Bank Performance, Risk and Securitization

Bank Performance, Risk and Securitization comprises a selection of chapters originally presented as papers at the European Association of University Lecturers of Banking and Finance Conference (otherwise known as the Wolpertinger Conference) held at the University of Malta, Valletta, Malta, in August 2012 (see also the companion volume, Bank Stability, Sovereign Debt and Derivatives).

One of the upshots of the 2007–2009 financial crisis is the evidence that liquidity risk had been underestimated and largely ignored by regulators. Indeed, the previous Capital Adequacy Accords, Basel I and II, did not explicitly require banks to provision for liquidity risk, as that risk had been considered incapable of threatening the stability of individual banks, let alone the entire banking system. For this reason, unlike credit and market risk, the Basel Accords had not set requirements for liquidity risk. Yet the recent financial crisis has shown how rapidly and acutely liquidity risk, in terms of both market liquidity risk and funding risk, can manifest itself in financial markets and how it can affect the stability of banks and indeed the whole financial system. Thus, the Basel Committee deemed it necessary to remedy the omission and, in the December 2010 final document (so-called Basel III),¹ it has promoted the gradual introduction of two internationally harmonized global liquidity standards for banks: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), to be introduced by 1 January 2015 and by 1 January 2018 respectively.

The regulation of an industry is generally motivated by market imperfections and/or (the risk of) market failures that can be extremely costly for the society. This implies that there are ‘gains’ associated with such regulation. However, regulation is not costless, and it is vital that the ‘cost’ of regulation does not exceed its expected gain. The deregulation of financial markets in many countries in the eighties was driven by this matter of course. Then the objective was to increase market efficiency by removing regulatory constraints. Even though new regulations in the form of capital adequacy requirements (i.e. the Basel I and II accords) were subsequently imposed, it is important to bear this in mind when further re-regulation of the banking industry is on the agenda in the aftermath of the 2008 financial crisis. Regulation of the banking industry is a balancing act! On one hand, as for example Lind (2005) points out, there are strong reasons for the prudential regulation of banks in order to mitigate their adoption of overly risky strategies; banks’ asset transformation through credit and liquidity creating activities is intrinsically vulnerable, and when the risk exposures of banks are high even minor disturbances in this transformation process can jeopardize the overall financial stability of the system. Moreover, as banks are the major providers of payment services, the solidity and soundness of these institutions are also crucial for trade and other payment- related activities in an economy.

Until now, financial performance indicators as a means of default forecast tools have been less frequently employed in Europe than in the United States; a widespread practice in fact is that each financial institution develops and applies its own bankruptcy prediction model. One of the most relevant indicators in the United States has historically been the Z-Score model, developed by Professor E. Altman in the late sixties.

Since the 1980s, the world of banking has changed considerably. Deregulation, internationalization, financial crises and reregulation are just some of the many changes that have affected banking business (Bátiz-Lazo and Wood, 2003; Power, 2004; Larson et al., 2011). Under the influence of their external environment, banks have become larger, more diversified, international and competitive (Goddard et al., 2007; Wilson et al., 2010) prompting the need for new sources of income, complex tools for risk assessment and risk mitigation as well as greater cost- and productivity consciousness (Muir et al., 2011:94).

Securitization is the financial technique that involves the transfer of assets by an originating institution to a third party, typically a special-purpose vehicle (SPV). The financial vehicle successively issues asset-backed securities (or other structured finance securities) representing claims against specific pools of assets.

Microcredit and microfinance¹ can be included in the branch of ethical finance² that supports the struggle against poverty and financial exclusion.³ The term ‘microfinance’ is usually used to identify those financial services that are offered not only to clients with low income or none, but also to individuals who have difficulty in accessing basic financial services. The term ‘microcredit’ refers to small loans issued to individuals who are either poor or excluded from the financial system, and who lack traditional collateral; microcredit is usually granted in order to finance microentrepreneurial activity, and is often associated with technical support services and non-traditional collateral. According to this approach, microcredit is identifiable as a product of microfinance, and qualifies as an instrument in the struggle against poverty and financial exclusion, both due to the characteristics of the beneficiaries and to the technical and economic attributes of the instrument.⁴ The recent economic crisis has brought to the attention of European policymakers the debate on poverty and financial exclusion; in this context, microcredit is an instrument that has become highly regarded both by single states and by the European Commission. The search for resources to dedicate to microcredit has created the need for an alternative funding model specifically tailored to inclusive finance.

