Showing papers in "Journal of Banking and Finance in 1995"

The role of capital in financial institutions

Abstract: This introductory article examines the role of capital in financial institutions — why it is important, how market-generated capital ‘requiremenents’ differ from regulatory requirments and the form that regulatory requirements should take. Along the way, we examine historical trends in bank capital, problems in measuring capital, and some possible unintended consequences of capital requirements. Within this framework, we evaluate how the contributions to this special issue advance the literature and suggest topics for future research.

Bank regulation and the credit crunch

Abstract: This study investigates the direct link between regulatory enforcement actions and the shrinkage of bank loans to sectors likely to be bank dependent. We partition the shrinkage due to loan supply into the component due to explicit regulatory enforcement actions and that due to a voluntary response by bank management to low capital-to-asset ratios. We find that banks with formal actions shrink at a significantly faster rate than those without, even after controlling for differences in capital-to-asset ratios. Furthermore, much of the reduced lending has been in categories containing primarily loans to bank-dependent borrowers.

Fair value accounting: Effects on banks' earnings volatility, regulatory capital, and value of contractual cash flows

Abstract: We investigate fair value accounting critics' assertions by restating earnings and regulatory capital to reflect banks' disclosed investment securities fair values. We find: (1) Fair value-based earnings are more volatile than historical cost earnings, but share prices do not reflect the incremental volatility. (2) Banks violate regulatory capital requirements more frequently under under fair value than historical cost accounting. Fair value-based violations help predict regulatory capital violations, but share prices do not reflect this potential increased regulatory risk. Only historical cost violations are market information events. (3) Share prices reflect interest rates changes, even though investment securities' contractual cash flows are fixed.

The impact of default risk on the prices of options and other derivative securities

Abstract: This paper presents a model for valuing derivative securities when there is default risk. The holder of a security is assumed to recover a proportion of its no-default value in the event of a default by the counterparty. Both the probability of default and the size of the proportional recovery are random. The paper shows how data on bonds issued by the counterparty can be used to provide information about model parameters.

Futures trading, information and spot price volatility: evidence for the FTSE-100 stock index futures contract using GARCH

Abstract: This paper examines the impact of trading in the FTSE-100 Stock Index Futures on the volatility of the underlying spot market. To examine the relationship between information and volatility (as subject neglected in previous studies) the GARCH family of techniques is used. The results suggest that futures trading has led to increased volatility, but that the nature of volatility has not changed post-futures. The finding of price changes being integrated pre-futures, but being stationary post-futures, implies that the introduction of futures has improved the speed and quality of information flowing to the spot market.

Separating the likelihood and timing of bank failure

Abstract: We use a split-population survival-time model to separate the determinants of bank failure from the factors influencing the survival time of failing banks. Basic indicators of a bank's condition, such as capital, troubled assets, and net income, are important in explaining the timing of bank failure. However, many of the other variables typically included in bank failure models, such as measures of bank liquidity, are not associated with the time to failure. The results also suggest that the closure of large banks is not delayed relative to the closure of small banks.

Financial innovation and the management and regulation of financial institutions

Abstract: New security designs, improvements in computer and telecommunications technology and advances in the theory of finance have led to revolutionary changes in the structure of financial markets and institutions. This paper provides a functional perspective on the dynamics of institutional change and uses a series of examples to illustrate the breadth and depth of institutional change that is likely to occur. These examples emphasize the role of hedging versus equity capital in managing risk, the need for risk accounting and changes in methods for implementing both regulatory and stabilization public policy.

Bank capital shocks: Dynamic effects on securities, loans, and capital

Abstract: We used quarterly data for individual banks to estimate recent dynamic responses to bank capital shocks. While it took bank capital and securities only one year to adjust to capital shocks, liabilities and most loan categories took two to three years to complete their adjustments. Compared with those in the late 1980s, capital shocks were twice as large and portfolio responses to capital shocks tended to be more rapid in the early 1990s. Larger banks adjusted each component of their portfolios faster than smaller banks. Capital shocks caused banks with capital shortfalls to contract more and more quickly in the 1990s than they had in the 1980s.

Discount rate changes and security returns in the U.S., 1962–1991

Abstract: It is well-known that financial markets respond quickly to announcements of changes in the discount rate. We extend previous research and ask whether rate changes provide information about subsequent long-term market performance. Between 1962 and 1991, stock returns following discount rate decreases are higher and less volatile than returns following rate increases. The stock performance patterns are not due to changes in short or long-term bond rates.

