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Showing papers in "Federal Reserve Bank of New York Economic policy review in 2016"


Posted Content
TL;DR: In this article, Mehran and Mollineaux find that while credible public information about individual banks can enhance the ability of regulators and market participants to monitor and exert discipline on banks' behavior, there are also endogenous costs associated with transparency that can be detrimental to the banking system.
Abstract: 1.INTRODUCTIONBank transparency can be defined as the availability to outside stakeholders of relevant, reliable information about the periodic performance, financial position, business model, governance, and risks of banks. Outside stakeholders include depositors, investors, borrowers, counterparties, regulators, policymakers, and competitors. Transparency is the joint output of a multifaceted system whose component parts collectively produce, gather, and validate information and disseminate that information to participants outside the bank. Components include mandated, publicly available accounting information; information intermediaries such as financial analysts, credit rating agencies, and the media; and supervisory disclosures (including stress-test disclosures), banks' voluntary disclosures, and information transmitted by securities prices (Bushman and Smith 2003; Bushman, Piotroski, and Smith 2004). While access to information is a necessary condition for transparency, transparency also relies on the active efforts of information receivers, as dictated by their incentives to gather, interpret, and incorporate available information into decision-making processes (see, for example, Freixas and Laux [2012]; Mehran and Mollineaux [2012]).1An important unresolved issue is the extent to which bank transparency promotes or undermines bank stability. A large theory literature explores bank transparency and how it affects the risk profile of individual banks and the financial system as a whole. Overall, this literature finds that while credible public information about individual banks can enhance the ability of regulators and market participants to monitor and exert discipline on banks' behavior, there are also endogenous costs associated with transparency that can be detrimental to the banking system.Consider the positive effects of transparency. Transparency plays a fundamental corporate governance role in all industries, supporting monitoring by boards of directors, outside investors, and regulators, as well as the exercise of investor rights granted by existing laws. Credible, publicly available information is used to assess and reward the actions and performance of top executives and is incorporated into the design of incentive compensation contracts and decisions about when to fire executives (Bushman and Smith 2001; Armstrong, Guay, and Weber 2010). For banks, however, the role of information transcends the classic governance objective of aligning the behavior of executives with the interests of shareholders. Banks face distinctive governance challenges because they must balance the demands of being value-maximizing entities with those of serving the public interest (Mehran and Mollineaux 2012; Mehran, Morrison, and Shapiro 2011). High leverage combined with subsidized deposit insurance, government guarantees, and bank opacity creates motives and opportunities for risk taking that can be optimal from the point of view of shareholders, given limited liability, but not from that of the economy as a whole if it raises systemic risk through an increased probability of failure.2For example, Anginer et al. (2014) find that for an international sample of banks, shareholder-friendly corporate governance is positively associated with bank insolvency risk and, consistent with increased risk taking, is also associated with a higher valuation of the implicit insurance provided by the financial safety net. Also consistent with a conflict between firm-level governance and bank stability concerns are the findings of Fahlenbrach and Stulz (2011) that during the financial crisis of 2007-08, the price performance of bank shares was worse for banks in which the CEO's incentives were better aligned with shareholders' interests ex ante.The banking literature suggests that, in addition to supporting corporate governance mechanisms, transparency can promote bank stability by enhancing the market discipline of banks' risk-taking decisions (see, for example, Rochet [1992]; Blum [2002]; Cordella and Yeyati [1998]). …

