Browsing by Author "Jokivuolle, Esa"

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  • Kiema, Ilkka; Jokivuolle, Esa (2013)
    Bank of Finland Research Discussion Papers 25/2013
    The aim of the Internal Ratings Based Approach (IRBA) of Basel II was that capital suffices for unexpected losses with at least a 99.9% probability. However, because only a fraction of the required regulatory capital (a quarter to a half) had to be loss absorbing capital, the actual bank solvency probabilities may have been much lower, as the global financial crisis illustrates. Our estimates suggest that under Basel II IRBA the loss-absorbing capital of an average-quality portfolio bank suffices for unexpected losses with a 95%-99% probability. This translates into an expected bank failure rate as high as once in twenty years. Even if the bank s interest income is incorporated into our model, the expected failure rate is still substantial. We show that the expected failure rate increases with loan portfolio riskiness. Our calculations may be viewed as a measure of regulatory "self-delusion" included in Basel II capital requirements. Keywords: capital requirements, Internal Ratings Based Approach, Basel II,financial crisis.
  • Jokivuolle, Esa; Peura, Samu (2000)
    Suomen Pankin keskustelualoitteita 2/2000
    We present a model of risky debt in which collateral value is correlated with the possibility of default.The model is then used to study: 1) the expected amount of debt recovered in the event of default as a function of collateral; and 2) the amount of collateral needed to mitigate the riskiness of a loan to a desired degree.The results obtained could prove useful for estimating recovery rates required by many popular models of credit risk and for determining collateral haircuts in debt transactions.The analysis also generates testable predictions of the behaviour of historical recovery rates of risky debt when collateral is involved.Regulators might benefit from the analysis in developing capital adequacy requirements and reviewing banks' lending standards relative to current collateral values.
  • Jokivuolle, Esa; Peura, Samu (2001)
    Bank of Finland. Discussion papers 15/2001
    The rating-sensitive capital charges on credit risks under the new Basel Accord are likely to increase the volatility of minimum capital requirements, which may force banks to hold larger capital cushions in excess of minimum requirements.We analyse this claim on the basis of numerical simulations on hypothetical bank portfolios, in which the bank's choice of capital cushion is assumed to satisfy a value-at-risk-type constraint.The results suggest that the size of the cushion depends on the bank's credit portfolio risk and its chosen approach for calculating the minimum capital requirement.Although the more ratings-sensitive internal ratings based approach imposes lower minimum capital requirements on sufficiently high-quality credit portfolios than does the standardised approach, this capital relief is countered by the need for larger relative cushions under the former approach.The results imply that the cushions induced by greater rating sensitivity may influence both banks' choices between proposed approaches for calculating capital requirements as well as the aggregate level of post-reform bank capital.Hence these cushions should be given due consideration in the final calibration of the Basel risk weights. Key words: new Basel Capital Accord, credit risk, internal ratings, value-at-risk
  • Ambrocio, Gene; Hasan, Iftekhar; Jokivuolle, Esa; Ristolainen, Kim (2020)
    Bank of Finland Research Discussion Papers 10/2020
    Published in Journal of Financial Stability 2020 ; 50 ; October https://doi.org/10.1016/j.jfs.2020.100772
    We survey 149 leading academic researchers on bank capital regulation. The median (average) respondent prefers a 10% (15%) minimum non-risk-weighted equity-to-assets ratio, which is considerably higher than the current requirement. North Americans prefer a significantly higher equity-to-assets ratio than Europeans. We find substantial support for the new forms of regulation introduced in Basel III, such as liquidity requirements. Views are most dispersed regarding the use of hybrid assets and bail-inable debt in capital regulation. 70% of experts would support an additional market-based capital requirement. When investigating factors driving capital requirement preferences, we find that the typical expert believes a five percentage points increase in capital requirements would “probably decrease” both the likelihood and social cost of a crisis with “minimal to no change” to loan volumes and economic activity. The best predictor of capital requirement preference is how strongly an expert believes that higher capital requirements would increase the cost of bank lending.
