How Banks Respond to Distress: Shifting Risks in Europe's Banking Union

48 Pages Posted: 5 Feb 2020

See all articles by Mark Mink

Mark Mink

De Nederlandsche Bank (DNB)

Rodney Ramcharan

University of Southern California, Marshall School of Business

Iman van Lelyveld

De Nederlandsche Bank; Vrije Universiteit Amsterdam

Date Written: January 24, 2020

Abstract

This paper uses granular bond portfolio data to study how banking systems across the European Union (EU) adjust their asset holdings in response to regulatory solvency shocks. We also study the impact of these shocks at financial intermediaries on the prices of bonds in their portfolio. Despite the creation of a Single Supervisory Mechanism (SSM) in the EU, we find that risk-shifting interacts with regulatory arbitrage motives to explain how banks adjust their portfolios after adverse solvency shocks. After regulatory solvency declines, banks increase their exposure to domestic bonds, including higher yielding but zero risk-weight sovereign bonds. The increase in banking system risk might therefore be even larger than the decline in risk-weighted solvency ratios suggests. Distress in the banking system also feeds back onto bond prices. Bonds owned by less-well capitalized banking systems trade at a discount relative to otherwise similar bonds owned by better capitalized intermediaries.

Keywords: bank capital, portfolio allocation, risk shifting, SSM

JEL Classification: G11, G12, G15, G21

Suggested Citation

Mink, Mark and Ramcharan, Rodney and van Lelyveld, Iman, How Banks Respond to Distress: Shifting Risks in Europe's Banking Union (January 24, 2020). De Nederlandsche Bank Working Paper No. 669, January 2020. Available at SSRN: https://ssrn.com/abstract=3531005 or http://dx.doi.org/10.2139/ssrn.3531005

Mark Mink (Contact Author)

De Nederlandsche Bank (DNB) ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

HOME PAGE: http://www.dnb.nl/en/onderzoek-2/onderzoekers/overzicht-persoonlijke-paginas/dnb278721.jsp

Rodney Ramcharan

University of Southern California, Marshall School of Business ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

HOME PAGE: http://https://sites.google.com/site/rodneyramcharan/

Iman van Lelyveld

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Vrije Universiteit Amsterdam ( email )

Netherlands

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