Systemically Important Banks: evidence from Central and Eastern Europe countries
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1 Systemically Important Banks: evidence from Central and Eastern Europe countries Objectives. Today, one of the key issues of economic development in different countries is to ensure the stable functioning of the financial sector in general and banking in particular. Implementation of systemic risk during global financial and economic crisis outlined the problem of existence of systemically important financial institutions, whose activity, rather termination of which has a significant impact on the financial sector functioning and financial stability in the country. This, in turn, requires appropriate financial support from the government and raises the problem of moral hazard which is associated with the implementation by banks aggressive risk and high-yield strategies with hope of receiving government support in the future. During the G-20 summit, which took place in Canada in June 2010, some new tasks of banking supervision were approved in order to enhance the stability of the financial system, establish reliable supervision systems by concentrating the supervisors attention on systemically important financial institutions with consideration of their impact on financial stability (IMF Global Financial Stability Report, October 2012; Chen Zhou, 2009). Therefore nowadays the question of systemically important banks identification is actively discussed in international environment. Under the Financial Stability Board s coordination, methodologies to identify global systemically important financial institutions (SIFIs) have been developed ( Global systemically important banks: Assessment methodology and the additional loss absorbency requirement (BCBS, November 2011), as well as guidance to help national authorities identify banks that pose systemic risks to their domestic economies ( A framework for dealing with domestic systemically important banks (BCBS, August 2012). The Financial Stability Board also adopted a framework to decrease the probability of a SIFI failing, through, for example, capital surcharges and more intensive supervision. It must be stressed that today identification and regulation of SIFIs is mainly carried out by developed and developing economies having high threat of systemic risk. Since financial stability issues (including sources of systemic risks, features of business and financial cycles, impacts of shocks) in economic literature are regarded separately in the context of advanced economics and emerging market and developing economies it should be taken into account differences in country s development. Countries of advanced economics and emerging market differ substantially in terms of economic size, legal and institutional frameworks, and other factors that affect financial systems. It is crucial to
2 understand common characteristics relevant for understanding the prevalent financial stability issues in these countries. The transitional nature of CEE countries financial systems is reflected in their relatively small overall size, lower complexity, a dominant role of banks and a relatively small role of nonbank financial institutions, thin capital markets, and greater challenges in providing broad access to finance, importance of foreign capital, weaker institutional frameworks and market infrastructures, important supervisory capacity constraints, and a relatively greater involvement of the state in the financial system. Moreover because of the traditional bank intermediary model dominated in CEE countries, many global risk areas had not yet developed there. Banking sector assets in CEE countries have remained relatively small as a percentage of their GDPs and bank concentration is low, with a resulting low threat of systemic risk. That raises following question: Are systemically important banks existing in CEE countries? Do bankruptcy of systemically important banks really influence on banking system stability (banking crisis)? Therefore this research concentrates on the systemically important banks issue in CEE countries. Research hypothesis of this paper are as follows: Hypothesis 1. Default of systemically important bank is not a source of systemic banking crisis in Central and Eastern Europe (CEE) countries (there is no link between default of systemically important bank and systemic banking crisis occurrence). Hypothesis 2. Main sources of systemic banking crisis in CEE countries are in the area of financial sector impairment caused specifics of banks business model. Practical contribution of the research. In response to the financial crisis of 2008, banking industry has been undergoing fundamental regulatory changes focusing authority s attention on risks to the financial system posed by systemically important financial institutions. The question of systemically important banks identification and regulation is highly significant for national financial sector supervision system, since wrong identification of systemically important banks will bring incorrect measures from regulators on the one hand, underestimation of systemically importance of the bank may causes dropping the financial threatening position of these banks and, from here, unpredictable source of financial instability of the whole financial system; on the other hand, overestimation of systemically importance of the bank may leads to intensive regulation of these banks and creation of regulation burden for them, bank performance declining.