  • Ambrocio, Gene; Hasan, Iftekhar; Jokivuolle, Esa; Ristolainen, Kim (2020)
    Journal of Financial Stability October ; 2020
    Published in BoF DP 10/2020 http://urn.fi/URN:NBN:fi:bof-202006012160
    We survey 149 leading academic researchers on bank capital regulation. The median (average) respondent prefers a 10% (15%) minimum non-risk-weighted equity-to-assets ratio, which is considerably higher than the current requirement. North Americans prefer a significantly higher equity-to-assets ratio than Europeans. We find substantial support for the new forms of regulation introduced in Basel III, such as liquidity requirements. Views are most dispersed regarding the use of hybrid assets and bail-inable debt in capital regulation. 70% of experts would support an additional market-based capital requirement. When investigating factors driving capital requirement preferences, we find that the typical expert believes a five percentage points increase in capital requirements would “probably decrease” both the likelihood and social cost of a crisis with “minimal to no change” to loan volumes and economic activity. The best predictor of capital requirement preference is how strongly an expert believes that higher capital requirements would increase the cost of bank lending.
  • Tölö, Eero; Jokivuolle, Esa; Virén, Matti (2015)
    Bank of Finland Research Discussion Papers 29/2015
    Published in Journal of Financial Services Research 2021 ; 60 ; 1 http://dx.doi.org/10.1007/s10693-021-00351-2
    We investigate how European banks’ overnight borrowing costs depend on bank size. We use the Eurosystem’s proprietary interbank daily loan data on euro-denominated transactions from 2008-2014. We find that large banks have had a clear borrowing cost advantage over small banks and that this premium increases progressively with the size of the bank. This result is robust with respect to subsamples, subperiods, time aggregation, and control variables such as Tier 1 capital ratio and rating. During episodes of financial stress, the size advantage becomes several times larger. However, we also find evidence that the new recovery and resolution framework for banks may have slightly reduced the borrowing cost advantage of larger banks in Europe.
  • Jokivuolle, Esa; Pylkkönen, Pertti; Vauhkonen, Jukka (2004)
    Suomen Pankki. Rahoitusmarkkinaraportti 2
    Suurin osa EU:n rahoituspalvelujen yhdentymisen toimintasuunnitelmasta on toteutunut, mutta tärkeitä hankkeita on myös edelleen kesken. Toimenpiteiden kansallinen implementointi on osin vasta alussa. Komissio päättää toimintasuunnitelman jatkotoimista vuonna 2005. Tämän artikkelin yhteydessä olevassa kehikossa esitellään lisäksi globaalin rahoitus-järjestelmän kannalta keskeisen elimen, Financial Stability Forumin, toimintaa.
  • Jokivuolle, Esa; Vihriälä, Vesa; Virolainen, Kimmo; Westman, Hanna (2020)
    Nordic Economic Policy Review
    The global financial crisis has led to extensive regulatory reforms around the globe. The bail-in rules introduced in the Bank Recovery and Resolution Directive are an essential part of the new bank crisis management landscape in Europe. The paper seeks to clarify their implications and applicability in three ways. First, we provide a concise overview of the issues involved based on recent – mainly theoretical – literature. Second, we describe the key features of the European resolution framework. Third, we discuss the implications of the bail-in approach for crisis management in the Nordic context.
  • Kiema, Ilkka; Jokivuolle, Esa (2019)
    Revue de l'OFCE
    Empirical evidence shows that a financial distress, faced by a bank or the whole economy, might cause large-scale withdrawals of deposits even when bank deposits are protected by deposit insurance, implicitly or explicitly guaranteed by a government. Building on Kiema and Jokivuolle (2015), we present a new model of such partial bank runs. In our model withdrawals are caused by the fear that both the bank and the government's deposit guarantee might fail in the future. Our focus is on a guarantee rather than on insurance, since the assets of deposit insurance funds might not be sufficient in large-scale systemic crises. Guarantee failure is possible because, being sovereign, the government may choose not to keep its promises. This option causes a fixed welfare cost (e.g. a reputational cost), which in a sufficiently severe crisis may be smaller than the costs from deposit guarantee payments. We also assume that, being welfare-maximizing, the government recapitalizes the bank during the early stage of the bank run. When decisions concerning deposit guarantee payments are made, recapitalization costs are already sunk costs, but the partial bank run has reduced the coverage costs that the remaining deposits might cause for the government. In this way, the depositors who withdraw funds during a partial bank run decrease the danger of a deposit guarantee failure and increase the incentives of the remaining depositors to keep their deposits in the bank. We apply our framework to the European Deposit Insurance Scheme (EDIS), and we view the reliability of the Single Resolution Fund and its backstop as the counterpart to the reliability of the government's promises. It turns out that in an asymmetric shock that affects only a single eurozone country, the EDIS improves bank stability, but its effects might be ambiguous in a systemic crisis that affects the whole Banking Union.