Insolvency experience, risk-based capital, and prompt corrective action in property-liability insurance

Abstract: This paper analyzes the accuracy of the risk-based capital formula for property-liability insurers that was adopted in 1993 by the National Association of Insurance Commissioners (NAIC). A logit analysis is conducted on a large sample of solvent and insolvent insurers spanning the period 1989–1993. Predictive accuracy is very low when the ratio of NAIC risk-based capital to actual capital is the sole indendent variable in the logit analysis, but accuracy improves significantly when the components of the formula and variables for firm size and organizational form are used as regressors. Improvements in the formula are needed to facilitate prompt corrective action and reduce insolvency costs.

Overinvestment, Tobin's q and gains from foreign acquisitions

Abstract: U.S. acquisitions of foreign firms, show that bidder abnormal returns are substantially higher for high q bidders than low q bidders; further, bidder returns are significantly and inversely related to free cash flow for low q bidders but not for high q bidders. There is also evidence that financial markets reward more the initial than subsequent foreign investments of value maximizing U.S. multinational firms. Finally, bidder returns are found tc be higher when foreign acquisitions take place in low-tax-rate jurisdictions; in addition, the results show that the 1986 Tax Reform Act exerted a negative effect on bidder returns.

Economic news and equity market linkages between the U.S. and U.K.

Abstract: The source of equity market linkages between the U.S. and U.K. is investigated by focusing on intraday price movements of stock index futures contracts. We document heightened U.K. return volatility at 11:30 a.m. and 1:30 p.m. GMT, which corresponds to regular macroeconomic releases in the U.K. and U.S., respectively. The response of U.K. equities in the half-hour surrounding the U.S. announcements is significant and similar to price movements for U.S. equities to the same announcements. These results support the hypothesis that the documented international equity market linkages are attributable to reactions of foreign traders to public information originating from the U.S.

Conditional volatility and the informational efficiency of the PHLX currency options market

Abstract: The relative performance of implied and historical volatility predictors is compared for four exchange rates from 1985 to 1991. For three currencies, ARCH models estimated up to 1989 show that PHLX implied volatilities provide specifications for daily conditional variances which can not be significantly improved by using past returns. This result is consistent with the informational efficiency of the Philadelphia currency options market. Out-of-sample forecasts of the average volatility over four-week periods are evaluated for 1990 and 1991. Once more the implied predictors are superior to historical predictors.

Three paradigms for the role of capitalization requirements in insured financial institutions

Abstract: Standard models for deposit insurance strike analogies to more familiar financial contracts and conceive of risk as exogenous The oldest model of deposit insurance likens it to passively underwriting casualty insurance A more sophisticated, but still bilateral model likens deposit insurance to writing a passive put option on the enterprise whose funding is insured Delays in acknowledging the wreck of the S&L industry and its federal insurer (FSLIC) discredit these models as guides to managing a deposit-insurance fund Deposit insurance is better interpreted as a trilateral performance bond that enhances the credit of an insured institution This interpretation endogenizes risk, emphasizes incentive conflict, and underscores the need to optimize loss-control activity The bonding model clarifies that a subset of the monitoring and disciplinary activities traditionally undertaken by government officials can usefully be privatized

International diversification through closed-end country funds

Abstract: The primary objectives of this paper are to assess the potential of closed-end country funds (CECFs) as vehicles for achieving international diversification at ‘home’ and to examine the effect of the closed-end status of these funds on their investment characteristics. The main findings are: First, CECFs exhibit significant exposure to the U.S. market factor and act more like U.S. securities than do their underlying assets. Second, despite these characteristics, CECFs retain significant exposure to their local (home) market factors and provide U.S. investors with substantial diversification benefits. Emerging market funds such as Brazil, Mexico, and Taiwan receive large weights in optimal international portfolios comprised of CECFs, implying that these funds can play a unique role in spanning the opportunity set for U.S. investors. Third, performance evaluations indicate that our sample CECFs generally did not offer significant ‘overseas alphas’. Fourth, fund value and net asset value are found to be co-integrated for the majority of CECFs from North America and Europe, but not for those representing the Asian emerging markets.

