Taylor, Stulz, Dice Center for Research in Financial Economics. STULZ, Shim, Jeungbo, Tom Doan, "undated". Jensen, Michael C. Blundell, R. Raghuram G. Rajan, Houston, Joel F.
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If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation. Please note that corrections may take a couple of weeks to filter through the various RePEc services. Economic literature: papers , articles , software , chapters , books. Cyclical behavior of the financial stability of eurozone commercial banks. In light of the financial crisis and the European sovereign debt crisis, we investigate the cyclical behavior of the financial stability of banks of the Eurozone, using an unbalanced dynamic panel of commercial banks covering the period —, and the generalized method of moments system.
We find a negative relationship between business cycle and bank risk-taking, indicating that financial stability is procyclical.
Several causes have been responsible for bank stability in the past ranging from macroeconomic volatility both external and internal. For example, Caprio and Klingebiel 19 and Kaminsky 20 reported trade imbalance while the real exchange volatility is another major factor in Latin America and South East Asia stability predicament. The East Asian bank instability identified how excessive dependence on short-term and foreign currency nominated debt shook bank stability. According to Borio, 6 other stability factors prevalent in the recent state of bank instability among conventional banks are characterized by a sharp repricing of its product mix, particularly credit risk that, given the leverage built up in the system, led to, and was made worse by, a disappearance of liquidity in many markets leading to further risk-taking behaviour by US banks lending even more to the sub-prime mortgage market.
The performance of this sub-prime mortgage market of the conventional bank product mix advanced into a prolonged period of broad-based aggressive risk-taking in lending. The situation was complicated by lack of clarity of the new- derivatives instruments. Borio 6 adds that banks experienced a crisis of confidence in valuations.
As time passed, the original quality of assets weakened and became more apparent, and therefore banks were affected with liquidity problems and default on different classes of assets that also lowered consumer confidence levels considerably. The first good reason for the existence of intermediaries suggests that banks screen potential borrowers on behalf of their depositors, and furthermore banks are valuable providers of monitoring.
Another reason is that banks are good at creating safe assets, and as such they are the most efficient institutions to handle credit risk and liquidity because of the immense expertise they possess. Several studies provide a theoretical basis for our article. For example, Pyle 26 and Hart and Jaffe 27 regard banks as utility-maximizing units and use mean-variance analysis to compare portfolio choice with and without a capital regulation, while Koehn and Santomero 28 showed that the introduction of higher leverage ratios may shift their product mix to include more riskier assets.
Kim and Santomero 29 suggested the use of correct processes of risk measurements, and recommend the use of the solvency ratio. Rochet 30 found that the effectiveness of capital regulations depended on whether the banks were value-maximizing, meaning capital regulations could not prevent risk-taking actions by banks. Another strand of the literature on factors of bank stability uses option models. For example, Furlong and Keeley 31 and Keeley 32 found that higher capital requirements reduce the incentives for a value-maximizing bank to increase asset risk. The recent product mix by conventional banks saw growth of credit risk transfer and the development of a market for credit risk transfer influence structural innovation in the financial system as it puts forward a wide range of instruments to deal with different aspects of credit risk 33 that also affected consumers in many ways.
For example, Scheicher 33 reports that such instruments present default protection for individual firms through credit default swaps CDS , and that such CDS are packaged and traded by means of collateralized debt obligations CDOs that eventually became the centre of bank instability. It is important to note that the link between liquidity, capital, risk and confidence has occupied the banking literature.
As a result, supervisory authorities argue that in order to protect the stability of the financial system, additional restraints on capital adequacy should be implemented. Nonetheless, almost no effort has to date been devoted to an analysis of one of the key ingredients that makes banks safer institutions and that is their own holdings of liquid assets. Borio, 6 for instance, asks three pertinent questions on factors of bank stability: How much liquidity should banks hold as a buffer against bank run?
Do liquidity ratios reflect capital and risk behaviours? How might the size of bank liquidity shield be influenced by bank idiosyncratic factors? Although we might not directly answer all these questions, our discussion and conclusions would epitomize them. Generally, the requirements for a higher capital to assets ratio is assumed to reduce the deposit funding of a bank and is linked to risk-taking strategies.