  • Jokivuolle, Esa; Keppo, Jussi (2014)
    Bank of Finland Research Discussion Papers 2/2014
    The global financial crisis of 2007-2008 has given rise to new regulatory initiatives to put restrictions on the size and term of bankers' pay. We revisit the question whether these regulations are justified, both theoretically and empirically. We model bonuses as a series of sequential call options on profits and show that they provide the higher risk-taking incentives the shorter is the time between the payment points. However, using data on CEO bonuses at the end of 2006 and our model, we find no robust relationship between risk-taking incentives and US banks' stock returns during the global financial crisis. The crisis returns are related negatively to leverage and positively to the market to book equity ratio. Our findings suggest that regulating leverage would be more effective than regulating bankers' compensation. Keywords: Banking, bonuses, regulation, compensation
  • Jokivuolle, Esa; Keppo, Jussi; Yuan, Xuchuan (2015)
    Bank of Finland Research Discussion Papers 5/2015
    Revised version uploaded 30 September 2019.
    Regulators restrict bankers’ risk-taking by bonus caps or deferrals. We derive a structural model to analyze these compensation regulations and show that for a risk-neutral banker subject to positive switching costs of reducing bank risk, a bonus deferral is impotent while a sufficiently tight bonus cap reduces risk-taking. The model suggests that a bonus cap that equals fixed salary (as in the EU) reduces risk on average by 13% under conservatively calibrated positive switching costs. Further, the bonus cap would have considerably reduced risk-taking incentives in most US banks that did poorly during the global financial crisis. We also show that the bonus deferral is effective if the banker is risk-averse and the switching costs are not too high.
  • Jokivuolle, Esa; Kiema, Ilkka; Vesala, Timo (2010)
    Bank of Finland Research Discussion Papers 17/2010
    Tämä versio korvaa aiemman version, joka on Bank of Finland Discussion Paper 23/2009, "Credit allocation, capital requirements and procyclicality". This replaces earlier version 23/2009. Published also in Journal of Financial Services Research, August 2014, Volume 46, Issue 1: 55-76 ; https://doi.org/10.1007/s10693-013-0169-z
    We show how banks excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in normal times. Model simulations suggest that the differentiation of risk-weights in the Basel framework might be further increased in order to take full advantage of the allocational effects of capital requirements. Our analysis also provides a new rationale for the countercyclical elements of capital requirements. Keywords: bank regulation, Basel III, capital requirements, credit risk, crises, procyclicality JEL classification numbers: D41, D82, G14, G21, G28
  • Jokivuolle, Esa; Kiema, Ilkka; Vesala, Timo (2009)
    Bank of Finland Research Discussion Papers 23/2009
    Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II's procyclical impact has been less discussed. In this paper, we investigate the effect of capital requirements on the allocation of credit and its interaction with procyclicality, and compare Basel I and Basel II type capital requirements. We consider competitive credit markets where entrepreneurs of varying ability can apply for loans for one-period investment projects of two different risk types. The risk of a project further depends on the state of the economy, modelled as a two-state Markov process. In this type of setting, excessive risk taking typically arises because higher-type borrowers cross-subsidize lower-type borrowers via a pricing regime based on average success rates. We find that risk-based capital requirements (such as Basel II) alleviate the cross-subsidization effect and can be chosen so as to implement first-best allocation. This implies that the ensuing reduction in the proportion of high-risk investments may mitigate the procyclical effect of Basel II on economic activity. Moreover, we find that optimal risk-based capital requirements should be set lower in recessions than in normal times. Our simulations show that when measured by either cumulative output or output variation, Basel II type capital requirements may actual be slightly less procyclical than flat capital requirements. The biggest reduction in procyclicality is however achieved with optimal risk-based capital requirements which are considerably higher than Basel II requirements and which are adjusted downwards in recession periods. Keywords: Basel II, bank regulation, capital requirements, credit risk, procyclicality JEL classification numbers: D41, D82, G14, G21, G28
  • Jokivuolle, Esa; Virén, Matti (2019)
    BoF Economics Review 3/2019
    We provide preliminary evidence of potential risk reduction benefits from banks’ loan portfolio diversification cross-border within the Euro area. Using aggregate data on banking sector cor-porate loan losses for each Euro area member-state, our estimates suggest that the static diversification benefit could be substantial. The minimum capital needed to withstand the max-imum annual loss from a hypothetical fully diversified Euro area bank loan portfolio over the period 2001-2017 would have been only 40 % of the total capital needed to withstand the maximum losses on a country by country basis. We also calibrate the country-specific loan loss distributions and the Euro area portfolio’s loss distribution to the Vasicek (2002) model, which underlies the Basel framework’s Internal Ratings Based Approach. We find that the im-plied asset correlation parameter of a median country portfolio is about twice as large as that of the fully diversified Euro area portfolio.