24 citations


Posted Content
TL;DR: In this article, the authors provide a framework to understand the role, the organization, and the limitations of risk management in banks when it is designed from the perspective of increasing the value of the bank for shareholders.
Abstract: 1. INTRODUCTION The Oxford Dictionary defines risk as a situation that involves exposure to danger. It also states that the word comes from the Italian word risco, which means danger. I call risks that are only danger bad risks. Banks--and any firm for that matter--also have opportunities to take risks that have an ex ante reward on a standalone basis. I call such risks good risks. (1) One might be tempted to conclude that good risk management reduces the exposure to danger. However, such a view of risk management ignores the fact that banks cannot succeed without taking risks that are ex ante profitable. Consequently taking actions that reduce risk can be costly for shareholders when lower risk means avoiding valuable investments and activities that have higher risk. Therefore, from the perspective of shareholders, better risk management cannot mean risk management that is more effective at reducing risk in general because reducing risk in general would mean not taking valuable projects. If good risk management does not mean low risk, then what does it mean? How is it implemented? What are its limitations? What can be done to make it more effective? In this article, I provide a framework to understand the role, the organization, and the limitations of risk management in banks when it is designed from the perspective of increasing the value of the bank for shareholders. In corporate finance, the well-known Modigliani-Miller theorem of leverage irrelevance implies that the value of a firm does not depend on its leverage. For the theorem to hold, markets have to be frictionless, so there cannot be transaction costs of any kind. As has been stressed by modern banking research, there is no reason for banks to exist if the conditions of the Modigliani-Miller theorem hold. With the Modigliani-Miller theorem, a bank has the same value whether it is mostly financed by debt or mostly financed by equity. Hence, the value of a bank is the same irrespective of its risk of default or distress. It follows that if the conditions for the Modigliani-Miller theorem apply, a bank has no reason to manage its risk of default or its risk of financial distress (see, for example, Stulz [2003]). When the Modigliani-Miller theorem does not apply, the most compelling argument for managing risk is that adverse outcomes can lead to financial distress and financial distress is costly (Smith and Stulz 1985). When a firm is distressed, it loses its ability to implement its strategy effectively and finds it more difficult and expensive to conduct its business. As a result, the value of a firm's equity is reduced by the present value of future costs of financial distress. When a firm manages risk so that it reduces the present value of these future costs of distress by more than the cost of reducing risk, firm value increases. Banks differ from firms in general because they create value for shareholders through their liabilities as part of their business model. Banks produce liquid claims and the value of a bank depends on its success at producing such claims. For instance, the value of a bank depends on its deposit franchise. A bank's ability to issue claims that are valued because of their liquidity depends on its risk, so that risk management is intrinsic to the business model of banks in a way that it is not for nonfinancial firms (DeAngelo and Stulz 2015). Since an increase in risk can enable a bank to invest in assets and projects that are valuable but can also lead to a loss in value because of an adverse impact on the bank's risk of financial distress and its ability to create value through liabilities, there is an optimal amount of risk for a bank from the perspective of its shareholders. A well-governed bank will have processes in place to identify this optimal amount of risk and make sure that its actual risk does not differ too much from this optimal amount. Theoretically, the bank's problem is simple: it should take any project that increases its value, taking into account the costs associated with the impact of the project on the banks total risk. …

20 citations


Posted Content
TL;DR: In the context of finance, culture can be a very complex issue as it involves behaviours and attitudes as discussed by the authors. But efforts should be made by financial institutions and by supervisors to understand an institution's culture and how it affects safety and soundness.
Abstract: 1. INTRODUCTION Culture can be a very complex issue as it involves behaviours and attitudes. But efforts should be made by financial institutions and by supervisors to understand an institution's culture and how it affects safety and soundness. While various definitions of culture exist, supervisors are focusing on the institution's norms, attitudes, and behaviours related to risk awareness, risk taking, and risk management or the institution's risk culture. (Financial Stability Board 2014) The issue of corporate culture in banking has surfaced in recent discussions as a topic of pivotal significance for addressing two concerns: restoring public trust in the banking system and enhancing financial stability. (1) With more than $100 billion in fines imposed on the largest financial institutions since the financial crisis, there is now a growing suspicion that ethical lapses in banking are not just the outcome of a few "bad apples"--such as rogue traders--but rather a reflection of systematic weaknesses. The lack of confidence in banking engendered by such mistrust may invite more intrusive regulation, which could reduce risk but may also restrict lending. Given how essential banks are for economic growth and their complementarity with financial markets for channeling capital from savers to investors, this issue is of broad economic interest. (2) In this dialogue, considerable attention has been paid to executive compensation in banking, with the prevailing view being that improperly structured pay was one of the culprits in the recent financial crisis (see, for example, Curry [2014]). This issue was addressed in the Dodd-Frank Act, which requires regulatory agencies to implement appropriate incentive-based compensation rules covering institutions with assets of $1 billion or more. The Office of the Comptroller of the Currency, for example, published a proposed rule in 2011 that is based on three principles: (1) incentive-based compensation should balance risk and reward, and should include deferred compensation and other mechanisms to reduce the sensitivity of compensation to short-term results; (2) compensation plans should be compatible with effective controls and risk management; and (3) incentive-based compensation should be supported by strong corporate governance. Focus on compensation is a useful first step. But as important as pay is for driving employee behavior, it is but one piece of the puzzle, and excessive reliance on compensation may actually distract attention from other important determinants of the decisions banks make. I am heartened by the growing recognition of bank regulators in the United States and Europe that organizational culture in banking is a crucially important factor in generating positive observable outcomes in banking. Culture not only determines the efficacy of compensation in influencing employee behavior, but it can also induce employees to work in a manner consistent with the stated values of the organization, particularly when achieving this outcome via formal contracts may be either costly--owing to bargaining, asymmetric information, and imperfect state observability--or infeasible (see Kreps [1990] and Song and Thakor [2016]). Cultural difference means that the same incentive-based compensation scheme can produce different behavioral outcomes in two banks. It is easy to see, however, why culture has not been a big part of banking regulation. Variables like capital ratios and compensation are tangible and visible, so it is easy to target them in the formulation of regulations. Culture, by contrast, is a nebulous concept that often means different things to different people. Because it is fuzzy, culture tends to be overlooked. Moreover, we have a vast body of research on capital requirements and incentive-based compensation, but precious little on culture, at least in economics. This omission too adds to the reasons why culture has received relatively scant attention until recently in regulatory discourse. …

