Research Question: This paper analyses the effect of a sustained period of low interest rates on the outlook for the German banking sector. Low interest rates provide a particular challenge for German banks, which are highly dependent on interest income and exhibit relatively high cost-income ratios. It is thus an open question whether German banks will manage to earn their cost of capital in this environment. Contribution: We analyse the interest earnings from loans and the interest expenses for deposits, i.e. the core business interest margin of a bank. We consider different future interest rate scenarios and analyse the extent to which they cause a further narrowing of the core business interest margin. Finally, we test whether a special feature of German accounting standards could serve as a buffer in sustaining profitability for some time. Results: Our results indicate that a sustained period of low interest rates will increase the pressure on the core business interest margin earned by German banks. Even if interest rates stayed constant at current levels, the core business interest margin of German banks would be reduced by 16% over the next four years. Moreover, this projected decline in the core business interest margin will result in only 20% of German banks earning a cost of capital of 8% by the end of this decade. However, by applying a special feature of German accounting standards and using hidden and open reserves, German banks may alleviate this decline to a certain extent.
Central banks are under increased scrutiny because of the rapid growth in, and composition of, their balance sheets. Therefore, understanding the processes that shape these balance sheets and their consequences is crucial. We contribute by studying an extensive dataset of banks’ liquidity uptake and pledged collateral in central bank repos. We document systemic arbitrage whereby banks funnel credit risk and low-quality collateral to the central bank. Weaker banks use lower quality collateral to demand disproportionately larger amounts of central bank money (liquidity). This holds both before and after the financial crisis and may contribute to financial fragility and fragmentation.
Banks have been subject to a wave of investigations regarding fraudulent behavior. Much of the discussion centers on manipulation of hard information by employees down the line, who missell mortgages due to flawed debt-to-income ratios or manipulate LIBOR and FX rates. Despite these prominent cases, little is known in the academic literature as to whether and how manipulation of hard information is affected by incentives of these employees, and if anything there is increasing reliance on quantitative, hard information based models for regulating banks. In this paper, we fill this gap by analyzing almost a quarter million of retail loan applications. We show that loan officer incentives significantly skew ratings even in settings where ratings are computed using hard information only. These incentives have a first-order effect on bank profitability. Our results suggest that ratings are subject to the Lucas critique: Incentives influence the hard information reported by loan officers and thus change the link between hard information and default probabilities.
The landmark decision by the U.S. Supreme Court on Citizens United v. Federal Election Commission asserts for the first time that corporations benefit from First Amendment protection regarding freedom of speech in the form of independent political expenditures, thus creating a new avenue for political activism. This paper studies how corporations adjusted their political activism in response to this ruling. The paper presents evidence consistent with the hypothesis that institutional investors, in particular public pension funds, have a preference for not using the new avenue for political activism, a preference not shared by other investors.
This paper analyzes the effect of the removal of government guarantees on bank risk taking. We exploit the removal of guarantees for German Landesbanken which results in lower credit ratings, higher funding costs, and a loss in franchise value. This removal was announced in 2001, but Landesbanken were allowed to issue guaranteed bonds until 2005. We find that Landesbanken lend to riskier borrowers after 2001. This effect is most pronounced for Landesbanken with the highest expected decrease in franchise value. Landesbanken also significantly increased their off-balance sheet exposure to the global ABCP market. Our results provide implications for the debate on how to remove guarantees.