Liquidity Risk Management And Credit Supply

Published Date: 02 Nov 2017

Elnaz Abazarisouha

Liquidity Risk Management and Credit Supply during Financial Crisis:

Evidence from European Banks

Research Plan in

Accounting and Finance

VAASA 2013

TABLE OF CONTENTS PAGE

INTRODUCTION

This paper examines the effect of individual bank liquidity exposures on bank’s ability to supply credit during the period of financial crisis in Europe. Specifically it wants to answer this hypothetical question: How much did the accumulation of cash and other liquid assets of banks change in respond to liquidity risk changes in European banking system during the latest crisis. Furthermore it aims to measure the effects of different types of holding assets on Bank’s lending.

Financial institutions are responsible to get the deposits and also provide them in cash to the depositors on demand. This scenario is working as long as depositors trust banks, however in the situation in which depositors lose their faith in banks and demand for their deposits en masse might make the bank collapse by sale of illiquid loans. (Starahan, 2012)

The first signs of crisis could be sighted to the first quarter of 2007 in rising problems and climbing delinquency. Then it went with Bear Sterns arose in summer 2007. In the beginning Europe seemed to be far away of American financial crisis, but soon the low interest rates and great liquidity, spread the problem to Europe and made European financial institutions to search for yield. Later the mortgage backed securities lost in value and Lehman brothers (one of the leading investment banks of Wall Street) collapsed. Bank’s liquidity risk increased and financial system stopped. Central banks in respond to banking equity needs lowered the policy rates and supported the banking sector with Trouble Asset Relief Program (TARP) in US and Long-Term Refinancing Operation (LTRO) in EA.

At the end of 2008 world trade declined and debt levels of countries increased as the result of supporting banking sector. The problem went further to Greece and then spread in GIIPS and Eurozone and many EU banks faced the lack of dollar funding. As the result, in order to provide extra liquidity for European banks, Federal Reserve and European central banks opened swap line.(Noeth and Sengupta, 2012)

According to Shambaugh (2012), Europe faced to three crises, named as: economic recession, growth crisis and banking crisis. What made the Crisis in Europe worse is that the most of the debt of troubled countries was in Euro and needless to say Euro is the domestic currency of all nations of Eurozone. Furthermore the creditors of debts obligations were in other parts of the Eurozone rather than the troubled countries.

Poor economic performance cause nonperforming loans and nonperforming loans leading to financial aids by the sovereigns and as the result lower tax incomes, which put its stress on public finances. On the other hand a higher debt declines economic growth and public investments. If sovereigns fail to pay the debt it would be unpleasant for the institutions that have a large amount of sovereign debt holdings. (Noeth and Sengupta, 2012)

LITERATURE REVIEW

Several studies explained the financial crisis period all over the world; the reason is that the latest financial crisis 2008 was the greatest shock to the financial system since the great depression 1930s. Thus it requires a deep studying to understand the causes of disaster and the ways we can deal with it, specifically in banking system to prevent from further consequences.

Ivashina and Metrik (2010) Found that lending had a decreasing trend during the financial crisis and this story is true for all types of loans. Although it seems that the decline is in respond to decreasing in demand, they show that supply changes stemmed from bank’s ability to access to deposit financing can also be effective. The authors state that unlike the decline in demand, decline in supply push up the interest rate and cause a noticeable fall in lending. They mentioned recent crisis as a "combination of a recession and banking crisis" which is problematic.

Cornett, McNutt, Strahan and Tehranian (2010) assumed that banks need cash and liquid assets to manage the liquidity risk and the higher undrawn loan commitments lead to higher liquidity risk. Furthermore they found that credit supply decreased and liquid asset increased as the result of greater liquidity risk exposures. In other words banks had to decline their credits to make liquid assets to handle the liquidity risk. They conclude that banks which holding assets with low market liquidity increased their cash during crises. On the other hand banks with stable sources of financing less influenced by crises and were able to continue to lend. Ones which used core deposits and more equity capital saw significant increases in lending.