16 citations


Posted Content
TL;DR: A review of the recent corporate governance literature that examines the role of financial reporting in resolving agency conflicts among a firm's managers, directors, and capital providers can be found in this article.
Abstract: 1. INTRODUCTION We review the recent corporate governance literature that examines the role of financial reporting in resolving agency conflicts among a firm's managers, directors, and capital providers. We view governance as the set of contracts that help align managers' interests with those of shareholders, and we focus on the central role of information asymmetry in agency conflicts between these parties. In terms of the firm-specific information hierarchy, the literature typically views management as the most informed, followed by outside directors, then shareholders. We discuss research that examines the role of financial reporting in alleviating these information asymmetries and the role that financial reporting plays in the design and structure of incentive and monitoring mechanisms to improve the credibility and transparency of information. Most of this research is large-sample and does not pay particular attention to industry-specific characteristics that may influence a firm's governance structure. For example, the firm-specific governance structure and financial reporting systems of financial institutions and other regulated industries are expected to be endogenously designed. The design is also expected to be conditional on (in other words, take into account) the existence of certain external monitoring mechanisms (for example, regulatory oversight and constraints), which may either substitute for or complement internal mechanisms, such as the board. Similarly, the rationale for regulation in certain industries (for example, the existence of natural monopolies) is also expected to influence firms' governance structures. These and other differences between firms in different industries suggest that inferences drawn from studies spanning multiple industries may not necessarily hold for specific industries or research settings. (2) The same point can also be made about extrapolating inferences drawn from U.S. firms to their international counterparts. Different countries have their own (often unique) laws, regulations, and institutions that influence the design, operation, and efficacy of a firm's governance mechanisms as well as the output of its financial reporting system. We also highlight the distinction between formal and informal contracting relationships, and discuss how both play an important role in shaping a firm's overall governance structure and information environment. Formal contracts, such as written employment agreements, are often quite narrow in scope and are typically relatively straightforward to analyze. Informal contracts, govern implicit multiperiod relationships that allow contracting parties to engage in a broad set of activities for which a formal contract is either impractical or infeasible. For example, the complexity of the responsibilities and obligations of a firm's chief executive officer make it difficult to draft a complete state-contingent contract with the board that specifies appropriate actions under every possible scenario the firm could face. Consequently, although some CEOs have formal employment contracts, these contracts are necessarily incomplete and relatively narrow in scope. As a result, the board and the CEO develop informal rules and understandings that guide their behavior over time. Much of the governance literature emphasizes informal contracting based on signaling, reputation, and certain incentive structures. The general conclusion in this literature is that financial reporting is valuable because contracts can be more efficient when the parties commit themselves to a more transparent information environment. Another key theme of this article is that a firm's governance structure and its information environment evolve together over time to resolve agency conflicts. That is, certain governance mechanisms and financial reporting attributes work more efficiently within certain operating environments. Consequently, one should not necessarily expect to see every firm converge to a single dominant type of corporate governance structure or compensation contract, or to adopt a similar financial reporting system. …

