Private Information and Risk Management in Banking

In this chapter we describe the risk management challenges faced by financial institutions. The very nature of the banking business requires that financial firms become experts at risk assessment in order to manage their own inventories of risk, obtained during day-to-day business transactions with bank customers. Banks are exposed to interest rate risk, currency risk, liquidity risk, credit risk, and operational risk. The first step in a risk management program is accurate risk measurement. A useful risk measurement tool is the Value at Risk (VaR) model. The 99% VaR model produces predictions such as the worse loss that may occur 1 in every 100 days (or years). In contrast, the 99% Expected Shortfall denotes the average of all losses that occur with a one percent probability. We show that the roots of the global financial crisis of 2007–8 can be found in the failure of financial intermediaries to measure and manage risk properly.

Banking and Real Economic Activity

This chapter reviews insights about how the banking system affects real economic performance. After arguing that the causality debate—the high-level question of whether the characteristics of a banking system have causal consequences for the real economy—has essentially been settled, we evaluate the specific channels through which banking activity may exert real effects. We focus on the rich empirical literature spawned by the theoretically ambiguous impact of greater banking competition, which has found concentration of the banking system to be a significant determinant of the structure and health of non-financial industries. We also discuss how, after the 2007–9 financial crisis, there has been revitalized interest in modeling the role that financial intermediaries play in amplifying aggregate shocks and initiating crises. We conclude by noting the importance of accounting for the changing institutional, structural, and technological properties of the financial sector in understanding the interplay between financial and real activity.

Banking Globalization

The financial crisis has renewed interest in the globalization of the banking industry, the patterns of entry into foreign markets, and the effects of complex banking organizations. There is a rich body of literature on international banks, which has recently been expanded by the improved theoretical modeling of the international banking firm and by focusing on implications for (systemic) risk. In this chapter, we focus on three main questions. First, what are the determinants of cross-border entry through acquisitions of commercial banks? Second, what are the effects of cross-border entry on complexity and the efficiency of banks? Third, what are the risk effects of international bank acquisitions, in particular with regard to systemic risk? We begin with a brief summary of the stylized facts, and we conclude with implications for researchers and policymakers.

Hardy Perennials

In the long history of systemic banking crises—including, but not limited to, the Global Financial Crisis—the worst cases have been caused or at least severely exacerbated by what may be called bad banking and bad policies: those that permitted or encouraged excessive risk-taking and even “looting” of other people’s money. With each crisis there is an inevitable chorus of calls for more official prudential regulation and supervision to prevent a recurrence. Empirical evidence suggests that policy is best directed toward ensuring a dynamic approach to regulation focusing on the information that is being disclosed to market participants, the degree of market discipline on the behavior of bankers, and the incentives in the financial system, including those for regulators.

Market Discipline in Regulation

With the introduction of Basel II in 2004, “market discipline” became one of the Basel Committee’s three pillars of prudential regulation. Although many academic papers have sought to test for the presence of effective market discipline in banking, few have dealt fully with the question. Effective market discipline involves two distinct steps: monitoring a bank’s condition and influencing it to avoid unacceptably large risks. Both phases of market discipline are necessary; neither one alone sufficient. In this chapter, we provide a careful definition of market discipline, explain how it may complement supervisory efforts to control an institution’s risk-taking, and review the available literature on the efficacy of market discipline. We also discuss how recent changes in supervisory actions toward failing banks has changed the channels through which market discipline will work going forward.

Bank Capital Requirements after the Financial Crisis

Regulators responded with an array of strategies to shore up weaknesses exposed by the 2008 financial crisis. This chapter focuses on reforms to bank capital regulation. We first discuss the ways in which the post-crisis Basel III reforms recalibrated the existing framework by improving the quality of capital, increasing the quantity of capital, and improving the calculation of risk weights. We then shift to the major structural changes in the regulatory capital framework—capital buffers on top of the minimum requirements; a leverage ratio that explicitly accounts for off-balance-sheet exposures; risk-based and leverage capital surcharges on the largest banks; bail-in debt to facilitate orderly resolution; and forward-looking stress tests. We conclude with a quantitative assessment of the evolution of capital in the global banking system and in the US banking sector.

Shadow Banking

Financial innovation has transformed intermediation from a process involving a single financial institution to a chain of transactions broken down among several institutions. Following the Great Financial Crisis, financial intermediation has shifted significantly from banks to non-banks, providing credit in the “shadows” of the regulated banking system. This chapter offers a definition of shadow banking and explanations for its existence, as well as providing an overview of attempts to measure its size. It explains how shadow banking differs from other forms of non-bank intermediation, in particular market-based finance, and discusses why regulators and academics should care about it. Further, the chapter reviews efforts to strengthen supervision and regulation and discusses some policy challenges on the horizon in the context of case studies.

Payments

Payments, paper-based or electronic, are essential for efficient economic exchange. For retail payments, debit and credit cards have been replacing cash and checks for point of sale transactions. Cards and automated clearing house (US) and giro networks (Europe and elsewhere) have replaced cash and checks for bill payments and employee disbursements. Daily retail payments have relatively small average values but number in hundreds of millions of transactions. Daily wholesale wire transfer transactions are in the thousands but their value is in the trillions. They are used to make large-value business, government, and financial market transactions, along with settling payments made over other networks. To be widely adopted, a retail payment instrument has to have lower cost and greater convenience. Cost is also emphasized for wholesale payments but this has generated risk. Reducing risk has raised costs. The issues associated with retail and wholesale payments are quite different; they are discussed separately in this chapter.

Technological Change and Financial Innovation in Banking

Financial intermediation has changed dramatically over the past thirty years, due in large part to technological change. The chapter first describes the role of the financial system in a modern economy and how technological change and financial innovation can affect social welfare. We then survey the empirical literature relating to several specific financial innovations, broadly categorized as new production processes, new products or services, or new organizational forms. In each case, we also include examples of significant FinTech innovations that are transforming various aspects of banking. Drawing on the literature on innovations from the 1990s and 2000s informs what we might expect from recent developments.

Banking

A lot has happened in the ten years since the global financial crisis. This chapter starts with a summary of key regulatory and operational issues that have impacted banks in Europe, the US and elsewhere. Banks are much more heavily regulated than pre-crisis, their performance in the US and Europe has been subdued although there are signs that those in the former have turned the corner. There continues also to be ongoing discussion as well as regulatory efforts to improve banking system stability with new rules on capital, liquidity, bailouts, and bail-ins to be fully completed. These issues are covered in the first part of the chapter. We then move on to discuss emerging research themes covering areas including: banks and their impact on the real economy; capital, liquidity, and tax regulation; systemic risk; unconventional monetary policy; FinTech; bank governance and culture; financial consumer protection and financial literacy; and finally financial inclusion. The final part of the chapter provides summaries of all the chapters in the Handbook.