A paper by Eken, Selimler, Kale and Ulusoy (2012), has analyze the profitability, capital adequacy, credit risk and liquidity risk of European banks, during the financial crisis. The results show a sharp decrease in Return On Assets (ROA) and Return On Equity (ROE) in respond to huge amount of non-performing assets. However Net Interest Margin and leverage multipliers remained unchanged over the period of analysis. Moreover the results suggest that the effects of crisis on small size banks were less than the medium and large sizes. Unlike ROA and ROE the capital adequacy of EU banks increased significantly during the crisis. They noted that liquidity management is different between different groups of banks and it might stem from ownership and geographical effects. At last they stated that the size of the banks had influenced on allocating sources to credits or other assets.

Noeth and Sengupta (2012) compare the banking situation between US and EU in part of their study and noted that European corporation relies on bank’s funding more than corporations in US. A significant number of nonfinancial debts in European banks belong to corporate loans from banks. The other difference is that US firms relies on capital market, however, European firms relies on bank financing. As the result the effect of deleveraging on European banks is much more than their US counterparts.

Banks use more than deposits and equity capital to finance their balance sheet according to (Strahan, 2012), however, even other sources became rare over the financial crisis. For instant one of these additional financing tools is repurchase agreement, known as repo, which uses to finance risky assets. However repo lost its financing ability from almost 100 percent in 2007 to about 55 percent at the end of 2008.

Based on these studies I am eager to find the effect of liquidity exposures on bank’s ability to supply credit over the period of financial crisis in Europe. My first hypothesis is European banks changed their management of liquidity risk, in tight liquidity condition during financial crisis. Moreover I hypothesize that banks with high liquidity risk exposures increase in their cash and other liquid assets more than the other banks in lower liquidity risk situation during the crisis; and also I hypothesize that the former banks reduce their lending and their new commitments to lend more than the later ones.

METHODOLOGY AND DATA

The empirical part of this paper is taken from Cornett et al. 2011 and I will follow the methods closely. I build a panel data set from 2006 to 2010 which includes all the commercial banks in 27 European Union members. Tight liquidity conditions are measured by TED spread (quarterly average of daily spread between the 3-months London Interbank Offered Rate and the 3-month treasury rate). TED spread measures the relation between the independent variables, the liquid assets and credit supply. To examine the research question empirically I estimate the following regressions:

/=+ + Illiquid Assets/

+ Illiquid Assets/*TED +

+ *TED+

+*TED+

+ *TED+ Log

+ Log *TED+

/ =++ Illiquid Assets/ Assets i, t-1

+ Illiquid Assets/ *TED+

+ TED+

+*TED+

+ 1*TED+ Log

+ Log *TED+

∆/ =++Illiquid Assets/1

+Illiquid Assets/ 1*TED+

+ TED+

+ *TED+

+ *TED+ Log

+ Log *TED+

First regression model tests how much liquid assets European banks held during the crisis. Second regression estimates the bank lending over the period and the last one tests the credit changes in the banking system. The summary of the variables would be as following:

Dependent Variables

/

∆Liquid asset ratio

/

∆Loan ratio(t)

∆/

∆Loan commitment ratio(t)

Explanatory Variables

Illiquid Assets/

Illiquid asset ratio

Core deposit ratio

Log

The log of total asset

Loan commitment ratio

Equity capital ratio

Dependent variables are the credit creation variables and explanatory variables are liquidity exposures of European banks. The panel data have been built from the Bankscope database and information are collected from bank assets, deposits, and capital, off balance sheet and undrawn loan commitments. Each of the explanatory variables is independent in the regressions and each interacted with TED spread. TED spread is obtained from the Bulgarian National Bank and three month treasury rate from the Federal Reserve Economic Data (FRED). Interacting liquidity exposures with TED spread and also CRISIS dummies provide us the macroeconomic illiquidity.

I divided the banks into two groups according to bank size obtained from the Bankscope based on book value of the assets. Three mentioned regressions run for both groups of large and small banks during non-crisis quarters, during crisis quarters and at the end of crisis.

PRELIMINARY TABLE OF CONTENTS

Introduction

Purpose of the study

Structure of study

Literature review

Financial crisis 2008

European banking system

Basel III

Methodology

Empirical Strategy

Empirical specification

Data

Regression Results

Robustness tests

Summery and Conclusion