Therefore, some economists and regulators see this trend with uncertainty as they argued that low capital leads to bank failures, financial instability and consequent consumer confidence levels. Furthermore, regulatory authorities also argue that allowing bank capital to lessen is not safe or proper, and that in order to protect consumer confidence in the financial system therefore additional restraints on capital adequacy should be implemented.
The argument that the losses suffered when a bank fails leads to excessive costs taken up by the investors in situations when banks experience bank runs.
This reason is evidenced by the current financial turmoil where banks issued and bought several securities in the financial market that were contaminated. This line of argument is mainly based on market evaluation and on the relative riskiness of commercial banks. It generally holds that the debt and equity capital in the securities market tends to be enough to keep the commercial banking system to assume undue risks. Furlong and Keeley 31 report that the federal deposit insurance was an important factor towards the increase of capital standards in banking during the s.
Furthermore, they noted that an increase in asset risk was obvious because of the enforcement of higher capital ratio requirements. The effect of a higher capital ratio on default risk is explained as the central issue in bank capital regulation. Shrieves and Dahl 37 examined the differential responses of undercapitalized banks and suggested that, for undercapitalized banks, the degree of undercapitalization is a substantial influence on the probability of equity market issues. Berger et al 38 too found growth rates for a number of asset mix to have positive relationship with capital.
Financial markets have become obscure in several behaviours. For instance, some markets, hedge funds or CDS, hardly disclose useful information for risk assessment. Notwithstanding its importance, disclosure alone does not necessarily guarantee genuine transparency. Market participants need adequate, bias-free and relevant information delivered in an appropriate, timely manner. As an illustration, recent market occurrences involving off-balance-sheet entities and complex financial instruments reveal the lack of transparency ensuing from the incorrect information disclosed late and in the wrong way.
Information on mortgages too suffers from a similar predicament, leaving many borrowers failing to make a well-informed decision. These complex instruments surrounded by speculation may not have similar effects for Islamic banks compared to conventional banks.
In a study on the performance of Bank Islam Malaysia Berhad, Samad and Hassan 39 examined liquidity, and solvency risk for the period — The analysis showed that Islamic banks were somewhat more liquid when compared to the other eight commercial banks operating in the same market. Bashir 40 examines the relationship between banking characteristics and performance measures for 14 Islamic banks for the period — in 8 Middle Eastern countries, and found that Sharia-compliant banks in his sample have more liquidity than non-Sharia-compliant banks.
More recently, Samad 42 examined the financial performance and liquidity of Islamic banks and conventional banks in Bahrain for the period — for 6 Islamic and 15 conventional banks. Results for Samad 42 confirmed the study by Bashir 40 that there were higher ratios of liquidity in Islamic banks compared to those of conventional banks. With respect to risk, according to Sarker 8 Islamic banking products have different risk characteristics, and therefore different prudential regulation should be erected while Khan and Bhatti 43 report that in order to manage risk of the banking sector as a whole, central banks of the Islamic countries have stipulated various capital adequacy and reserve requirements that are not uniform to all Islamic banks in various regions of the world.
It should be noted that Islamic banks do not have a large portion of their assets in fixed-income, interest-bearing assets as compared to conventional banks. Therefore, they may require a larger capital adequacy ratio and a larger liquidity ratio, and that by basing on this argument the Basel Committee has stipulated higher minimum capital requirements for Islamic banks. We obtained our data from Bankscope, and our sample is drawn from the following six countries for the period — Bahrain, Kuwait, Qatar, Saudi Arabia, Oman and United Arab Emirates. The data have included two types of product mix or bank specializations: Islamic and conventional.
This classification criteria is in accordance with the International Association of Islamic Banks membership categorization. The sample comprises banks of which 50 provide an Islamic bank product mix and an conventional bank product mix. In our study, we measure financial stability in the banking sector BS using three important indicators. We expect positive and significant results.
The macroeconomics of lending of last resort: A positive perspective. If this downside risk materialises, the bank is insolvent and thus has to be closed. It consists of a macroeconomic block and the characterisation of four key types of economic players: commercial banks, depositors, the CB, and the unions. Like other businesses, financial institutions and banks expand their loan magnitude to generate more earning or profits. Despite the relevance of financial stability considerations, the economics profession does not offer a workhorse model for how macroprudential actions interact with the more traditional inflation-fighting role of monetary policy.
