Macroeconomics Uncertainty and Banks' Lending Decisions: The Case of Italy

This paper discusses the role that macroeconomic uncertainty plays in banks’ choices regarding the optimal asset allocation. Following the portfolio model proposed by Baum et al. (2005), the paper aims at disentangling how Italian banks choose between loans and risk-free assets when the uncertainty on macroeconomic conditions increases. The econometric results confirm that macroeconomic uncertainty is a significant determinant of Italian banks’ investment decisions, also after controlling for other factors. In periods of increasing turmoil, bank-specific ability to accurately forecast future returns is hindered and herding behaviour tends to emerge, as witnessed by the reduction of the cross-sectional variance of the share of loans held in portfolio.Bank, business cycle, uncertainty, lending decisions, GARCH

Macroeconomic uncertainty and banks' lending decisions: The case of Italy

This paper discusses the role that macroeconomic uncertainty plays in banksÂ’ decisions on the optimal asset allocation. Using a portfolio model recently proposed in the literature, the paper aims at disentangling how Italian banks choose between loans and risk-free assets when uncertainty on macroeconomic conditions increases. The econometric results confirm that macroeconomic uncertainty is a significant determinant of banksÂ’ investment decisions, also after controlling for other factors. In periods of increasing turmoil, banksÂ’ ability to accurately forecast future returns is hindered and herding behaviour tends to emerge, as witnessed by the reduction of the cross-sectional variance of the share of loans held in portfolio.bank, business cycle, uncertainty, lending decisions, GARCH

Market and Supervisory Information: Some Evidence from Italian Banks

There is an increasing debate on the potential use of the signals arising from financial markets as a complement to the information set available to supervisors. Following this stream of research, this paper provides for the first time some empirical evidence on Italian banks, using a unique dataset matching accounting ratios, equity-market variables and supervisory judgements. More specifically, we analyse the behaviour of four well-used equity-based indicators for the Italian banks whose shares were listed on the Milan stock exchange between 1995 and 2002 and look at the correlation across banks and across indicators, verifying what type of signal (if any) different variables are able to convey. Moreover, we investigate whether equity-based indicators provide additional information for supervisors with respect to the set of data they usually rely on, assuming the supervisory ratings as a benchmark.Bank; supervision; market discipline; early warning

Is Bank Portfolio Riskiness Procyclical? Evidence from Italy using a Vector Autoregression

This study analyzes the cyclical behaviour of the default rates of Italian bank borrowers over the last two decades. A vector autoregression (VAR) modelling technique is employed to assess the extent to which macroeconomic shocks affect the banking sector (first round effect). The VAR also helps to disentangle the feedback effects from the financial system to the real side of the economy. We find evidence of the first round effect and some support for the feedback effect which operates via the bank capital channel.First-round effect; procyclicality; feedback effects; VAR; banks; default rate

Credit risk and business cycle over different regimes

In the recent banking literature on the relationship between credit risk and the business cycle, the presence of asymmetric effects both across credit risk regimes and through the business cycle has been generally neglected. Employing threshold regression models both at the aggregate and the bank level and exploiting a unique dataset on Italian bank borrowersÂ’ default rates, this paper analyzes whether this relationship is characterized by regime switches and thus by asymmetries, determining the thresholds endogenously. Our results show that not only are the effects of the business cycle on credit risk more pronounced during downturns but also when credit risk conditions are poor.Credit Risk, Panel Threshold Regression Models, Regime Switching, Default Rate, Business Cycle, Cyclicality, Basel 2

Incentives through the cycle: microfounded macroprudential regulation

Following a decline in the fundamental risk of assets, the ability of banks to expand the balance sheet under a Value-at-Risk constraint in- creases (as in Adrian and Shin (2010)), boosting the bank’s incentives to provide costly monitoring effort that prevents asset deterioration. On the other hand, high asset demand and prices, eventually, raise the bank’s pay- off in the event of liquidation associated to asset deterioration, jeopardiz- ing incentives. This paper shows that a microprudential regulatory regime that disregards the equilibrium effect of macro variables (asset prices) on micro behavior (effort), performs poorly as low fundamental (exogenous) risk reduces bank’s effort and induces high (endogenous) deterioration risk. This analysis calls for a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the author- ity in designing incentive compatible capital requirements, providing a theoretical foundation to the countercyclical buffer of Basel III.Macroprudential regulation, financial stability, capital requirement.

BanksÂ’ Riskiness Over the Business Cicle: a Panel Analysis on Italian Intermediaries

Supervisors and policy makers pay increasing attention to the possible procyclical nature of banksÂ’ behaviour. Indeed, to guarantee macro and financial stability, it is important to understand whether, and to what extent, banks are affected by the macroeconomy and second round effects occur. This paper provides a comprehensive investigation of these issues using a large dataset of Italian intermediaries over the period 1985-2002. In particular, estimating both static and dynamic models, it investigates whether loan loss provisions and non-performing loans show a cyclical pattern. The estimated relations may be employed to carry out stress tests to assess the effects of macroeconomic shocks on banksÂ’ balance sheets.procyclicality, banks, loan loss provisions, non-performing loans, business cycle

Dynamic provisioning: rationale, functioning, and prudential treatment

Current policy debate has renewed interest in countercyclical provisioning policies; dynamic provisions are regarded as a valuable device for pursuing this goal. Last July, Ecofin supported “the introduction of forward-looking provisioning, which consists in constituting provisions deducted from profits in good times for expected losses on loan portfolios, and which would contribute to limiting procyclicalityâ€. This paper describes: i) how dynamic provisions work in a general framework based on expected losses; ii) how they work according to the Spanish system, which is the only real example of countercyclical provisioning; iii) the differences and similarities between the expected loss model and the Spanish approach. Building on proposals currently under discussion in the international community, it also suggests a possible way forward for introducing a system of dynamic provisions that, while meeting the prudential goal of having more conservative provisioning policies, would not clash with accounting standards.dynamic provisions, capital buffers, Basel 2, credit risk, procyclicality

Countercyclical contingent capital (CCC): possible use and ideal design

Contingent capital – any debt instrument that converts into equity when a predefined event occurs – has received increasing attention as a viable tool for allowing banks to raise capital when needed at relatively more affordable prices than common equity. While the debate has focused on contingent capital for systemically important financial institutions, this paper concentrates on its possible use for covering capital needs arising from the implementation of countercyclical buffers. We propose the introduction of countercyclical contingent capital (CCC) based on a double trigger. The interaction of the two triggers would determine a quasi-default status. Conversion would be required when the financial system is simultaneously facing aggregate problems and the individual bank – while still in a going concern status – shows weaknesses. Building on this proposal, the paper tests how different double triggers would have worked in the past and discusses the optimal design of the conversion mechanism and prudential treatment.Basel 2, capital buffer, procyclicality, contingent capital, financial crisis, reforms