A LITERATURE REVIEW OF BANKS PROFITABILITY AND RISK ADJUSTMENT DECISIONS

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1 A LITERATURE REVIEW OF BANKS PROFITABILITY AND RISK ADJUSTMENT DECISIONS Dr. Petr Teplý Dr. Liběna Černohorská, Dr. Barbora Šútorová Charles University in Prague, Czech Republic University of Economics in Prague, Czech Republic University of Pardubice, Czech Republic ICBEFSM 2014: International Conference on Business, Economics, Financial Sciences and Management Toronto, Canada 17 June 2014

2 Agenda Introduction Theoretical background Literature review Capital shortfall of EU banks Conclusion 17 June 2014 A Literature Review of Banks Profitability and Risk Adjustment Decisions 2

3 1. Introduction Introduction to The Czech Republic President Milos Zeman 3

1. Introduction CV PetrTeplý Education 2000 Johnannes Kepler University in Linz, Austria 2006 University of Otago, New Zealand 2006 State University of New York, New Paltz, USA 2009 Ph.D.

4 1. Introduction CV PetrTeplý Education 2000 Johnannes Kepler University in Linz, Austria 2006 University of Otago, New Zealand 2006 State University of New York, New Paltz, USA 2009 Ph.D. in Finance, Charles University, Czech Rep. Research interests: banking, finance, risk management, financial stability, financial innovation, public finance, RIA (Co)authorofover100 articles and 10 books Guest lectures in New Zealand, Turkey, USA Presentations at Harvard University, China, CostaRica, Dubai, Egypt, France, India, Indonesia, Japan, Nepal, Singapore, UK Job experience CSOB Bank, Czech Republic 2006 Spencer Clarke, New York, USA EEIP, a.s., Czech Republic Member of Supervisory Board of The Czech Export Bank 4

5 Books about risk management, finance and banking 5

6 Agenda Introduction Theoretical background Literature review Capital shortfall of EU banks Conclusion 17 June 2014 A Literature Review of Banks Profitability and Risk Adjustment Decisions 6

7 2. Theoretical background Low capital ratio of a bank -> high leverage of a bank Assets Assets Total Liabilities Liabilities Equity Creditors Shareholders = ()

8 2. Theoretical background Capital as a buffer against risks LOSSS Source: OECD (2012). Developments in the Value of Implicit Guarantees for Bank Debt: The Role of Resolution Regimes and Practices

9 2. Theoretical background Decreasing banks capital ratios implies their lower risk absorption Source: Economist (2011)

10 2. Theoretical background because banks prefer low capital ratio and high return on average equity (ROAE) Financial firms = () () Focus on profit maximization 10

2. Theoretical background Socialization of

voters/shortterm targets Focus on profit

11 2. Theoretical background Socialization of losses vs. privatisation of profits Politicians Financial firms Regulators Focus on voters/shortterm targets Focus on profit maximization Lack of personal responsibility The taxpayer will pay as usual! Source:Petr Teplý (2011) 11

2. Theoretical background Zombie bank a zombie bank as a financial institution with i) a priceto-book value ratio smaller than 1, ii) a negative economic worth, iii) mispriced assets and iv) support

12 2. Theoretical background Zombie bank a zombie bank as a financial institution with i) a priceto-book value ratio smaller than 1, ii) a negative economic worth, iii) mispriced assets and iv) support by government bail-outs and guarantees. Examples: Allied Irish Banks, BoA, CITI, Commerzbank, Crédit Immobilier de France Kaupthing, Landesbanken, RBS, Spanish cajas, UniCredit Many zombie banks are still present in Japan, what gives a negative example to follow as these banks do not provide lending to the economy and therefore do not fullfil their basic function ZBs hinder economic growth in the EU and Japan (they struggle to survive and do not lend money) Source: Onaran,Y. (2011):. Zombie Banks: How Broken Banks and Debtor Nations Are Crippling the Global Economy. 12 New York: Bloomberg Press

13 2. Theoretical background Real estate bubble in Canada! When the bubble bursts, Canadian banks wil cry. 13 Do they have sufficinet capital for that?