Our second measure of stability is the BS Tobin Q , which we calculate by equity by earnings. In Tobin's Q Tobin, , 57 Q gives the summary of available and pertinent information about the future for a bank's investment decision. Q implies that a unit increase in the firm's capital stock increases the present value of the firm's profits by Q , and therefore raises the value of the firm by Q. Moore et al 45 and Almeida et al 46 have also used Tobin's Q in their model to examine liquidity during economic constraints or crisis period, and found a significant relationship between Tobin's Q and cash flow.
In our study, we expect a positive Tobin Q because a value that is greater than 1 indicates the bank is doing well in terms of decision investment making decisions in our case Sharia-compliant decisions versus conventional banking decisions , which may lead to differences in changes in capital, liquidity and risk. We therefore also interpret that if Tobin Q is higher, then the access profit of a bank is used to improve its liquidity and risk capital as in accounting it constitutes some form of non-distributable profit.
Therefore, generally, a higher Tobin's Q means more confidence as far as depositors are concerned. Return on average assets for bank i , in country j on period t. Equity over earnings for each bank in country j and year t. Profit before tax for bank i in each country for each year. Equity to assets ratio, bank i country j.
Net loans to Total assets, bank i country j. Cost income ratio, bank i country j. Consumer confidence proxied by the ratio of deposits over total assets for bank i in country j. Another variable we have examined is the Loan Loss provision. Most reported values have been very small and rounded to 0. As for the GCC banking, it has a mean of 5 and a standard deviation of 5, while the highest is This variation is evident by nature of accounting for NPA with respect to Islamic banks as they account for loan loss under profit loss because the nature of Islamic banking is a Profit—Loss Sharing Contract.
There is an interesting variation in the variable Cost—income ratio CIR with a mean of 44 per cent, but when we compare the CIR for the two bank specialization we note remarkable difference. The NLTA for all the banks has a mean of 50 per cent and a standard deviation of 26 per cent.
Results of the ROAV fixed effect regression. Results of the Tobin Q fixed effect regression. Results of the NPA — fixed effect regression. Results of the LIQ-fixed effect regression. We also use Tobin's Q to measure the effect of instability, and to assess whether it impacted the same for Islamic and conventional banks. As shown in Table 3 , the equation Open image in new window shows interesting results. On the other hand, conventional banks alone posit a positive relationship for PBT implying that profitability factors account significantly for bank value.
Although Islamic banks are more capitalized than conventional banks conventional banks have higher averages of liquidity compared to Islamic banks , we have found that liquidity in GCC banks generally tends not to be determined by bank-specific factors. This implies that factors external to the bank such as macroeconomic and market behaviour have a significant relationship with bank liquidity.
Such macroeconomic factors that prevailed, for example in the US and European markets, were likely the major contributory factor to the recession. Furthermore, Islamic banks reported very small NPA, and have shown a positive and significant relationship with liquidity, implying that sub-prime loans, as is the case in the United States and United Kingdom, may have a substantial effect on bank liquidity. Moreover, the regression for all banks in the sample too exhibits a positive and significant relationship with LLP , but shows an insignificant relationship when separated.
We also found that in GCC, conventional banks have higher liquidity levels than their counterparts, suggesting that, unlike the findings of Samad and Hassan, 39 in GCC conventional banks tend to carry more liquidity, most likely to maintain confidence levels for their consumers. Generally, compared to US or EU banks, GCC banks carried higher liquidity levels because of its economy during the period examined having accumulated funds from oil surpluses. Other studies 47 , 48 , 49 detailed several advantages of the Islamic banking system, citing Iran with its long experience since The stability contributed by Islamic banking may not be influenced by policy and other exogenous shocks alone.
Kia and Darrat 49 compare the Islamic bank product mix, and conclude that it provides the most stable and invariant policy function, while Kaleem 5 too supports on the stability of the Islamic monetary instruments in a dual banking system in Malaysia as less vulnerable to crises. Our last measure for consumer confidence levels proxied by deposit and customer funding over total liabilities indicates higher confidence levels for Islamic banks in this region that operates both banks in parallel.
A recent review by the American Congress 50 reveals that the regulatory system not only failed to manage risk, but also failed to call for adequate disclosure of risk through a satisfactory level of transparency.
