Essays on bank capital, macroeconomic activity and financial deepening

This dissertation consists of three essays on banking. The first two chapters analyze, theoretically and empirically, the relationship between bank capital and macroeconomic activity. The third chapter addresses a policy question about financial deepening in some emerging market economies. The first chapter develops a dynamic stochastic general equilibrium model to examine the impact of macroprudential regulation on the bank's financial decisions and the implications for the real sector. It explicitly incorporates costs and benefits of capital requirements. We model an occasionally binding capital constraint and approximate it using an asymmetric nonlinear penalty function. It is seen that higher capital requirements can dampen business cycle fluctuations and stronger regulation can induce banks to hold buffers and hence mitigate an economic downturn. We also see that higher capital requirements can enhance the welfare of the economy as a whole. Lastly, we find that switching to a counter-cyclical capital requirement regime can help moderate business cycle fluctuations and raise welfare. The second chapter empirically evaluates the impact of bank capital on lending patterns using an innovative instrumenting strategy. We construct an unbalanced quarterly panel of around nine thousand commercial banks over sixty quarters, from 1996 to 2010. Using different measures of capital, we find a moderate relationship between bank equity and lending. The relationship is also found to differ by size. The bigger banks have a greater responsiveness of lending to capital than smaller ones. The third chapter evaluates financial deepening in the West African Economic and Monetary Union (WAEMU) and compares their performance with other top performers in Africa. First, we use an unbalanced panel of 16 countries and 158 banks and document some key areas that need immediate policy attention. Next, we use the financial possibility frontier methodology to benchmark the performance of some important economies in our sample, with respect to each other and their estimated potential. We find that the WAEMU countries perform poorly compared to the control group and their own estimated potential. We make policy recommendations to solve this problem and increase financial depth

Real effects of financial distress : the role of heterogeneity

What are the heterogeneous e_ects of _nancial shocks on _rms' behavior? This paper evaluates and answers this question from both an empirical and a theoretical perspective. Using micro data from Portugal during the sovereign debt crisis, starting in 2010, we document that highly leveraged _rms and _rms that had a larger share of short-term debt on their balance sheets contracted more in the aftermath of a _nancial shock. We use a standard model to analyze the conditions under which leverage and debt maturity determine the sensitivity of _rms' investment decisions to _nancial shocks. We show that the presence of long-term investment projects and frictions to the issuance of long-term debt are needed for the model to rationalize the empirical _ndings. We conclude that the di_erential responses of _rms to a _nancial shock do not provide unambiguous information to identify these shocks. Rather, we argue that this information should be use to test for the relevance of important model assumptions.info:eu-repo/semantics/publishedVersio

Do households care about cash? Exploring the heterogeneous effects of India's demonetization

The recent demonetization exercise in India is a unique monetary experiment that made 86 percent of the total currency in circulation invalid. In a country where currency in circulation constitutes 12 percent of GDP, the policy turned out to be a purely exogenous macroeconomic shock that affected all agents of the economy. This paper documents the impact of this macroeconomic shock on one such systematically important agent of the economy: the household. By construction, the policy helped households with bank accounts in disposing of the demonetized cash. We use a new household-level data set to tease out the effects of this policy on households with no bank accounts relative to households with bank accounts. Our results show that the impact of demonetization on household income and expenditure has been transient with the major impact being seen in December-2016. We find that households with no bank accounts experienced a significant decrease in both income and expenditure in December-2016. There is significant heterogeneity in the impact across households in different asset classes. We also show evidence of recovery of household finances whereby households were able to smooth out consumption during the post-demonetization period. However, this recovery phase is associated with an increase in household borrowing from different sources, primarily for the purpose of consumption. In particular, informal borrowing (money lenders, shops) increased substantially during this period. Thus, the policy although transient in nature, contributed to the unintended consequence of increased leverage for households.info:eu-repo/semantics/publishedVersio

Global capital flows and the role of macroprudential policy

Can countercyclical bank capital requirements reduce the negative effects of global liquidity shocks? We use the Lehman Brothers bankruptcy as a natural experiment to document the role of the banking system as a transmission channel of global financial disturbances to domestic economies. Using granular and confidential data from the Bank of Portugal, our results suggest that in the aftermath of the Lehman collapse, domestic firms cut investment by 14% and employment by 2.3%. In order to evaluate the effectiveness of macroprudential regulation, we model an open-economy with a banking sector borrowing from domestic and international depositors. We show that, during a financial crises, in an economy with countercyclical bank capital requirements (compared with an economy with constant capital requirements): (i) gross domestic product falls5p.p. less and (ii) the fall in investment is 3 p.p. lower. We show that imposing countercyclical capital requirements entails a trade-off between lower volatility and lower economic activity. Overall, we find that countercyclical bank capital requirements may not be welfare improving for the Portuguese economy.info:eu-repo/semantics/publishedVersio