9 citations


Journal Article
TL;DR: In this paper, a new paradigm for bank corporate governance in the post-crisis era was proposed, which would mandate a higher level of competence for bank directors, consistent with the greater knowledge required to understand and to oversee today's more complex financial institutions.
Abstract: 1. INTRODUCTION Legislation and regulation, particularly laws and regulations related to corporate finance and financial markets, tend to follow crisis. The myriad corporate scandals in the previous decade led to a heightened awareness of the role played by corporate governance, so it is hardly surprising that corporate governance has been the focus of regulation for some time now. In the wake of Enron, Tyco, and other high-profile failures, the Sarbanes-Oxley Act of 2002 focused on the internal controls of firms and the risks that poor governance imposed on the market. In the aftermath of the recent financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act unleashed a plethora of changes for markets that involved restrictions on what banks can do, who can regulate them, and how they should be liquidated, as well as mortgage and insurance reform and consumer protection initiatives. Surprisingly, the duties required of bank directors per se were not a focus of specific attention in either act. We believe the role that bank corporate governance issues played in the financial crisis is not inconsequential and that, as suggested by the recent JP Morgan Chase London Whale fiasco, these bank corporate governance issues pose an ongoing risk to the financial markets. Hence, bank corporate governance in the post-crisis era warrants careful review. That governance problems can arise in banks is well understood (Levine 2004; Bebchuk and Spamann 2010; de Haan and Vlahu 2013; Adams and Mehran 2008, revised 2011; Calomiris and Carlson 2014). What may not be appreciated, however, is the degree to which the unique features of banking complicate both the role of the board and its governance effectiveness. In an earlier paper (Macey and O'Hara 2003), we reviewed the different models of corporate governance, with a particular focus on the duties that board members owe to different constituencies. We argued that these unique features of banks dictated a heightened "duty of care" for bank directors. (1) We discussed the various legal cases defining the duty of care for directors, and how the courts have vacillated in their application of these duties owed by directors. Since then, a lot has changed with respect to banking structure and practice, but little has changed with respect to the duties and obligations of bank directors. This inertia with respect to bank directors is all the more puzzling given that Dodd-Frank explicitly addressed the externalities imposed by individual banks on the financial system yet imposed no additional requirements on bank directors to make them responsible for limiting such risks. (2) In this article, we propose a new paradigm for bank corporate governance in the post-crisis world. We argue that bank directors should face heightened requirements owing to the increased risk that individual banks pose for the financial system. Our thesis is that the greater complexity and opacity of banks, and the increased challenges in monitoring these complex institutions, require greater expertise on the part of bank directors. We propose new "banking expert" and "banking literacy" requirements for bank directors akin to the "financial expert" requirements imposed on audit committees by Sarbanes-Oxley As we argue, these requirements would mandate a higher level of competence for bank directors, consistent with the greater knowledge required to understand and to oversee today's more complex financial institutions. It has been argued that large, complex financial institutions are now simply too large to govern--that "too big to fail" is "too big to exist." This may be true, but before we throw in the towel on the corporate form of bank organization in favor of some regulator-based form of control, we think it makes sense to try to craft a more relevant corporate governance standard for banks. Similarly, it has been argued that mendacity is to blame for the myriad scandals in banking--that bank management, and presumably bank directors, are somehow not sufficiently motivated to "do the right thing. …

