Five Essays on Bank Regulation Inaugural-Dissertation zur Erlangung des Grades eines Doktors der Wirtschafts- und Gesellschaftswissenschaften durch die Rechts- und Staatswissenschaftliche Fakult¨at der Rheinischen Friedrich-Wilhelms-Universit¨at Bonn vorgelegt von MARKUS BEHN aus Uelzen Bonn, 2014 Dekan: Prof Dr Rainer H¨ uttemann Erstreferent: Prof Dr Rainer Haselmann Zweitreferent: Prof Martin Hellwig, PhD Tag der m¨ undlichen Pr¨ ufung: 05.12.2014 Diese Dissertation ist auf dem Hochschulschriftenserver der ULB Bonn (http://hss.ulb.uni-bonn.de/diss online) elektronisch publiziert Acknowledgments In writing this thesis I received support from many people to whom I am grateful First and foremost, I wish to thank my supervisor Rainer Haselmann for his constant guidance, advice, and encouragement I learned a lot from countless discussions with him, and our joint research has been very inspiring and fruitful I thank Martin Hellwig for agreeing to join my dissertation committee His excellent comments and suggestions were highly appreciated Moreover, I am grateful to Vikrant Vig, for teaching me a lot about economic reasearch, and for many interesting and helpful discussions I also thank Thomas Kick for providing invaluable support during my time as a visiting scholar at Deutsche Bundesbank and for being an excellent co-author, as well as Paul Wachtel and Amit Seru for great collaboration Carsten Detken enabled me an inspiring and very productive traineeship at the European Central Bank During my time there I had numerous interesting discussions with Willem Schudel and Tuomas Peltonen, which greatly benefited both my research and my understanding of practical issues in bank regulation The Bonn Graduate School of Economics and the Max Planck Institute for Research on Collective Goods are great places to research I wish to thank all the people who keep these places going, in particular Urs Schweizer, Silke Kinzig, Pamela Mertens (BGSE), and Monika Stimpson (MPI) I am also grateful for the financial support received from both these institutions The past four years at the BGSE have been a great experience Thanks a lot to Matthias Wibral for the dedicated mentoring during my first year in Bonn and for organizing the football matches during all these years Many thanks also to my fellow grad students, in particular the class of 2009, for making the time in Bonn an ii experience that I will never forget Finally, I wish to thank my family I am grateful to my parents for their unconditional love and support Above all, I thank Annegret for being the best wife I could wish for iii Contents List of Figures ix List of Tables xi Introduction 1 Pro-Cyclical Capital Regulation and Lending 1.1 Introduction 1.2 Institutional background and data 14 1.2.1 Introduction of risk-weighted capital charges 14 1.2.2 Data and descriptive statistics 18 1.2.3 Graphical analysis of the impact of the financial crisis on banks’ 1.3 1.4 1.5 1.6 capital charges 22 Methodology 25 1.3.1 Identifying changes in loan supply 25 1.3.2 Selection of IRB portfolios 28 Empirical results 31 1.4.1 Loan-specific risk weights and lending 31 1.4.2 Capital regulation and firms’ overall access to funds 37 Further evidence: The impact of bank, loan, and firm characteristics 41 1.5.1 The lending reaction of IRB banks: The role of bank equity 42 1.5.2 The lending reaction of IRB banks: The role of loan size 44 1.5.3 The lending reaction of IRB banks: The role of firm risk 44 Conclusion and discussion 48 iv Setting Countercyclical Capital Buffers Based on Early Warning Models: Would it Work? 50 2.1 Introduction 50 2.2 Data 54 2.2.1 Definition of vulnerable states 54 2.2.2 Macro-financial and banking sector variables 55 2.2.3 Development of key variables 59 Methodology 61 2.3.1 Multivariate models 61 2.3.2 Model evaluation 63 Empirical results 66 2.4.1 Estimation and evaluation 66 2.4.2 Out-of-sample performance of the models 77 2.4.3 Robustness checks 77 Conclusion 82 2.3 2.4 2.5 Limits of Model-Based Regulation 83 3.1 Introduction 83 3.2 The introduction of model-based regulation in Germany 89 3.3 Data 93 3.4 Banks’ lending reaction to the introduction of IRB 96 3.4.1 Bank-level lending 96 3.4.2 Loan-level lending and hard information 98 3.5 The impact of changed lending incentives on the quality of PD estimates in banks’ internal models 103 3.5.1 Empirical strategy 104 3.5.2 Descriptive analysis 106 3.5.3 Regression framework: IRB versus SA loans 110 3.5.4 Regression framework: IRB loans issued before and after the event 112 3.5.5 3.6 Further results 115 Conclusion 118 v A3 Appendix to Chapter 119 The Political Economy of Bank Bailouts 120 4.1 Introduction 120 4.2 Institutional background: Local politicians and the German savings bank sector 126 4.3 4.4 Data 129 4.3.1 Distress events 130 4.3.2 Bank and macroeconomic variables 132 4.3.3 Restructuring efforts following bailouts 136 4.3.4 Political variables 137 Political determinants of bank bailouts 140 4.4.1 The timing of distress events 141 4.4.2 The impact of political factors on the bailout decision by politicians 144 4.4.3 Fiscal and other factors affecting the bailout decision of politicians 148 4.5 Consequences of political bailouts 149 4.5.1 Bank performance following bailouts 151 4.5.2 Macroeconomic performance following distress events 157 4.6 Conclusion 159 A4 Appendix to Chapter 161 Does Financial Structure Shape Industry Structure? Evidence from Timing of Bank Liberalization 168 5.1 Introduction 168 5.2 Liberalization reforms and data 172 5.2.1 The event: Bank liberalization reforms across the world 172 5.2.2 Bank data 175 5.2.3 Efficiency classification of banking markets and macroeconomic data 182 5.2.4 Industry data 183 5.2.5 Firm data 185 vi 5.3 5.4 5.5 5.6 Loan supply and financial structure 186 5.3.1 Bank-level evidence on loan supply 187 5.3.2 Country-level evidence on loan supply 5.3.3 Financial structure 194 189 Industry evidence 196 5.4.1 Economic growth 196 5.4.2 Differential effects on output 199 5.4.3 Differential impact on industry volatility 202 Firm evidence 204 5.5.1 Debt taking 204 5.5.2 Differential impact on firms 205 Robustness checks 208 5.6.1 Selection concerns 208 5.6.2 Endogeneity concerns regarding the event 209 5.6.3 Concerns regarding alternative events 210 5.6.4 Concerns regarding the efficiency classification of domestic banking markets 210 5.7 A5 Related literature and discussion 211 5.7.1 Related literature 211 5.7.2 Conclusion 214 Appendix to Chapter 215 Bibliography 240 vii List of Figures 1.1 The crisis shock and the German economy 22 1.2 Total risk-weighted loans and total loans 24 1.3 Institutional setup and identification 26 2.1 Development of key variables around banking crises 60 2.2 ROC curve for benchmark model (Model 5) 74 2.3 Predicted crisis probabilities and banking sector capitalization 75 2.4 Out-of-sample performance of the model 78 3.1 PDs and regulatory risk weights 92 3.2 Aggregate lending around the Basel II introduction 97 3.3 Average PDs and actual default rates 109 3.4 PD kernel densities 110 3.5 Average PDs and actual default rates by loan cohorts 114 3.6 Average PDs and actual default rates—all quarters 119 4.1 Institutional setup 128 4.2 Support measures and the electoral cycle 142 4.3 Capital injections from the owner and electoral cycle 145 4.4 Long-run performance and electoral cycle 154 4.5 CI from owner and electoral cycle (in % of all distress events) 163 5.1 Impact of liberalization on financial structure 175 5.2 Impact of liberalization on foreign loan supply 191 5.3 Aggregate loan supply 193 viii 5.4 Industry output 198 ix Corc´ostegui, Carlos, Luis Gonz´alez-Mosquera, Antonio Marcelo, and Carlos Trucharte 2002 “Analysis of procyclical effects on capital requirements derived from a rating system.” Banco de Espa˜ na Working Paper Series Coricelli, Fabrizio 2001 “The financial sector in transition.” In Financial Liberalization, edited by Gerard Caprio, Patrick Honohan, and Joseph E Stiglitz Cambridge University Press Dages, Gerard, Linda Goldberg, and Daniel Kinney 2005 “Foreign and domestic bank participation in emerging markets: lessons from Mexico and Argentina.” Economic Policy Review (Sep):17–36 Dam, Lammertjan and Michael Koetter 2012 “Bank bailouts, interventions, and moral hazard.” Review of Financial Studies 25 (8):2343–2380 Dan´ıelsson, J´on, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault, and Hyung Son Shin 2001 “An academic response to Basel II.” LSE Financial Markets Group, Special Paper No 130 Das, Sonali and Amadou Sy 2012 “How risky are banks’ risk weighted assets? 