Journal of Financial Services Research

Cole and White (J Financ Serv Res 2012) show that small banks which failed during the financial crisis–like small banks which faile in previous crises–tended to have high concentration of loans financing commercial real estate and real estate development several years before failure. In contrast, large banks failed during the financial crisis due to the novel strategy of investing in poorly underwritten subprime mortgages. The fact that large banks fail as a resut of changing business models while small banks fail for predictable reasons makes justifies a heightened level of supervision of large banks (consistent with the Dodd-Frank Act).

A popular view of banking crises sees them as consequences of prior bank lending “manias.” Such manias are supposed to be especially likely in legally unrestricted banking systems, where banks can issue notes and are not subject to statutory reserve requirements. Here it is argued that the bank lending mania hypothesis (1) exaggerates the role of subjective factors, including bankers' “confidence” or “optimism,” as a stimulus to bank lending, and (2) is not supported by evidence from past, legally unrestricted banking systems.

We propose a simple, parsimonious, and easily implementable method for stress-testing banks using a top-down approach that captures the heterogeneous impact of shocks to macroeconomic variables on banks’ capitalization. Our approach relies on a variable selection method to identify the macroeconomic drivers of banking variables as well as the balance sheet and income statement factors that are key in explaining bank heterogeneity in response to macroeconomic shocks. We perform a principal component analysis on the selected variables and show how the principal component factors can be used to make projections, conditional on exogenous paths of macroeconomic variables. We apply our approach, using alternative estimation strategies and assumptions, to the 2013 and 2014 stress tests of medium- and large-size U.S. banks mandated by the Dodd-Frank Act, and obtain stress projections for capitalization measures at the bank-by-bank and industry-wide levels. Our results suggest that accounting for bank heterogeneity yields expected capital shortfalls that can be over 30 percent larger than in the case where heterogeneity is ignored. Furthermore, we find that while capitalization of the U.S. banking industry has improved in recent years, under reasonable assumptions regarding growth in assets and loans, the stress scenarios continue to imply sizable deterioration in banks’ capital positions.

Corporate insiders frequently borrow from lending institutions and pledge their personal equity as collateral for the loan. This borrowing, or pledging, potentially affects shareholder risk through changing managerial incentives or contingency risk. Using an exogenous shock to lending supply, we document a significant increase in risk arising from pledging. Difference-in-differences regressions indicate that insider pledging corresponds with a 16.5% relative increase in risk despite unchanged firm fundamentals. The empirical analysis supports contingency risk in linking pledging to volatility. Overall, our findings suggest that pledging allows influential insiders to extract private benefits of control at the expense of outside shareholders.

In recent years, the emergence of electronic finance—especially online banking and brokerage services, and new trading systems—has reshaped the financial landscape around the world. This paper reviews these developments and finds that they are greatly impacting the structure of and competition in financial services industries and will have a large impact on incumbents. Its assessment of how e-finance, and globalization more generally, affects countries highlights the need for changes in four financial sector policy areas—safety and soundness, competition policy, consumer and investor protection, and global public policies—to mitigate risks and reap as much as possible the potential benefits of e-finance.

The primary argument set forth in this article is that the theory of finance can and should be rigorously applied to the study of the insurance firm. In order to illustrate this point, we turn our attention to the insurance solvency literature, where the implications of default risk for insurance company decision-making and regulatory policy are widely discussed but not nearly as widely understood. Rather than treat the probability of ruin as an exogenous constraint that is arbitrarily imposed by regulators, the approach taken here is to endogenize the probability of ruin with respect to a complex contracting process undertaken by a variety of self-interested claim holders. This treatment enables us to evaluate regulatory constraints such as minimum capital requirements within a rigorous theoretical framework. Our analysis suggests that even in an unregulated market, insurers would voluntarily limit their premium-capital ratios in an effort to economize on contracting costs. Furthermore, mutual insurers are likely,ceteris paribus, to employ less leverage than insurers organized as stock corporations.