Post 2007 crisis unconventional monetary policy in the UK

The main focus of this PhD thesis is to investigate the unconventional monetary policy tools introduced by the Bank of England (BoE) in its response to the recent financial crisis and to analyse its impact on the UK economy and especially the banking sector. The thesis consists of four chapters; an introductory chapter and three self-contained chapters. The first chapter mainly inspects the types and the sizes of the unconventional interventions of the monetary authorities in the UK, the US, and the EU after the collapse of Lehman Brothers in 2008. It also describes the transmission channels through which the impact of the unconventional monetary policies is delivered into the wide economy, and includes a survey of the literature of quantitative easing. The second chapter employs a flow of funds (FOFs) analysis based on Godley and Lavoie (2007) balance sheet framework using ONS sectoral data for the period between 2007 and 2011. It focuses on two distinct sub-periods (2007-2008 and 2009-2011) to assess the initial effects of mid-2007 financial crisis on the UK economy and examine the influence of BoE’s asset purchase program (APP) on the sectoral financial positions in the main financial asset categories. The analysis implicates five main results. First, APP was unsuccessful in expanding bank lending which dropped by about £208 billion in the 2009-2011 period. Second, APP might have positive effects on debt securities and equity prices and hence consumer wealth. Third, through reducing the cost of borrowing, it appears that APP induced the majority of sectors to issue more debt securities. Fourth, after the introduction of APP early in 2009, several sectors relied more on equity rather than debt capital. Finally, domestic productive sectors (NFCs, MFIs, OFIs, and INSs) showed some abroad bias and sent massive amounts of money out of the country. The third chapter explains the drop in total bank lending after the introduction of APP from an agent-based computational economics (ACE) point of view. The baseline model contains four types of agents -households (HHs), big firms (BFs), small and medium enterprises (SMEs), and banks-. These agents interact monthly for a period of 50 months in an environment that simulates bank lending markets in the UK after APP was introduced in 2009. The ACE model is anchored to the actual values of several variables -such as homeownership statistics and nonfinancial firms leverage ratio- around the time of the program initiation. The lower bond yields caused by APP encourage BFs to substitute bank borrowing with security debt (bonds). In addition, the risk weight regime of Basel capital adequacy requirements induces banks to favour mortgages over business loans to SMEs. My analysis contrasts the implications on bank behaviour of Basel III capital adequacy requirements (scenario 3) with Basel I (simple capital adequacy requirements with no risk weights) and the case of no capital requirements (scenarios 1 and 2 respectively). The scenario analysis shows that in the absence of risk weighting (i.e. scenarios 1 and 2), both lending to SMEs and total lending would have been higher. The combination of lower bond yields and Basel III capital adequacy requirements on banks appears to play a role in the drop in the amount of bank loans to businesses. Similar to the actual data, simulation results indicate that the rise in the amount of mortgages was not enough to counter the decrease in business loans which represents the main cause of the shrinkage in total bank lending. The fourth chapter tries to analyse the same issue of falling bank lending after APP introduction using a three-sector DSGE model. The main results show that a negative shock in gilts yield -initiated by massive asset purchases under the program- induces big unrestricted firms to shift from bank borrowing to security debt (bonds). The fall in BFs bank borrowing decreases the share of the loans to BFs in banks asset compositions and hence increases the amount of risk weighted assets. Induced by Basel III capital requirements, banks start to adjust their portfolios to accommodate more mortgages and less loans to small and medium enterprises (SMEs). The analysis of the role of capital adequacy requirements points out that while the introduction of strong enough capital requirements decreases the risks in the banking system, it may deprive the bank financing from SMEs