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essays that contribute to the literature on bank regulation The first three chapters deal... a historic change for the regulation of banks in the European Union, as the ECB takes over the supervision of the largest and most significant banks from national supervisors Among other things, this change creates a larger distance between banks and regulators On the one hand, this may mean a loss of knowledge, if one believes that national supervisors are closer to local banks and hence have a better... Selection of takeover banks 216 5.11 Bank- level loans—robustness 217 5.12 Measures of bank efficiency—robustness 218 xi Introduction The story of the financial crisis of 2007/2008 is also a story of bank regulation Commentators from academia and policy institutions have identified an inappropriate regulation of banks and capital markets as one... of liberalization of credit markets interacts with the efficiency of the incumbent domestic banking sector, and the changed nature of the supply of financing it induces has implications on the allocation of credit and economic growth 6 Chapter 1 Pro-Cyclical Capital Regulation and Lending 1.1 Introduction The design of banks’ capital charges has long been one of the most important and controversial issues... have a differential impact on banks Thus, it is difficult to determine whether a change in bank lending is driven by the procyclicality of capital regulation or the way the bank is affected by the recession shock The latter concern is an important identification challenge, since larger German banks introduced the IRB approach while most smaller banks continue to use the traditional standard approach (SA)... provisioning rules on bank lending in Spain Exploiting variation across banks, they show that lowering capital requirements when economic conditions deteriorate helps banks to maintain their supply of credit Our paper uses within -bank variation to examine the effect of risk-based capital regulation on lending in the context of a shock to credit risk Second, Aiyar, Calomiris, and Wiedalek (2012) exploit a policy... pro-cyclical regulation affected lending in Germany after the Lehman collapse and that this had severe consequences for firms’ overall access to funds Our findings illustrate how microprudential and macroprudential goals of banking sector regulation might conflict with one another.11 On the one hand, the reduction in lending we document is due to capital charges that are based on improved evaluation of credit... literature on macroprudential regulation Recent contributions from the academic side include Kashyap, Rajan, and Stein (2008), Brunnermeier et al (2009), Hellwig (2010), Hanson, Kashyap, and Stein (2011), and Acharya et al (2012) 13 Basel III tries to account for both sides of the trade-off described above: While it continues to rely on risk-based regulation and the incentives such regulation provides for banks,... from banks using the standard approach On the other hand, if banks tend to ration especially large loans, the magnitude of the pro-cyclical effect on aggregate firm borrowing could be even larger If this is the case, then the new capital regulations have important and, perhaps, undesirable macroeconomic implications The effects on aggregate firm borrowing are difficult to identify because there is only... the traditional regulatory approach Since banks tend to reduce especially large IRB credit exposures during the recession, firms relying on IRB loans experience an even stronger reduction in aggregate borrowing (5 to 10 percent larger) as compared with firms relying on loans under the traditional approach Overall, the findings in this chapter confirm the claim that model-based capital regulation has exacerbated ... present work contains five essays that contribute to the literature on bank regulation The first three chapters deal with the effects of model-based, risk-weighted capital regulation as specified... goals of banking sector regulation might conflict with one another.11 On the one hand, the reduction in lending we document is due to capital charges that are based on improved evaluation of credit... charges are responsive to economic conditions—were adjusted in a different way compared with loans under the traditional approach, for which capital charges not respond to economic conditions Importantly,