Has the banking sector become more vulnerable over time? Deniz Anginer Financial Economist, DECFP Asli Demirguc-Kunt

1. Has the banking sector become more vulnerable over time? Deniz Anginer Financial Economist, DECFP Asli Demirguc-Kunt Chief Economist FPD, Research Manager DECFP May 2011 Dubrovnik Economic Conference

2. Globalization • The last two decades have seen a tremendous transformation in the global financial sector driven by: • Globalization • Innovations in financial engineering and communications technology • De-regulation • These global trends have resulted in: • Increased productivity • Increased capital flows • Lower cost of borrowing • Price discovery and more opportunities for risk diversification • Same trends have also resulted in increased concentration, complexity, and exposure to common sources of risk

3. Economic Convergence – KOF Index

4. Political Convergence – KOF Index

5. Social Convergence – KOF Index

6. What do we do? • We examine whether these global trends have lead to an increase in banks’ exposure to common risk factors • We construct a default risk measure for all publicly traded banks using the Merton (1974) contingent claim model • Create a weekly time series of default probabilities for over 2,000 banks in over 70 countries and examine the evolution of the covariance structure of default risk of banks over time • We also examine cross-country differences and link them various measures of financial and economic openness

7. What do we find? • Systematic default risk has a significant global component in the banking sector • There has been a significant increase in default risk co-dependence leading up to the 2007/2008 financial crisis • The increase in co-dependence has been higher for North American and European banks, as well as banks that are larger • Developing countries which are more integrated, have liberalized financial systems and weak banking supervision have higher co-dependence in their banking sector

8. Policy Implications • In the aftermath of the crisis of 2007/08, there has been renewed interest in macro-prudential regulation • There has also been a growing consensus to adjust capital requirements to better reflect an individual bank’s contribution to the risk of the financial system as a whole • Acharya et al (2010) Brunnermeier, Crockett, Goodhart, Persaud, and Shin (2009), Financial Stability Forum (2009) • Our results support an increase in scope for intra-national supervisory co-operation, as well as capital charges for too-connected-to-fail’ institutions that can impose significant externalities

9. Literature • Growing number of papers examine the risk of individual banks to the banking system • Acharya et al (2010), Adrian and Brunnermeier (2009), Huang et al. (2009), Chan-Lau and Gravelle (2005), Avesani et al. (2006), and Elsinger and Lehar (2008) • Others have examined the correlation structure of equity returns of a subsample of banks • De Nicolo and Kwast (2002), Schuler (2002), Hawkesby, Marsh and Stevens (2003,2007) • Larger contagion/convergence literature • Forbes and Rigobon (2002), Kee-Hong Bae and Stulz (2003), Bekeart and Wang (2009); Pukthuanthong and Roll (2009)

10. Average PD = 4% Default C - 4 - 3 - 2 - 1 0 1 2 3 4 Merton Model • We compute default probabilities implied from the structural credit risk model of Merton (1974) • Commonly used in default prediction outperforming accounting-based models in hazard regressions • Campbell, Hilscher and Szilagyi 2008; Hillegeist, Keating, Cram, and Lundstedt, 2004; Bharath and Shumway, 2008) • Merton (1977) points out the applicability of the contingent claims approach to pricing deposit insurance in the banking context. • Bongini, Laeven, and Majnoni (2002), Bartram, Brown and Hundt (2008) and others have used the Merton model to measure default probabilities of commercial banks Log Asset Value Distribution

11. Data Coverage • Market cap and equity volatility obtained from Datastream; Bank assets and liability information comes from BankScope • Our results are robust to alternative Distance-to-Default definitions • We impose a number of filters to ensure data integrity • Final sample includes 2029 banks from 70 countries starting in 1998

12. Average Distance to Default

13. Average Distance to Default for Different Regions

14. Global Component of Changes in Credit Risk • Principal components of log changes in Default probabilities for commercial banks Jan 1998 – Oct 2010 • The first component explains 60% of variation in changes in default risk of commercial banks

15. Clustering in Default Risk • This chart shows the percentage of banks in a given week that have simultaneous worst change in default risk over a 12 month time period

16. Decomposing the Systematic Changes in Default Risk • We follow Heston & Rouwenhorst (1994)’s method to decompose the systematic variance of changes in default risk into global and regional effects:

17. Increase in Bank Concentration • Concentration measures assets of 3 largest banks as a share of assets of all commercial banks • There has been a substantial increase in concentration in both developing and developed countries

18. Decomposing the Systematic Changes in Default Risk • Banks Size explains a significant portion of systematic variation in default risk • Co-dependence is significantly higher for larger banks

19. Variance Ratio • Variance ratio (Bekaert and Wang (2009), Ferreira and Gama (2005)): • Variance ratio calculated for all banks in the data set Jan 1998 – Oct 2010 period • Starting in 2004 there has been an upward trend leading up to the crises

20. Comovement • Co-movement (Harmon et al (2010): • Chart shows the distribution in a given year of the % of banks that had a positive increase in default probability

21. Quintile Regression • Quintile regression (Boyson, Stahel and Stulz (2010), Brunnermeier and Pedersen (2009): • Co-dependence is higher for higher levels of default risk changes

22. Trends in Co-dependence • We formally test to see if there has been a change in co-dependence over time • During the crisis there has been an increase in co-dependence for all banks in all regions • On average we find that starting in 2004 leading up to the crisis, there has been an upward increase in co-dependence • But there is much cross-country variation, which we explore next

23. Cross-Country Regressions

24. Conclusion • We create a database of default risk measure for all publicly traded banks using the Merton (1974) contingent claim model • We show that systematic default risk has a significant global component in the banking sector and that there has been a significant increase in default risk co-dependence leading up to the 2007/2008 financial crisis • There is much cross-sectional variation, and countries which are more integrated, have liberalized financial systems and weak banking supervision have higher co-dependence in their banking sector • Our results support an increase in scope for intra-national supervisory co-operation, as well as capital charges for too-connected-to-fail’ institutions that can impose significant externalities

25. THANK YOU