Production of information, information asymmetry, and the bid-ask spread: Empirical evidence from analysts' forecasts

Abstract: In this paper we suggest that market makers deduce the extent of the adverse selection problem associated with a stock (and set up the bid-ask spread accordingly) by observing how many financial analysts are following that stock. Market makers do this based on the belief that more financial analysts would follow a stock with a greater extent of information asymmetry since the value of private information increases with informational asymmetry. Similarly, financial analysts deduce the profit potential of a stock from the size of the spread set up by market makers (based on the expectation that market makers would set up a greater spread for the stock with a greater information asymmetry). This structural view of the process determining the bid-ask spread and analyst following is empirically tested using a simultaneous equations regression analysis. The empirical results are generally consistent with this view. Hence, our study supports the notion that the decisions of two major players in the financial markets (i.e., market makers and financial analysts) are made interactively.

The implementation of prompt corrective action: An assessment

Abstract: To lessen forbearance, the FDIC Improvement Act of 1991 (FDICIA) requires that undercapitalized banks be subject to prompt corrective actions. We show that from 1984 through 1989, the vast majority of banks exhibiting a high risk of insolvency would not have been considered undercapitalized based on the current risk-based capital (RBC) standards, and so would not have been subject to mandatory corrective actions under FDICIA. We present evidence suggesting the usefulness of the RBC ratios could be enhanced substantially by adopting an improved standard for loan loss reserve adequacy and modifying the RBC risk weights to account for the greater credit risks of problem assets.

When does the prime rate change

Abstract: We study the frequency of prime rate changes. We model the prime rate as a time-series variable that can be changed only at some cost. This yields a logit model in which the probability of a prime rate change is a function of market variables. We test this model using data from a micro data set that gives the dating of prime rate changes. The results indicate that adjustment costs are important to the prime rate adjustment process, and that changes in exogenous variables have a significantly larger effect on the probability of a prime rate increase than decrease.

The incremental information content of bond rating revisions: The Australian evidence

Abstract: The objective of this study is to provide evidence on the information content of bond revisions by controlling for the information content of concurrent annual accounting income numbers and testing the incremental information content of bond rating revision. The reasons for this approach is threefold. First, the information content of annual accounting income numbers is well documented in the literature. Second, bond rating agencies in their revisions extensively utilise accounting information, hence it could be argued that bond rating revisions only confirm what is already known by equity investors. Third, recent evidence indicates an ‘earnings drift’ effect surrounding earnings announcements which could drive abnormal returns associated with bond revisions. However, by controlling for the information content of annual accounting income numbers, evidence can be provided on the value added by rating agencies. The results of the study indicate that only the announcement of bond downgrades has incremental information content.

Loan Sales as a Response to Market-Based Capital Constraints

Abstract: Models of bank loan sales often appeal to regulatory constraints to motivate this off-balance-sheet activity. Here, we present a market-based model of bank asset sales in which information asymmetries create the incentive for unregulated banks to originate and sell loans to other banks, rather than fund them with deposit liabilities. Banks have a comparative advantage in locating and screening projects within their locality. However, because of private information, banks can fund projects in their portfolio only to the extent that their capital can adequately buffer potential losses on these investments. A loan sales market allows a banker having adequate capital to acquire profitable projects originated by a banker whose own capital is insufficient to support the additional risk.

Day-of-the-week effects in federal funds rates: Further empirical findings

Abstract: We extend the Spindt and Hoffmeister (1988) model of the daily operation of an institution's federal reserve account to show strong inter-and intra-period incentives to borrow and lend in the federal funds market at predictable points in the 10 trading day settlement period. Using intraday high and low prices, we demonstrate changes in the federal funds rate consistent with our model's predictions. We provide evidence of predictable changes in the variance of Fed funds returns on a daily and intraday basis. Our analysis confirms that Federal Reserve requirements result in daily and intraday variances which are not constant.

The effect of bank capital requirements on bank off-balance sheet financial innovations

Abstract: A popular explanation for the explosive growth in banks' off-balance sheet (OBS) activities is the avoidance of capital adequacy requirements. Several studies have examined this and other motivations behind bank OBS activities with mixed results. We shed further light on the issue of OBS growth by modelling OBS products as financial innovations subject to a logistic diffusion adoption pattern. Our data also allows us to investigate the impact of important changes in capital adequacy regulations on OBS diffusion rates. We find that changes in capital requirements have had no consistent impact on the speed of diffusion across OBS activities.

