achieve the best of both worlds.

Bank Capital Ratios Across Countries: Why Do They Vary?

This paper extends the literature on bank capital structure by modeling capital structure as a function of important public policy and bank regulatory characteristics of the home country, as well as of bank specific variables, country macro-economic conditions and country level financial characteristics. The model is estimated with annual data for an unbalanced panel of the 78 largest private banks in the world headquartered in 12 industrial countries over the period between 1992 and 2005. The results indicate that bank capital ratios are significantly affected in the hypothesized directions by most of the bank-specific variables. Several of the country characteristic and policy variables are also significant with the predicted sign: banks maintain higher capital ratios in home countries in which the bank sector is relatively smaller and in countries that practice prompt corrective actions more actively, have more stringent capital requirements, and have more effective corporate governance structures.

BANKING AND CURRENCY CRISES AND SYSTEMIC RISK: A TAXONOMY AND REVIEW

Many countries have experienced banking and currency crises in recent years. Although these crises appear to share many common causes and consequences, they have generally been analysed by different sets of economists. This paper develops a common framework, applies this framework to analysing recent crises, evaluates the historical evidence, and suggests potential solutions. Governments are identified as one of the major causes of the crises through first providing poorly structured financial guarantees that both increase fragility and misallocate resources, then pursuing unstable macroeconomic policies that produce losses, and finally attempting to conceal the problems as long as possible before being forced to take corrective actions that, at least in the short run, often exacerbate the costs before restoring equilibrium.

Is the banking and payments system fragile

In his introduction to The Risk of Economic Crisis, a compilation of papers presented at a conference sponsored by the National Bureau of Economic Research (NBER), Martin Feldstein (1991, p. 1) recognizes that, despite the inability of less developed countries to service their debts, the massive collapse of savings and loan associations in the United States, wide swings in currency exchange rates, the increase in corporate and personal debt, and the stock market crash of 1987, we have not suffered an economic crisis in recent years. Nevertheless, he asserts: But the risk of such an economic collapse remains. As Charles Kindleberger’s distinguished and fascinating book (Manias, Panics and Crashes: A History of Financial Crises [Basic Books,19781) has ably demonstrated, economic crises have been with us as long as the market economy. At some point, greed overcomes fear and individual investors take greater risks in the pursuit of greater returns. A shock occurs and the market prices of assets begin to collapse. Bankruptcies of leveraged individuals and institutions follow. Banks and other financial institutions fail in these circumstances because they are inherently leveraged. The resulting failure of the payments mechanism and the inability to create credit bring on an economic collapse (Feldstein, 1991, pp. 1–2).

Derivatives and Systemic Risk: Netting, Collateral, and Closeout

In the U.S., as in most countries with well-developed securities markets, derivative securities enjoy special protections under insolvency resolution laws. Most creditors are “stayed” from enforcing their rights while a firm is in bankruptcy. However, many derivatives contracts are exempt from these stays. Furthermore, derivatives enjoy netting and close-out, or termination, privileges which are not always available to most other creditors. The primary argument used to motivate passage of legislation granting these extraordinary protections is that derivatives markets are a major source of systemic risk in financial markets and that netting and close- out reduce this risk. ; To date, these assertions have not been subjected to rigorous economic scrutiny. This paper critically reexamines this hypothesis. These relationships are more complex than often perceived. We conclude that it is not clear whether netting, collateral, and/or close-out lead to reduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.

Bank Market Structure and Performance: The Evidence from Iowa

This paper examines the relationship between bank market structure and performance in Iowa. Iowa was chosen for two reasons. First, pertinent performance data were available for almost all banks in the state. Second, Iowa law prohibits full service branch banking.1 Difficulties inherent in separating data relating to performance and market structure for individual offices from those for a branch system as a whole are thereby avoided.

Does the Japanese Stock Market Price Bank-Risk? Evidence from Financial Firm Failures

The ability of the Japanese stock market to appropriately price the riskiness of Japanese financial firms has been frequently questioned, particularly in light of Japan’s widespread financial distress in recent years and poor disclosure requirements. This paper examines the response in equity returns of Japanese banks to the failure of four commercial banks and two securities firms between 1995 and 1998. Using event study methodology, the analysis finds that share prices of surviving banks on the whole responded unfavorably to the failures and that financially weaker survivors were more adversely affected. This suggests that, despite the distress and alleged opaqueness, bank shareholders were able to use available indicators of financial condition both to incorporate new information quickly into stock prices and to differentiate among banks.

Post-Resolution Treatment of Depositors at Failed Banks: Implications for the Severity of Banking Crises, Systemic Risk, and Too-Big-To-Fail

Losses from bank failures have significant adverse implications for bank stakeholders, as well as for the macroeconomy. This article examines the potential sources of such losses, in particular the losses that may occur after the date a bank is failed, and makes recommendations on how to minimize these losses.

The Intellectual History of the Federal Deposit Insurance Corporation Improvement Act of 1991

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed by Congress in November 1991 and signed by President George Bush in December. The act promises to be the most important banking legislation since the Banking Act of 1933. Yet it is also one of most misunderstood and controversial laws enacted in recent years. As is true for much legislation, the act is long, sweeping in coverage, and complex. It may be divided into five major parts: (1) deposit insurance reform to correct the previous perverse incentive structure, (2) recapitalization of the FDIC, (3) consumer and related regulations, (4) supervision of domestic offices of foreign banks, and (5) “bank bashing.” In this chapter we trace the intellectual history of the underpinnings of only the deposit insurance reform provisions of the act, which may be classified under the heading structured early intervention and resolution (SEIR). These provisions are significantly different from most deposit insurance reform proposals suggested at the time the act was being considered. Because they are not as well understood as most of the other proposals, which have been circulating longer, and shall affect banking for years to come, it is useful to trace their history to determine, why and how they might be expected to work.1