Leverage and risk weighted capital requirements

The global financial crisis has highlighted the limitations of risk-sensitive bank capital ratios. To tackle this problem, the Basel III regulatory framework has introduced a minimum leverage ratio, defined as a banks Tier 1 capital over an exposure measure, which is independent of risk assessment. Using a medium sized DSGE model that features a banking sector, financial frictions and various economic agents with differing degrees of creditworthiness, we seek to answer three questions: 1) How does the leverage ratio behave over the cycle compared with the risk-weighted asset ratio? 2) What are the costs and the benefits of introducing a leverage ratio, in terms of the levels and volatilities of some key macro variables of interest? 3) What can we learn about the interaction of the two regulatory ratios in the long run? The main answers are the following: 1) The leverage ratio acts as a backstop to the risk-sensitive capital requirement: it is a tight constraint during a boom and a soft constraint in a bust; 2) the net benefits of introducing the leverage ratio could be substantial; 3) the steady state value of the regulatory minima for the two ratios strongly depends on the riskiness and the composition of bank lending portfolios.info:eu-repo/semantics/publishedVersio

Macroprudential Regulation and Macroeconomic Activity

This paper develops a dynamic stochastic general equilibrium model to examine the impact of macroprudential regulation on bank’s financial decisions and the implications for the real sector. I explicitly incorporate costs and benefits of capital requirements. I model an occasionally binding capital constraint and approximate it using an asymmetric non linear penalty function. This friction means that the banks refrain from valuable lending. At the same time, countercyclical buffers provide structural stability to the financial system. I show that higher capital requirements can dampen the business cycle fluctuations. I also show that stronger regulation can induce banks to hold buffers and hence mitigate an economic downturn as well. Increasing the capital requirements do not seem to have an adverse effect on the welfare. Lastly, I also show that switching to a countercyclical capital requirement regime can help reduce fluctuations and raise welfare

To ask or not to ask? Collateral versus screening in lending relationships

We study the impact of higher capital requirements on banks' decisions to grant collateralized rather than uncollateralized loans.We exploit the 2011 EBA capital exercise, a quasi-natural experiment that required a number of banks to increase their regulatory capital but not others. This experiment makes secured lending more attractive vis-à- vis unsecured lending for the affected banks as secured loans require less regulatory capital. Using a loan-level dataset covering all corporate loans in Portugal, we identify a novel channel of tighter capital requirements: relative to the control group and after the shock, treated banks require loans more often to be collateralized but less so for relationship borrowers. We further find this impact is stronger for collateral that saves more on regulatory capital.info:eu-repo/semantics/publishedVersio

Bank Capital and Lending: An Analysis of Commercial Banks in the United States

This paper empirically evaluates the impact of bank capital on lending patterns of commercial banks in the United States. We construct an unbalanced quarterly panel of around seven thousand medium sized commercial banks over sixty quarters, from 1996 to 2010. Using two different measures of capital namely the capital adequacy ratio and tier 1 ratio, we find a moderate relationship between bank equity and lending. We also use an innovative instrumenting methodolgy which helps us overcome the endogeneity issues that are common in such analyses. Our results are broadly consistent with some other recent studies that have analyzed US banking data

Global capital flows and the role of macroprudential policy

Can countercyclical bank capital buffers reduce the negative effects of global liquidity shocks? We use the Lehman Brothers bankruptcy as a natural experiment to document the role of the banking system as a transmission channel of global financial disturbances to the real economy. Using central bank administrative data, our results suggest that in the aftermath of the Lehman collapse the banking channel is responsible for 1.44% of the aggregate drop in investment and 0.58% of the drop in aggregate employment. In order to evaluate the effectiveness of counter-cyclical macroprudential policies, we model an open-economy with a banking sector. We compare the drop in actual GDP during the 2008 financial crisis against the counterfactual GDP had Basel III style counter-cyclical capital buffers (CCyB) been in place. We find that the GDP drop in the counterfactual scenario would have been 6 p.p. lower than in the data. We also demonstrate the beneficial effects of the CCyB in mitigating tail risk (GDP at Risk). We show that, over a 3–5 year horizon, the GDP distribution with an operational CCyB would have a higher mean and a much thinner left tail when compared to an economy without a CCyB