Carbon Emissions Announcements and Market Returns

The paper investigates the impact of carbon emissions on stock price returns of European listed firms. This relationship is assessed across all three emissions scopes, as well as using expecta-tions to detect if future emissions impact contemporary returns. Our findings show that firms with higher expected future emissions deliver contemporary lower returns, after controlling for market capitalization, profit, and other known return predictors. This result is statistically sig-nificant in the post Paris Agreement period with a two to three years expectation on scope 2 emissions. However, there is marginal to no significant negative relationship between current emissions and current returns. Overall, the results suggest that more Environment-minded in-vestors look further ahead and would expect lower returns from a polluting firm compared to a firm with no carbon emissions after the Paris Agreement

Leverage ratio, risk-based capital requirements, and risk-taking in the United Kingdom

We assess the impact of the leverage ratio capital requirements on the risk-taking behaviour of banks both theoretically and empirically. Conceptually, introducing binding leverage ratio requirements into a regulatory framework with risk-based capital requirements induces banks to re-optimise, shifting from safer to riskier assets (higher asset risk). Yet, this shift would not be one-for-one due to risk weight differences, meaning the shift would be associated with a lower level of leverage (lower insolvency risk). The interaction of these two changes determines the impact on the aggregate level of risk. Empirically, we use a difference-in-differences setup to compare the behaviour of UK banks subject to the leverage ratio requirements (LR banks) to otherwise similar banks (non-LR banks). Our results show that LR banks did not increase asset risk, and slightly reduced leverage levels, compared to the control group after the introduction of leverage ratio in the UK. As expected, these two changes led to a lower aggregate level of risk. Emperical results indicate that credit default swap spreads on the 5-year subordinated debt of LR banks decreased relative to non-LR banks post leverage ratio introduction, suggesting the market viewed LR banks as less risky, especially during the COVID 19 stress

The Impact of Quantitative Easing on UK Bank Lending: Why Banks Do Not Lend to Businesses?

The growing proportion of UK bank lending to the financial sector reached a peak in 2007 just before the onset of the Global Financial Crisis (GFC). This marks a trend in the dwindling amount of bank lending to private sector non-financial corporations (PNFCs), which was exacerbated with the Great Recession. Many central banks aimed to revive bank lending with quantitative easing (QE) and unconventional monetary policy. We propose an agent based computational economics (ACE) model which combines the main factors in the economic environment of QE and Basel regulatory framework to analyse why UK banks do not prioritize lending to non-financial businesses. The lower bond yields caused by QE encourage big firms to substitute away from bank borrowing to bond issuance. In addition, the risk weight regime of Basel I/II on capital induces banks to favour mortgages over business loans to small and medium enterprises (SMEs). The combination of lower bond yields and Basel II/III capital requirements on banks, which, respectively, impact demand and supply of credit in the UK, plays a role in the drop of bank loans to businesses. The ACE model aims to reinstate policy regimes that form constraints and incentives for the behaviour of market participants to provide the causal factors in observed macro-economic phenomena

The cyclicality of bank credit losses and capital ratios under expected loss model

We model the evolution of stylised bank loan portfolios to assess the impact of IFRS 9 and US GAAP expected loss model (ECL) on the cyclicality of loan write-off losses, loan loss provisions (LLPs) and capital ratios of banks, relative to the incurred loss model of IAS 39. We focus on the interaction between the changes in LLPs' charges (the flow channel) and stocks (the stock channel) under ECL. Our results show that, when GDP growth does not demonstrate high volatility, ECL model smooths the impact of credit losses on profits and capital resources, reducing the procyclicality of capital and leverage ratios, especially under US GAAP. However, when GDP growth is highly volatile, the large differences in lifetime probabilities of defaults (PDs) between booms and busts cause sharp increases in LLPs in deep downturns, as seen for US banks during the Covid-19 crisis. Volatile GDP growth makes capital and leverage ratios more procyclical, with sharper falls in both ratios in deep downturns under US GAAP, compared to IAS 39. IFRS 9 ECL demonstrates less sensitivity to lifetime PDs fluctuations due to the existence of loan stages, and hence can reduce the procyclicality of capital and leverage ratios, even when GDP is highly volatile