3 At the same time it must be taken into consideration that systemic risks are vary from country to country as well as the systemically important bank issue. Basically, banks in developed and some of developing economies, based on expansion into new markets, non-depository funding and non interest-based sources of profits, product synergies, scale and scope benefits and global coverage turned out to be most affected, requiring massive stabilization funds and in some cases governmental rescue. While the traditional business model of banking intermediation, relatively low concentrated banking sector with low dependence on sophisticated financial instruments, which dominates in transition countries, stipulates that many global risk areas including systemic had not yet developed there. Despite these differences at the national level majority of policymakers have been strengthening existing supervisory practices and regulations applying to SIFIs new rules and restrictions. For example, part of CEE countries members of EU (Poland, Hungary, Czech Republic, Slovakia and Slovenia) have to participate in the new European regulatory and supervisory architecture, centered on the prevention of systemic risk posed by large banks. As these countries are relatively new to EU decision-making processes, they tend to be rule-takers rather than rule-makers. Thus in the context of lacking a clear and comprehensive picture of the nature of national policy responses to deal with SIFIs research devoted systemically important banks issue and their influence on banking system stability in CEE countries has profound topicality. Literature review. The basis of systemically important banks issue and their identification is founded by the Basel Committee on Banking Supervision by adopting consultative document Global systemically important banks: Assessment methodology and the additional loss absorbency requirement (BCBS, November 2011). The methodology for identifying systematically important banks is based on the indicator-based measurement approach and distinguishes five criteria of banks systemic importance on a global scale (size, interdependence, uniqueness of services, international activity, business complexity), each of which has the same weight (20%) and is represented by one or more indicators. For each bank every indicator has a relative value, which is calculated as a ratio of its position and the position of all banks. According to the obtained results all banks are ranked according to the degree of systemic importance within four groups with appropriate capital requirements (Group 1-1%, Group 2-1.5%, Group 3-2%, Group 4-2.5%). It should be noted that the methodology for determining systemically important banks offered by the Basel Committee has several
4 shortcomings, which were received in the form of comments from 39 leading banks, universities and associations, which requires the adaptation of the methodology to the needs of supervisors. As indicator-based approach is notable for assessment precision for transparency, simplicity and easiness for practical implementation and explanation for legislative bodies and public it s becoming matter for various discussions and modifications by researchers. Based on the methodology of the Basel Committee on Banking Supervision, P. Brämer and H.Gischer developed a modified approach to identify systemically important banks in the Australian banking system (Brämer P., Gischer H., December, 2011). The research of Skorepa M. and Seidler J. is also one of the examples of conducting indicator-based approach for a specific (the Czech) national banking sector, using a partly different approach (Skorepa, M., Seidler, J., 2013). Besides indicator-based approach in the contemporary economic literature there are other methodological approaches for identifying systemically important banks. In the study of the DeutscheBank Christian Weistroffer distinguishes the methods for identifying systemically important banks in accordance with such criteria as the subject (supervising authorities and scientific researchers) and the type of the used data (balance sheet and market data) (Weistroffer Ch., August 11, 2011). Mathias Drehmann and Nikola Tarashev differentiate between the methods based on the assessment of banks participation in systemic risks (participation approach), and the methods based on the assessment of banks contribution to systemic risks (contribution approach), which differ according to the distribution of the systemic risk among banks (Drehmann, Mathias and Tarashev, Nikola A., March 2011). Following the results of the seminar of the European Central Bank Recent advances in modelling systemic risk using network analysis, which was held in October 2009, it should be noted that the network method has a high potential in terms of macro-prudential supervision, including the supervision of the financial market infrastructure (the study of payment systems stability) and somewhat limited possibilities in terms of bank supervision, taking into consideration the rapidly changing market information and concentration solely on the interbank lending market (ECB, October ). The choice of appropriate approach is one of the critical issues in the context of designing a methodology for identifying systemically important banks. Studies devoted exploring simultaneously different measures of systemic importance - simple and sophisticated indicators both (Elias Bengtsson et al. 2013; Mathias Drehmann et al. 2011) indicate that they are complementary to a large extent and the choice of the specific measure is daunting task for regulator body. Taking into account such criteria as the unavailability of the market data in CEE countries at the same time, assessment precision and practical