  • Tölö, Eero; Jokivuolle, Esa; Virén, Matti (2017)
    Journal of Financial Intermediation July
    We construct a measure of a bank's relative creditworthiness from the Eurosystem's proprietary inter-bank loan data: average overnight borrowing rate relative to an overnight rate index (AOR). We then investigate the dynamic relationship between AOR and the credit default swap price relative to the corresponding market index of 60 banks during 2008–2013. Price discovery mainly takes place in the CDS market, but AOR also contributes to it. The lagged daily changes of AOR help predict CDS. This indicates that AOR includes private information, which the CDS market does not immediately incorporate. We further show that the private information advantage is concentrated on days of market stress and on banks, which mainly borrow from relationship lender banks. Such borrower banks are typically smaller, have weaker ratings, and are likely to reside in crisis countries. Competent authorities can use AOR as a complementary indicator of banks’ concurrent health.
  • Tölö, Eero; Jokivuolle, Esa; Virén, Matti (2014)
    Bank of Finland Research Discussion Papers 9/2014
    We investigate the relationship between the daily average interbank overnight borrowing rate (AOR) and the credit default swap price (CDS) of 60 banks using the Eurosystem's proprietary data from mid-2008 to mid-2013. We find that the AOR which is observable only by the competent Eurosystem authorities leads the CDS at least by one day. The lead was concentrated on days of market stress for banks which mainly borrow from "relationship" lender banks. Such borrower banks are typically smaller, have weak ratings, and likely reside in crisis countries.
  • Jokivuolle, Esa; Pylkkönen, Pertti; Vauhkonen, Jukka (2004)
    Bank of Finland. Financial market report 2
    The EU's Financial Services Action Plan is largely a reality; however, important initia-tives continue to be pending. National implementation of the required measures has in part only started. The Commission will decide on further steps to be taken in respect of the Financial Services Action Plan in 2005. The box attached to this article provides greater detail on the work of the Financial Stability Forum, an organisation of key importance to the global financial system.
  • Jokivuolle, Esa; Koskinen, Yrjö (1990)
    Bank of Finland. Bulletin 64 ; 4 ; April
  • Jokivuolle, Esa; Kilponen, Juha; Kuusi, Tero (2007)
    Bank of Finland Research Discussion Papers 26/2007
    We suggest a complementary tool for financial stability analysis based on stochastic simulation of a dynamic stochastic general equilibrium model (DSGE) of the macro economy. The paper relates to financial stability research in which financial aggregates crucial to financial stability are modelled as functions of macroeconomic variables. In these models, stress tests for eg banking sector loan losses can be generated by considering adverse scenarios of macro variables. A DSGE model provides a systematic way of generating coherent macro scenarios which can be given a rigorous economic interpretation. The approach is illustrated using a DSGE model of the Finnish economy and a simple model of Finnish banking sector loan losses. Keywords: DSGE models, financial stability, loan losses, stress testing JEL classification numbers: E13, E37, G21, G28
  • Tölö, Eero; Jokivuolle, Esa; Viren, Matti (2019)
    Bank of Finland Research Discussion Papers 22/2019
    Using the Eurosystem’s proprietary interbank loan data from more than one thousand banks, practically all major banks in Europe for 2008-2016, we show that larger European banks have had a lower cost of overnight borrowing than smaller banks. The size premium remains significant after controlling for time, relationship lending, competitive environment of lenders, and bank risk characteristics but has decreased over time in countries that were stricken by the Sovereign Debt Crisis. Further, the ultra-short maturity of the overnight loans and the daily frequency at which we measure them provide for an ideal setting to use difference-in-differences analysis to study the potential effect of the Bank Recovery and Resolution Directive (BRRD) on the size premium in overnight rates and to avoid possible simultaneity problems. However, we find that changes in the size premium cannot be related to the implementation dates of the BRRD in different member countries.