Deposit insurance and bank interest rate risk: Pricing and regulatory implications

Abstract: The linkage between the interest rate risk exposure of banks and the liabilities of a deposit insuring agency is not well understood. In this paper, a model is developed to evaluate the interest rate risk exposure of both deposit taking institutions and deposit insuring agents when bank equity has limited liability and interest rates are stochastic. Based on a sample of U.S. banks, empirical results are presented for the interest rate risk exposure of banks and its impact on the liabilities of the FDIC.

Scale economies and cost complementarities in commercial banks: On-and off-balance-sheet activities

Abstract: Bank off-balance-sheet (OBS) activities have grown dramatically, and have become significantly important especially at large banks. We investigate whether failure to incorporate OBS products may lead to a misspecification problem. Models that exclude deposits from the output specification suggest economies of scale, which vanish when deposits are included. We find that inclusion of OBS products has little effect on the scale economies measures. With only a few exceptions, the results provide no evidence of cost complementarities in joint production. The tremendous growth of bank OBS activities in the 1980s may be explained by the very small (approximately zero) pecuniary cost of these activities.

Bank holding company capital targets in the early 1990s: The regulators versus the markets

Abstract: Several studies suggest that the credit crunch was due in large part to banks' needs to raise their capital ratios. The changes in bank capital ratios may have been in response to financial market or regulatory standards. This study develops a model to test the relative impact of the regulators and the financial markets on bank holding companies' (BHCs) capital ratios. The results suggest that most BHCs were relatively satisfied with their capital ratios in 1989. However, the regulators appear to have placed increased pressure on banks in 1990, 1991 and 1992, especially BHCs that were subject to regulatory orders.

Forbearance, deposit insurance pricing, and incentive compatible bank regulation

Abstract: This paper examines the incentive compatible role of regulatory forbearance policy in the context of optimal bank regulation under moral hazard. We show that, when a bank's asset portfolio returns have market risk, the regulator can influence the bank's choice of ex ante risk by delaying the closure of an insolvent bank. The optimal closure policy involves co-ordinating the closure decision with market-wide performance. Such a policy may significantly alleviate the bank's ex ante risk-shifting problem. Furthermore, even fixed-rate deposit insurance can be optimal when combined with a sound forbearance policy and a minimum capital standard.

Banker judgement versus formal forecasting models: The case of country risk assessment

Abstract: The allocation of credit to less-developed countries depends upon lenders' judgements of country risk. Research in psychology suggests that human judgement may be prone to bias. This paper uses the Institutional Investor country credit ratings as indicators of banker judgement. In terms of their ability to predict the emergence of arrears on external debt-service, it is shown that bankers are overly pessimistic about the creditworthiness of less-developed countries. Multivariate statistical models have a higher overall predictive accuracy, although they may arguably be outperformed by banker judgement when allowance is made for the differential costs of type I and type II errors.

Capital requirements, loan renegotiation and the borrower's choice of financing source

Abstract: The main objective of this paper is to theoretically examine the impact of bank capital requirements on a borrower's choice of financing source. Our focus is on the tension between regulatory taxes, such as bank capital requirements (that reduce the value of a bank loan to a borrower), and the bank's incentive to renegotiate debt terms with financially distressed borrowers (that increases the value of a bank loan to a borrower). We show that borrowers that approach banks are necessarily of intermediate quality. This set of borrowers diminishes as bank capital requirements increase. Surprisingly, this happens not only because bank capital requirements increase loan prices and hence reduce the value of the loan to the borrower, but also because they weaken the bank's incentive to restructure troubled loans, thereby causing a dampened loan demand. Additionally, holding quality fixed, growth-oriented borrowers are more likely to prefer the capital market than borrowers expecting high cash flows early when facing a sufficiently high capital requirement. Finally, the effect of capital requirement increases is asymmetric - growth-oriented borrowers are more likely than 'cash cows' to migrate from banks to the capital market when banks confront higher capital requirements.

Seasonalities and intraday return patterns in the foreign currency futures market

Abstract: This study extends daily returns research in foreign currencies by focusing upon an intraday analysis of futures prices from the International Monetary Market (IMM). We find that insignificant daily returns are generally the result of significant negative returns overnight (when measured relative to the dollar) and significant positive returns during the trading day. The strengthening of foreign currencies intraday is concentrated during the opening hour, as well as during the last two hours of the U.S. trading day. Several other anomalies are found when hourly returns are examined. We propose a transactions hypothesis (reflective of relative country trading patterns) which is consistent with most of the return patterns uncovered.