5 significance of the results of systemic risk assessment it should be noted that in order to identify systemically important banks in CEE countries it is appropriate to use the indicator-based measurement approach. It should be noticed that nowadays there is no any study devoted systemically important banks identification in CEE countries; hence our paper is going to eliminate this. There are obvious difficulties in empirical testing of systemic importance measures also. As the Kimmo Soramäki and Samantha Cook (Soramäki, Kimmo and Cook, Samantha, 2013) state: actual bank failures are rare and the data is not generally publicly available. So the authors of this paper try to simulate the results of the bank failure depending on the share of interbank deposits and other variables. Another way of bank failures data substitution is usage of default indicator when losses on a bank s assets wipe out its equity cushion (Mathias Drehmann et al. 2011). Besides there is problem of separation the effects of the general economic conditions (fall in stock prices or housing prices) and the effects of the failure of the particular bank on the banking system. Since the failure of systemically important bank can be regarded as one of the systemic crisis reason (source) it s raised the question of usage of systemic banking crisis determinants model. Today a growing literature has studied the causes and consequences of bank fragility in several countries, including developed economies, developing countries, and economies in transition. Most of the studies use logit / probit models aimed at providing early warning systems. While most of the focus has been on advanced economies (Barrell et al, 2010; Babecký et al; 2013), the relevant empirical literature has devoted scant attention to transition countries. The determinants of banking crisis used in the literature differ from paper to paper but most of the studies highlight the key role of macroeconomic, financial, institutional indicators. In our paper we develop one of the most basic study devoted systemic banking crisis determinants identification - multivariate probability model of Asli Demirgüç-Kunt and Enrica Detragiache (Demirgüç-Kunt et all, 1998) including the new financial variable - the failure of systemically important bank. Methodology Data Data on bank-specific indicators (losses, equity and systemically important indicators) is based on the BankScope dataset for 868 banks from 18 CEE countries (Albania, Belarus, Bosnia and Herzegovina, Bulgaria,
6 Croatia, Czech Republic, Estonia, Hungary, Kosovo, Latvia, Lithuania, Macedonia (Fyrom), Poland, Republic of Moldova, Romania, Slovakia, Slovenia, Ukraine). Collecting data on banking crises is based on studies of Reinhart Carmen M. and Rogoff Kenneth This Time Is Different: Eight Centuries of Financial Folly (Appendix A.4 Historical summaries of banking crises, ) and Laeven, L. & Valencia, F. (2012) Systemic Banking Crises: A New Database. Information about research variables is presented in Table 1. Table 1. Summary of research variables Variable Size Interconnectedness Complexity Uniqueness of services International activity Bank failure Banking crisis Macroeconomic indicators Financial indicators Definition Total assets Loans and advances to banks; Deposit from banks; Wholesale funding/ total funding; Number of subsidiaries; Derivatives; Trading liabilities; Number of employees; Specialization; Savings deposits; Loans and advances to customers; The presence of foreign capital Proxy of bank default when losses on a bank s assets wipe out its equity cushion Dummy variable (1/0) indicating the banking crisis occurrence GDP, interest rate, trade, fiscal deficit and exchange rate Ratio of domestic credit to the private sector to GDP, ratio of bank liquid reserves to bank assets, rate of growth of real domestic credit, leverage ratio, loan-to-deposit ratio and failure of systemically important bank Theoretical model and estimation We will test hypothesis by usage of multivariate logit model of banking crisis developed by Asli Demirgüç-Kunt. The probability that a crisis will occur at a particular time in a particular country is hypothesized to be a function of a vector of macroeconomic variables (like GDP, interest rate, trade, fiscal deficit and exchange rate) and financial variables (like ratio of domestic credit to the private sector to GDP, ratio of bank liquid reserves to bank assets, rate of growth of real domestic credit, leverage ratio, loan-todeposit ratio etc) and default of systemically important bank). In each period the CEE country is either experiencing a systemic banking crisis (dependent variable - the crisis dummy - takes the value one), or it is not (dependent variable - the crisis dummy - takes the value zero). The probability that a crisis will occur at a particular time in a particular country is hypothesized to be a function of a vector of n explanatory variables X(i,t). Explanatory variables capture main sources of banking crisis concentrated on macroeconomic (like GDP, interest rate, trade, fiscal deficit and exchange rate) and financial variables (like ratio of domestic credit