Shareholder risk-taking incentives in the presence of contingent capital

Purpose This paper aims to present a model of shareholders’ willingness to exert effort to reduce the likelihood of bank distress and the implications of the presence of contingent convertible (CoCo) bonds in the liabilities structure of a bank. Design/methodology/approach This study presents a basic model about the moral hazard surrounding shareholders willingness to exert effort that increases the likelihood of a bank’s success. This study uses a one-shot game and so do not capture the effects of repeated interactions. Findings Consistent with the existing literature, this study shows that the direction of the wealth transfer at the conversion of CoCo bonds determines their impact on shareholder risk-taking incentives. This study also finds that “anytime” CoCos (CoCo bonds trigger-able anytime at the discretion of managers) have a minor advantage over regular CoCo bonds, and that quality of capital requirements can reduce the risk-taking incentives of shareholders. Practical implications This study argues that shareholders can also use manager-specific CoCo bonds to reduce the riskiness of the bank activities. The issuance of such bonds can increase the resilience of individual banks and the whole banking system. Regulators can use restrictions on conversion rates and/or requirements on the quality of capital to address the impact of CoCo bonds issuance on risk-taking incentives. Originality/value To model the risk-taking incentives, authors generally modify the asset processes to introduce components that reflect asymmetric information between CoCo holders and shareholders and/or managers. This paper follows a simpler method similar to that of Holmström and Tirole (1998)

Impact of IFRS 9 on the cost of funding of banks in Europe

On implementation, IFRS 9 increases credit loss (impairment) charges and reduces after-tax profits of banks. This makes retained earnings and hence capital resources lower than what they would be under IAS 39. To maintain their capital ratios under IFRS 9, banks may choose to hold higher levels of equity capital. This paper uses a modified version of CAPM, which accounts for the low-risk anomaly (as suggested by Baker and Wurgler (Baker and Wurgler in American Economic Review 105:315–320, 2015)), to estimate the impact of this potential increase in capital levels on the cost of funding of banks in six European countries, the UK, Germany, France, Italy, Spain and Switzerland. Our results indicate that weak low-risk anomaly exists for banks’ equity in the six countries, except France. The magnitude of the anomaly varies across countries, but is generally low relative to the long-run cost of equity for banks. Due to the weak anomaly, we find a minor “day 1” impact of IFRS 9 on the cost of funding of banks in the six countries

Leverage ratio and risk-taking: theory and practice

We assess the impact of the leverage ratio capital requirements on the risk‐taking behaviour of banks both theoretically and empirically. We use a difference‐in‐differences (DiD) setup to compare the behaviour of UK banks subject to the leverage ratio requirements (LR banks) to otherwise similar banks (non‐LR banks). Conceptually, introducing binding leverage ratio requirements into a regulatory framework with risk-based capital requirements induces banks to reoptimise, shifting from safer to riskier assets (higher asset risk). Yet, this shift would not be one‐for‐one due to risk‐weight differences, meaning the shift would be associated with a lower level of leverage (lower insolvency risk). The interaction of these two changes determines the impact on the aggregate level of risk. Empirically, we show that LR banks did not increase asset risk, and slightly reduced leverage levels, compared to the control group after the introduction of leverage ratio in the UK. As expected, these two changes lead to a lower aggregate level of risk. Our results show that credit default swap spreads on the five‐year subordinated debt of LR banks dropped relative to non‐LR banks post leverage ratio introduction

The asset reallocation channel of quantitative easing. The case of the UK

We investigate the impact of the Bank of England's asset purchase program (APP) on the composition of assets of UK banks with unique data on the received reserves injections. The Monetary Policy Committee (MPC) didn’t expect there to be strong transmission of the APP’s impact through the bank lending channel. We find that compared to the control group, treated banks reallocated their assets towards lower risk-weighted investments, such as government securities, but did not provide more credit to the real economy. Overall, our findings suggest that when banks are not adequately capitalised, risk-based capital constraints can limit the effectiveness of expansionary unconventional monetary policies and provide incentives for carry trade activities