The financial crisis and global economic downturn have caused a sharp deterioration in public finance across advanced economies. Between the end of 2009 and the beginning of 2011, the large fiscal deficits gave rise to the perspective of a rapid increase in the debt-to-GDP ratio in several euro area countries; the deficit increased from 1 percent to 8 percent, while the Gross Government Debt rose from 73 percent to 97 percent of the GDP. In emerging economies, government debt levels trended lower. The concerns with regard to the difficult budgetary position of Greece, shortly followed by similar worries about Portugal and Spain, resulted in a much more significant broadening of credit spreads in sovereign bonds and related CDSs. In early 2010, the credit differentials referring to other sovereign issuers in the euro area also increased, and a more marked increase in spreads with reference to the Greek debt was recorded due to investors fearing Greece’s default. On the other hand, the differentials concerning the bonds issued by Ireland, Great Britain and the United States were almost unaltered in the course of the same year (BIS, March 2011). In this context, the CDS market on government bonds from developed countries — nearly nonexistent a few years ago, when sovereign CDSs were chiefly referred to emerging debt — noticeably intensified when investors adapted their exposition to sovereign risk.

The two decades surrounding the turn of the 20th/21st centuries have witnessed unprecedented changes in the global financial landscape. One region particularly affected by change is Central and Eastern Europe (CEE), where the transition from centrally-planned to market economies resulted in the opening up of national financial systems to foreign investors. Financial institutions from developed countries, mainly in Western Europe, gradually established their presence in CEE through greenfield investments and the acquisitions of domestic firms, mainly through their participation in the privatization of state-owned companies. As a consequence of this, the share of foreign capital in the banking sector exceeds 90 percent in some CEE countries today. Such a high level of involvement has for some time caused controversy about possible positive and negative outcomes; while the undeniable benefits of this inflow of foreign capital, together with experience and know-how, have resulted in the rapid development of banking services, concerns have also been raised as to the potentially destabilizing role of foreign investors, especially in a time of crisis.

The aim of this chapter is to analyze certain fundamental characteristics of sovereign wealth funds (SWFs) to contribute to a better understanding of these investment vehicles. SWFs have in recent years become increasingly important, both in numerical terms and in terms of assets under management. As the importance of SWFs in the global financial system has increased academic research has investigated the specific features and implications of SWFs for financial markets, but on the other hand debate has focused on regulatory issues relating to the rise of SWFs.

Oil-related issues repeatedly dominate international news and economic policy discussions, especially as the price of this commodity escalates. Episodes occur with apparent regularity which create supply and demand uncertainty in the oil market, and as a consequence tend to affect its price. The major events since 1970s can be tentatively summarized as the formation of the Organization of Petroleum Exporting Countries (OPEC), major conflicts in oil-exporting regions, and the recent emergence of accelerated growth in developing economies.

Although fears of a ‘hard landing’ for the Chinese economy gradually disappeared in 2012, the unprecedented Chinese GDP growth of the preceding decades still, at the time of writing in 2013, has a somewhat alarming undertone. A hangover from the stimulus package of 2008/09 pushed up growth rates but also contributed to a troubled housing market. China’s residential property prices continue to soar, with some stagnation between 2011 and 2012, and fears have arisen that a bursting bubble could put both the national and the global economy at risk of a new slowdown. However, it is debatable to what extent there does indeed exist a housing bubble and if so, when it is expected to burst. Against the backdrop of global economic woes, the Chinese economy is growing at a somewhat slower pace, not least because the People’s Bank of China (PBC) made it more difficult for companies to borrow in 2010/11. As a result, the property bubble started to deflate during the summer of 2011, when housing prices began to fall following policies responding to complaints that members of the middle classes were unable to afford homes in major first-tier cities like Beijing and Shanghai. Although from May 2012 house prices started to rise again for the first time in almost a year, the deflationary trend of the property bubble was seen as one of the primary causes for China’s declining economic growth in 2012.