7 to the private sector to GDP, ratio of bank liquid reserves to bank assets, rate of growth of real domestic credit and default of systemically important bank). To be precise, our empirical specification is given by the following regression equation: C it = α + Xsβs +ε (1) Where C it : is a dummy variable indicating the systemic banking crisis; α: is a constant; Xs: denotes the subset of explanatory variables of systemic banking crisis (macroeconomic and financial variables); βs : is a vector of coefficients; ε: error term. The methodology for identifying systematically important banks is based on the adapted to the CEE countries indicator-based measurement approach recommended by Basel Committee and distinguishes five criteria of banks systemic importance (size, interconnectedness, uniqueness of services, international activity, business complexity), each of which has the same weight (20%) and is represented by one or more indicators. For empirical testing of systematically important bank s default authors intend to use proxy of the bank failure if losses on a bank s assets wipe out its equity cushion. Systemic importance categories (indicators) 1. Size. The bank size is one of the key factors of its importance in the context of the national economy. Thus, the bigger the volume of the bank s assets and its share of the market of banking services and the financial market of the country, the more pronounced would be the impact on the national economy if the bank leaves the market. 2. Interconnectedness. According to the international experience, besides the scope of the banking business, the relationship between banks traditionally seen through the mechanism of interbank lending, plays a significant role in terms of banks systemic importance. The key feature of the market of interbank lending is a high risk to business reputation of agency banks as interbank lending operations are usually unsecured and based on the assessment of the borrower s creditworthiness, its market position and duration of the agency
8 relations. High dependence of banks on the interbank market resources may adversely affect their financial situation in the case of unfavorable conditions on the financial market. To characterize the bank s position on the interbank lending market it is advisable to use the analysis of the volumes of funds from the interbank market and of the funds distribution on this market. Another indicator of the bank s dependence on the external sources is the share of other banks funds (wholesale funding) in the structure of its liabilities. A higher share is the evidence of significant dependence of the bank on the financial market resources and of the increased risk due to the operational nature of its reaction to changes in the economic environment and high volatility. 3. Complexity. Another criterion of systemic importance of banks is the complexity of the banking business. As its indicators we propose to use the volume of derivatives and trading securities. Taking into account the fact that the trading portfolio contains the securities purchased mainly for the purpose of generating a profit from short-term fluctuations in their prices, and therefore has a short-term speculative character, the indicator of the size of the trading portfolio of bank s securities serves as an indicator of the degree of vulnerability of its financial situation as a result of changes in the conditions of the securities market. Besides, a qualitative approach would allow to better take into account the various sources of complexity, such as any structural complexity arising from number of subsidiaries and employees. 4. Uniqueness of services. As a criterion of a bank s systemic importance it is also appropriate to take into account the degree of its uniqueness that manifests itself in the difficulty of replacing the bank by another bank on the market or in the duration of the substitution process, resulting in a deficit of the "unique" banking services on the market. One of the criterion can be specialization of the bank savings, mortgaged, investment or other. Turning to the more common services and functions provided to the general public (deposit taking and lending to customers), we propose to take into account market share in respect of essential functions, and intends to incorporate savings deposits and loans and advances to customers as quantitative indicators for uniqueness of services. This is based on the logic that the higher the market share of bank, the more difficult it will be to substitute the extent and level of service it provides. 5. International activity. According to the methodology of identifying global systemically important banks the last criterion of systemic importance is the international activity of banks, which leads to additional risks associated with the transfer of crisis impulses from different capital markets. In order to take into account the factor of systemic risks we propose to include the information about the presence of foreign capital. From
