Thomas Gehrig

To evaluate a bank’s resilience to financial stress, authorities often rely on private information from a peer institution, or counterparty. This reliance can be perilous, especially when assessing bailout options. Within a global games approach to bank runs, we study communication about a systemically important bank’s financial status between an informed counterparty of said bank and an uninformed authority. This communication is costless, non-binding, and unverifiable – and yet pivotal for the authority’s decision to bailout the bank. When information about the counterparty’s own liquidity needs is private, the counterparty may exaggerate the systemically important bank’s true need for support, but it may also withhold adverse information entirely. We show that the authority’s risks in assessing bailout options is (1) shaped by the strategic behavior of the informed counterparty, (2) dependent on knowledge of the counterparty’s own financial position, and (3) not necessarily continuous.

Ein Forum für die Wissenschaft seit 1798.

Ein Forum für die Wissenschaft seit 1798.

This article introduces a shrinkage procedure which allows to improve upon the parametric portfolio approach introduced in Brandt et al (Review of Financial Studies 22(9): 3411–3477, 2009) and more general factor conditional frameworks. We analyze optimal investment decisions for constant absolute and constant relative risk aversion. In both preference classes, especially out-of-sample performance of the optimal strategies is rather volatile. In order to reduce parameter and model uncertainty, we augment the optimal strategies by a shrinkage device that pulls the portfolio weights toward a predetermined policy portfolio. Our theoretical approach thereby extends the demand systems approach of Koijen and Yogo (Journal of Political Economy, 127(4):1475–1515, 2019) to more general classes of preferences and provides conditions for the existence of equilibrium. As a side product, we establish that the characteristics-based parametric portfolio approach of Brandt et al. (Review of Financial Studies 22(9): 3411–3477, 2009) can only be justified as optimal investments under exceedingly strong assumptions. In empirical US data, our shrinkage approach outperforms the parametric approach and the naive 1/N-strategy over quite a wide range of levels of absolute and relative risk aversion.

The relative importance of banks for the financial system differs widely in Europe and the U.S., where Europe has historically been more bank-based than the US How does the different role of the banking systems translate into the resilience of bank business models, and of the financial system overall? In aggregate, European banks are more exposed to systemic risk relative to U.S. banks despite the fact that their book-based tier-1 core capital is comparable. However, there is wide heterogeneity across European banks, rendering the transatlantic comparison more delicate. Also, the authors find differences in social responsibility scoring between the two systems. ESG scores tend to be higher for European banks, particularly on the social and environmental components. On the other side, US banks score higher on governance items. Effectively, at the start of the pandemic in March 2020 the largest European banks were more highly levered relative to their US peers, and, consequently lagging behind in terms of market capitalization. The emerging picture for the lower quintiles in the cross-section of European banks is more favorable in terms of resilience, both within Europe and across the Atlantic.

Stock repurchases of banks have become an increasingly popular instrument of banks’ payout policies after the Great Financial Crisis. Recent empirical evidence documents that stock repurchases are particularly popular among global systemically important banks that tolerate relatively high levels of exposure to systemic risk. Hence, stock repurchases add to reducing risk-bearing capital precisely for those banks that have the greatest capital shortfall. The allow to secure short-term gains at the cost of long-run stability. This thematic review of the empirical literature finds that various ESG-ratings are indeed informative about the true underlying intentions and planning horizons of bank business models. ESG-ratings are informative both, about idiosyncratic as well as systemic risk, and, hence, implicitly also about bank resiliency. While regulators generally are not in the business to save individual firms, in the banking industry, however, their mission is to maintain the stability of the financial sector as a whole. This implies to ensure that systemic risk remains within socially acceptable bounds. Especially the exposure to systemic risk as proxied by capital shortfall requires a sufficiently high level of bank capital. Accordingly, one strong recommendation emerges from this survey of the relevant empirical literature: Since ESG-scores are particularly informative about the planning horizon of the underlying firms or banks, permission to repurchase stock should be granted particularly to those banks with higher ESG scores. Granting permission also to banks with lower ESG-scores increases bail-out risk for the tax payer, as experienced recently in the case of Credit Suisse.

The resilience of supply chains is analyzed in a model of strategic technology investments in markets with essential resources. With a monopoly supplier, dual sourcing is a strategy to reduce switching costs in the long-run. It serves as an insurance mechanism against future opportunism by providing access to competitive global markets. Investments in dual sourcing are required to limit abuse of market power by the active source provider, even though the option of dual sourcing may not be exercised in equilibrium. The analysis has implications for the European natural gas market. Liquefied natural gas terminals may serve a strategic purpose of limiting ex-post opportunism even when delivering gas by pipeline is more efficient.

Summary: Corporate income taxation and prudential regulation are complementary instruments for public policy in banking markets. The common deductibility of interest payments induces debt bias and causes banks to be excessively levered. A reduction in debt-bias can achieve two goals at the same time: It enhances resiliency by lowering the cost of equity and it enhances the global competitiveness of banks by strengthening their capital structure. Moreover, even reforms that are fiscally neutral in the short run will reduce the fiscal burden on bank rescue operations in the long-run.