9 citations


Posted Content
TL;DR: In this paper, the authors argue that deferred cash is likely to reduce the free-rider problem because, unlike stock or stock options, deferred cash has no upside potential to gain in value.
Abstract: 1. INTRODUCTION Employee compensation packages at large financial firms have recently been the focus of great concern, in particular because of their possible role in the 2007-09 financial crisis. (1) Especially worrisome is that, while these pay structures are crafted to create shareholder value by rewarding employees for taking risks that increase the value of the firm, they often (perhaps unintentionally) lack robust risk management features. Consequently, the prevailing pay structure before the financial crisis may have created risks to financial stability and, in the downturn, imposed costs on other stakeholders, including taxpayers and creditors. (2) As a result, at no time in recent memory has the balance of risk and return in employee decision making been under greater scrutiny. A prosperous and healthy banking sector is essential to the growth of the U.S. economy. The health of the banking sector, in turn, rests on a competitive and fluid labor market, especially in the major financial centers. To ensure a competitive market, banks reward employees for their contribution to value creation. In banking, value creation entails risk taking. The costs of poor business decisions in banking are not fully internalized by the employee taking the risk, by the employees trading desk, or by the firm and its owners and creditors; poor business decisions also inflict costs on other stakeholders. This outcome holds whether decision makers act morally and judiciously or, alternatively, engage in fraud and abuse. The effect, however, is likely to be larger in the latter case, owing in part to the obfuscation of critical information that often accompanies fraudulent activities. (3) Therefore, early detection of the problem may be more difficult in these instances, and the longer the delay in detection, the larger the associated destruction of value and the higher the social costs. (4) The key issue, then, is how to design incentive schemes to motivate bank employees to increase the value of the firm and, at the same time, ensure that the employee and the firm also serve the broader public interest. A successful approach to designing these incentive schemes could take many forms. In this article, we focus on one such form: incentives based on employee compensation. In our framework, employee compensation is designed, first, to encourage a conservative approach to risk (which we refer to here as "conservatism") that better aligns the interests of bank employees with those of creditors and the public while still preserving incentives for creating value. Specifically, we explore incentive features associated with performance bonds--funded through the withholding of some portion of bank employees' compensation--and their prudential application in promoting financial stability. We argue that such a deferred cash program is likely to induce conservatism because it better internalizes the costs associated with risk taking. In this way, deferred cash complements both the bank's internal risk management and public enforcement. Further, we argue that deferred cash is likely to reduce the free-rider problem because, unlike stock or stock options, deferred cash has no upside potential to gain in value. This effect will, in turn, improve internal monitoring in cases of fraud, abuse, or excessive risk taking because such actions by one or more employees will now potentially have an adverse effect on the welfare of other employees. If a culture of internal information production and sharing exists within the firm, then internal monitoring is akin to a risk control scheme. Therefore, a second motivation for implementing a judicious deferred pay policy is that it is likely to make the firm less risky by promoting information production and sharing. Third, we argue that aggregation of deferred pay for material risk takers, over many years, can build a liquidity buffer that could be used to help cover any unexpected capital or liquidity shortfall in the event the firm comes under stress. …

7 citations


Posted Content
TL;DR: For example, Baumann et al. as mentioned in this paper found that the disclosure of more information is associated with higher risk-adjusted trading returns and higher risk adjusted market returns for the bank overall.
Abstract: 1.IntroductionMarket discipline has occupied an increasingly prominent position in discussions of the banking industry in recent years. Market discipline is the idea that the actions of shareholders, creditors, and counterparties of banking companies can influence the investment, operational, and risk-taking decisions of bank managers (Flannery 2001; Bliss and Flannery 2002). Bank supervisors have embraced market discipline as a complement to supervisory and regulatory tools for monitoring risk at individual banks and for limiting systemic risk in the banking system. For instance, the Basel Committee on Banking Supervision says "the provision of meaningful information about common risk metrics to market participants is a fundamental tenet of a sound banking system. It reduces information asymmetry and helps promote comparability of banks' risk profiles" (Basel Committee on Banking Supervision 2015).1For market discipline to be effective, market participants must have sufficient information to assess the current condition and future prospects of banking companies. This fact has prompted a range of proposals for enhanced public disclosure by banks. Many of these proposals have focused on disclosure of forward-looking risk information, such as value at risk (VaR) for trading portfolios or model-based estimates of credit risk exposure. In the words of a major international supervisory group, disclosure of VaR and other forward-looking risk measures is a means of providing "a more meaningful picture of the extent and nature of the financial risks a firm incurs, and of the efficacy of the firm's risk management practices" (Multidisciplinary Working Group on Enhanced Disclosure 2001).But to what extent does such information result in meaningful market discipline? Is risk taking or performance affected by the amount of information banks provide about their risk exposures and risk management systems? This article explores these questions by examining whether the amount of information disclosed by a sample of large U.S. bank holding companies (BHCs) affects the future risk-adjusted performance of those banking firms. We focus, in particular, on disclosures made in the banks' annual reports about market risk in their trading activities. Following previous work on disclosure (Baumann and Nier 2004; Nier and Baumann 2006; Perignon and Smith 2010; Zer 2014), we construct a market risk disclosure index and ask how differences in this index affect future performance. Drawing on data from the banking companies' regulatory reports, we examine each BHC's returns from trading activities and, using equity market data, we examine returns for the firm as a whole.The main finding of this analysis is that the disclosure of more information is associated with higher risk-adjusted trading returns and higher risk-adjusted market returns for the bank overall. This result is strongest for BHCs whose trading represents a large share of overall firm activity. The results are both statistically significant and economically meaningful, with a one standard deviation increase in the disclosure index leading to a 0.35 to 0.60 standard deviation increase in risk-adjusted returns. The positive relationship between disclosure and risk-adjusted performance is much less evident during the financial crisis period, however, suggesting that the findings reflect business-as-usual behavior. Finally, while higher values of the disclosure index are associated with better future performance, being a leader or innovator in disclosure practices seems to be associated with lower risk-adjusted market returns. This finding suggests that there may be a learning process in the market such that disclosure "first movers"-those banks that provide new types of information-face a market penalty.Overall, the results suggest that increased disclosure may be associated with more efficient trading and an enhanced overall risk-return trade-off. These findings seem consistent with the view that market discipline affects not just the amount of risk a BHC takes, but how efficiently it takes that risk. …

