01 January 2012

IMF Working Paper: Bank Funding Structures and Risk - Evidence from the Global Financial Crisis

This paper analyses the evolution of bank funding structures in the run up to the global financial crisis, and studies the implications for financial stability, exploiting a bank level dataset that covers about 11,000 banks in the US and Europe during 2001–09.

The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterwards. The likelihood of bank failure also increases with bank risk-taking. In the cross-section, the smaller domestically-orientated banks were relatively more vulnerable to liquidity risk, while the large cross-border banks were more susceptible to solvency risk due to excessive leverage.

Overall, the findings of this paper provide broad support to Basel III initiatives on structural liquidity and leverage, and show the complementary nature of these two areas. Banks with weaker structural liquidity and higher leverage before the global financial crisis were more vulnerable to subsequent failure. The results are driven by banks in the lower extremes of the distributions, suggesting the presence of threshold effects. In fact, the marginal stability gains associated with stronger liquidity and capital cushions do not appear to be large for the average bank, but seem substantial for the weaker institutions.

At the same time, there is evidence of systematic differences across bank types. The smaller banks were more susceptible to failure on liquidity problems, while the large cross-border banking groups typically failed on insufficient capital buffers. This difference is crucial from the financial stability perspective, and implies that regulatory and supervisory emphasis should be placed on ensuring that the capital buffers of the systemically important banks are commensurate with their risk-taking.

The evidence also indicates that bank risk-taking in the run-up to the crisis was associated with increased financial vulnerability, suggesting that bank decisions regarding the associated liquidity and capital buffers were not commensurate with the underlying risks, resulting in excessive hazard to their business continuity. Country-specific macro-economic conditions also played a role in the likelihood of subsequent bank failure, implying that banks failed to internalise properly the associated risks in their individual decision-making processes. Thus, while more intrusive regulations entail efficiency costs, the results point to associated gains in terms of financial stability that have to be pondered. This also supports the introduction of a macro-prudential framework as a complement to traditional, micro-prudential approach. In this regard, further work is needed to deepen the understanding of the role of the macro-economic environment on financial stability.

Full working paper

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