9 the position of a risk-based supervision the presence of a foreign capital in banks requires close attention primarily because of an increased risk of its withdrawal from the country in case of deterioration of the socioeconomic and political situation in the country or a substantial deterioration of banks performance. Therefore, banks with foreign capital should be an object of increased banking supervision in terms of the nature and scope of the systemic risk and its implications for the country in general. The technique for determining influence of banks systemic importance on banking crisis occurrence is based on using such measure of systemic risk as bank default in the years of banking crisis. The choice of bank default (situation when losses exceed bank equity) as systemic risk measure is caused by main function of bank equity - to absorb losses and to build and maintain confidence in a bank. Expected research outputs. We expect to identify systemically important banks in CEE countries by adopting indicator-based approach proposed by the Basel Committee on Banking Supervision and clarify if there is a link between the failure of the systemically important bank and the systemic banking crisis occurrence. We assume that main sources of systemic banking crisis in CEE countries are in the area of real sector deterioration or financial sector impairment caused specifics of banks business model. Bibliography Babecký, J., T. Havránek, J. Matějů, M. Rusnák, K. Šmídková and B. Vašíček, Leading indicators of crisis incidence: evidence from developed countries. Journal of International Money and Finance, forthcoming. Barell, R., E. P. Davis, D. Karim and I. Liadze, Bank regulation, property prices and early warning systems for banking crises in OECD countries. Journal of Banking and Finance, 34: Bengtsson E., Holmberg U. and Jönsson K. (2013) Identifying systemically important banks in Sweden What do quantitative indicators tell us?. Sveriges riksbank economic review 2013:2. BCBS (November 2011) Global systemically important banks: Assessment methodology and the additional loss absorbency requirement. BCBS (August 2012) A framework for dealing with domestic systemically important banks. Consultative document.
10 Brämer P., Gischer H. (December 2011) Domestic Systemically Important Banks: An indicator- Based Measurement Approach for the Australian Banking System. Working Paper No. 3/12. Chen Zhou (2009) "Are banks too big to fail?". DNB Working Papers 232, Netherlands Central Bank, Research Department. The Determinants of Banking Crises: Evidence from Developing and Developed Countries, with E. Detragiache, IMF Staff Papers, Vol 45:1. March Drehmann, Mathias and Tarashev, Nikola A. (March 2011) Systemic Importance: Some Simple Indicators. BIS Quarterly Review. ECB (October 5, 2009) Recent advances in modelling systemic risk using network analysis. Workshop. Frankfurt. Elliott, Douglas J. and Robert E. Litan (Jan. 16, 2011) Identifying and Regulating Systemically Important Financial Institutions: The Risks of Under and Over Identification and Regulation, Brookings Policy Brief. IMF Global Financial Stability Report (October 2012) A Report by the Monetary and Capital Markets Department on Market Developments and Issues. Kimmo Soramäki and Samantha Cook (2013). SinkRank: An Algorithm for Identifying Systemically Important Banks in Payment Systems. Economics: The Open-Access, Open-Assessment E-Journal, 7 ( ): Laeven, L. & Valencia, F. (2012). Systemic Banking Crises: A New Database. International Monetary Fund, IMF Working Papers, No 12/163. Reinhart, Carmen M, and Kenneth S Rogoff This Time Is Different: Eight Centuries of Financial Folly. Princeton, New Jersey: Princeton University Press. Skorepa, M., Seidler, J. (2013), An additional capital requirement based on the domestic systemic importance of a bank. CNB Financial Stability Report , pp Tarullo, Daniel K. (June 3, 2011) Regulating Systemically Important Financial Firms. Speech at the Peter G. Peterson Institute for International Economics, Washington, D.C. Weistroffer Ch. (August 11, 2011) Identifying systemically important financial institutions (SIFIs). Deutsche Bank Research.
11 Participants: Lyeonov Serhiy project leader, responsible for econometric part. Buriak Anna project participant, responsible for theoretical part. Alternative/additional sources of funding: no other sources available Project timetable. January-March 2015 literature review and reveal of banking sector and crisis specific features in CEE countries; April-May 2015 systemically important banks identification in CEE countries; June 2015 data processing; July-August estimation procedure; September 2015 final results.
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