14 2. Theoretical background When will the bubble burst? 14

15 Agenda Introduction Theoretical background Literature review Capital shortfall of EU banks Conclusion 17 June 2014 A Literature Review of Banks Profitability and Risk Adjustment Decisions 15

16 3. Literature review Overview of risk - return relationships 16

17 3. Literature review Literature review 1/2 Authors Short description Methodology and data used Shrives and Dahl [23] Jacques and Nigro[16] Rime [24] Heid, Porath and Stolz [12] Investigation of the relationship between changes in risk and capital in a large sample of the US banks Examination of the impact of the risk-based capital standards on the US bank capital and portfolio risk during the first year of the risk-based standards validity Analysis on whether and how Swiss Banks reacted to constraints placed on their capital Assessing how German savings banks adjust capital and risk under capital regulation Simultaneous equations applied on data for 1800 US banks In Simultaneous equations model applied on 2570 FDIC (Federal Deposit insurance Corporation) - insured commercial banks with assets greater than $100 million in Simultaneous equations model applied on data for 154 Swiss banks in A modified version of Shrives and Dahl s simultaneous equations applied on data of 570 local German savings banks in Capital Risk Relationship + - No relationship - (in case of a need to increase capital level) 17

18 3. Literature review Literature review 2/2 Authors Short description Methodology and data used Zhang, Wu and Liu [27] Teplý, Matějašák and Černohorský [25] Awdeh, EL- Moussawi and Machrouh, [3] Jokipii and Milne [15] Examines the effects of Regulation Governing Capital Adequacy of Commercial Banks on Chinese banks risk-taking behaviors Evaluation of regulatory pressure impact on risk and capital behavior of selected banks in the USA and the EU Analysis of the impact of capital requirements on risk-taking of Lebanese banks Examination of the relationship between short-term capital buffer and portfolio risk adjustments for the US banks Simultaneous equations applied on data for Chinese banks (55% of the whole Chinese banking system assets) in A modified Shrives and Dahl model on selected banks in the USA and EU in Simultaneous equations model applied on panel data set of 41 commercial banks in Lebanon in Simultaneous equations applied on panel data for the US bank holding company and commercial banks in Capital Risk Relationship

19 Agenda Introduction Theoretical background Literature review Capital shortfall of EU banks Conclusion 17 June 2014 A Literature Review of Banks Profitability and Risk Adjustment Decisions 19

4. Capital shortfall of EU banks The European Banking Union (EBU) 4 pillars in theory 1) The Single Supervisory Mechanism (SSM) 128 large banks, 85% of total assets ECB (= sole supervisor) will

20 4. Capital shortfall of EU banks The European Banking Union (EBU) 4 pillars in theory 1) The Single Supervisory Mechanism (SSM) 128 large banks, 85% of total assets ECB (= sole supervisor) will provide The Asset Quality Review (AQR) of the banks until 11/2014 The AQR results = DYNAMITE! (if done properly-> zombie banks will be revealed but gov t don t have many for their rescue; if not, zombie banks will fail later and the ECB will loose its reputation) 2) the Single Resolution Mechanism (SRM) 3) a common system of deposit protection 4) a single rule book for EU banks. 20

Trojan horse of the EU integration The EBU is an

21 4. Capital shortfall of EU banks In reality the EBU is here to rescue zombie banks and PIGS countries = the Trojan horse of the EU integration The EBU is an illusion and can t save the Eurozone s fall in the long-term! 21

22 4. Capital shortfall of EU banks How much capital is needed in the EU? (EUR 277bn estimated by PWC in 2013) Source: PWC (2013). De-leverage take 2 - Making a virtue of necessity 22

23 Agenda Introduction Theoretical background Literature review Capital shortfall of EU banks Conclusion 17 June 2014 A Literature Review of Banks Profitability and Risk Adjustment Decisions 23

24 5. Conclusion 1) Global casino banks are mostly undercapitalized 2) Positive capital risk relationship found in most literature 3) Increase of real estate prices in Canada is not sustainable! Are bankers ready? I don t think so 24

25 Discussion Thanks for your attention. Let s discuss it now! 25

26 Contact Dr. Barbora Šútorová Dr. Petr Teplý Senior Lecturer Institute of Economic Studies Faculty of Social Sciences Charles University Opletalova Prague Czech Republic Phone: Dr. Liběna Černohorská Senior Lecturer Institute of Economics Sciences Faculty of Economics and Administration University of Pardubice Studentská Pardubice Czech Republic Phone:

Introduction Global consequences of the crisis Origins of the Eurozone and ECB. The recent fall of the Eurozone Conclusion

Introduction Global consequences of the crisis Origins of the Eurozone and ECB. The recent fall of the Eurozone Conclusion A POTENTIAL BREAKDOWN OF THE EUROZONE Dr. Petr Teplý Charles University in Prague, Czech Republic University of Economics in Prague, Czech Republic Massey University Palmerston North, New Zealand 31 August