As a result, American Congress 50 identified eight specific areas most urgently in need of reform on the financial system to address the current bank stability situation. These are to 1 identify and regulate financial institutions that pose systemic risk; 2 limit excessive leverage of financial institutions; 3 increase supervision of the shadow financial system; 4 create a new system to regulate product mix, particularly mortgages and other consumer credit products; 5 create executive pay structures that discourage excessive risk-taking; 6 reform the credit rating system; and 7 establish a global financial regulatory floor.
Four of these American Congress 50 recommendations reflect distinct departure in regulatory practices in the nature of bank product mix such as areas of leverage, contracts, instruments and mortgages for both Islamic banks and conventional banks. Blum 51 discussed the possibility of increasing bank risk resulting from capital adequacy rules. By analysing a single bank with the result of optimal choices being compared with the first-best solution of the model, Blum 51 found that an additional unit of equity leads to an additional unit of investment larger than a unit in the risky asset.
This leverage effect makes equity more valuable to a regulated bank. Furthermore, Gehrig 52 discusses that excessive risk-taking also takes through direct investments in risky assets where such assets may be high-risk projects, or might be risky securities, and is difficult to monitor substituted safe assets over risky assets by outside investors or depositors. Policy implication is that Islamic banks product mix provides alternative practices in risk sharing and capital worth considering their adoption, and have significant relationship with stability factors and consumer confidence.
Areas for future research concerns the nature in which banks are exposed to the sub-prime exposure as argued by Woertz, 53 for example, in that banks in GCC may have direct exposure incurred by sovereign wealth funds, such as the Abu Dhabi Investment Authority and the Kuwait Investment Authority amidst maturity mismatches especially in real estate financing, and the probability that GCC bank customers had invested in CDOs issued in the United States. Skip to main content Skip to sections. Advertisement Hide. Download PDF. Original Article First Online: 08 December For example, the Gallup poll Figure 1 traces levels of confidence in banking from to , which shows a declining consumer confidence the US banking sector from 60 per cent to 32 per cent.
Open image in new window. Figure 1 Consumer confidence in the United States. The main contrasts of the dual product mix The main contrasting feature between Islamic and conventional banks is based on interest payment in their transactions, and the prohibition of undertaking or financing unethical activities such as gambling, prostitution, alcohol and narcotics. There are at least six basic ethical principles from the Quran : Avoidance of interest, risk sharing, treating of money as potential capital, prohibition of speculation, sanctity of contracts and avoidance of prohibited activities such as those connected with alcohol and gambling.
Table 1 summarizes the key features that differentiate the nature of two product mixes. Table 1 Differentiating features in bank's product mix. Islamic bank product mix Conventional product mix Each product or service is guided by sources of Sharia and products are approved by the Sharia Board within each bank Products are developed based on demand, competition and bank strategy.
The link between stability factors and confidence It is important to note that the link between liquidity, capital, risk and confidence has occupied the banking literature. Model In our study, we measure financial stability in the banking sector BS using three important indicators. Banks in a stable situation will not face liquidity constraints because not only will the deposits be easy to mobilize, but the timing of cash flows from loans will also not be affected by an increasing level of NPA.
We use loan loss provision over deposits to measure the impact of non-performing loans to bank sustainability. Finally, we estimate illiquidity using the ratio of current asset over current liability to find factors that may influence the level of liquidity among banks. Therefore, we run equations 1 , 2 , 3 and 4 : Open image in new window. This difference is attributed to two main factors. First, to some extent the nature of accounting treatment of PBT in profit—loss sharing arrangement may be counted as a financial cost, and second but to a great extent Islamic banks earn high PBT owing to its prices.
We chose to use PBT because we cannot use NIM to compare these two types of banks because Islamic banks do not charge nor earn interest. Table 2 Summary of statistics. Our first measure of BS , which is Open image in new window , and differentiated among two bank specializations or product mix are Open image in new window and Open image in new window for Islamic and conventional banks, respectively.
Table 3 gives the comparative results of the four regressions, which shows how the two types of banks are impacted by changes in financial conditions. ROAV ijt is positive and significantly related to PBT for all banks but exhibits a different relationship when examined separately. It has a positive but insignificant relationship with PBT , whereas is negatively and insignificantly related to PBT in Conventional banks. Table 3 Results of fixed effect regressions for GCC countries for — Washington: International Monetary Fund.
Google Scholar. Haque, A. American Journal of Applied Sciences 6 5 : — CrossRef Google Scholar. Aziz, Z. Kia, A. Department of Economics, Emory University. Working Paper.