2 citations


Posted Content
TL;DR: In this article, the authors propose to use cash compensation in banks as a contingent asset of the banks and derive a lower bound on the amount of cash that banks should hold to help reduce the risk of systemic crises.
Abstract: 1. INTRODUCTION Executive pay in banks and the possible incentives it provides for excessive risk taking have been the focus of considerable attention in the wake of the financial crisis. A particular concern is that traditionally compensation has been designed to align management's interests with those of equity holders but not those of creditors or other stakeholders such as taxpayers. From a regulatory perspective, the challenge is to modify compensation design in a way that continues to encourage value creation even as it discourages excessive risk taking that could lead to bank failures. In this article, we offer a simple set of guidelines for this purpose. Our approach, which relies on the use of cash rather than debt or equity as compensation, offers a framework for thinking about the role of cash in a bank's capital structure and for identifying a lower bound on the amount of cash that banks should be required to hold to help reduce the risk of systemic crises. The simplicity and transparency of a cash requirement--as well as the ease with which such a requirement could be made operational--are key. Our objective is to draw on the various properties of cash as part of a bank's assets to furnish us with a benchmark level of cash holdings that is optimal from a regulatory standpoint. Distilled to its basics, our approach is to use cash compensation in banks as a contingent asset of the banks. We propose that incentive compensation in banks involve a substantial cash component; that this component be deferred and placed in an escrow account with a vesting schedule; and that ownership of the account revert to the bank in "stressed" times (subject to creditors' forfeitures), allowing the bank to access this cash to pay down its debt or otherwise bolster its assets. Importantly we do not pin down the absolute size of cash holdings but determine this sum in relation to the bank's equity levels and other parameters; inter alia, as the equity cushion decreases, our proposed cash holding requirement increases. As an alternative to holding more cash, banks can choose to deleverage to bring down the minimum required cash holdings. For "typical" numbers for U.S. banks, we find a cash requirement of around 18 to 25 percent of equity value. However, empirical analysis suggests that the numbers are highly variable depending on the actual asset mix used by a bank at a given point in time; for instance, looking at the years immediately preceding the crisis, we find that cash requirements for many U.S. financial institutions (including those like Fannie Mae and Freddie Mac that would later fail) often exceeded 50 to 60 percent even by late 2006 and early 2007. (1) There is an important, if obvious, caveat to our proposal. Since our analysis focuses on avoiding bank failures in stressed times, the cash holdings we derive will necessarily be more than those required in "normal" times. We regard this as the natural cost of a strategy that aims to reduce the costs of financial system disruption stemming from bank failures. Our proposal is outlined in Section 2; a discussion of its empirical properties follows in Section 3. Section 4 examines the use of deferred cash in compensation and its role in promoting financial stability relative to that of other instruments, such as inside debt, deferred equity, and contingent capital. The model underlying the proposal is presented in Section 5. 2. THE PROPOSAL In Section 5 we derive our minimum cash holding rule in a simple model. We find that a bank's minimum cash C holding must satisfy (1) C [greater than or equal to] (1 - q)D - qE(1 - MES), or, equivalently, that (2) [C/E] [greater than or equal to] (1 - q) [D/E] - q(l - MES), where D is the amount of the banks debt, 1 - q is the potential loss in asset value that would result from a liquidation in stressed times, E is the equilibrium value of the bank's equity (assuming implementation of our proposal), and MES is the marginal expected shortfall of bank equity conditional on the banks being stressed at the time. …

1 citations