Banking regulation and, in particular, macroprudential regulation have gained significant interest since the crisis that began in 2007. At the centre of banking regulation is a deep-rooted concern that the economic and social costs of systemic crises are significant and their implications are far-reaching. Banks play a number of crucial roles in the functioning of any economy. However, the banking system in which they operate is inherently fragile, and after many painful experiences, regulators are quite convinced that this is particularly true during economic downturns. As such, it is important to explore and assess prudential policies that could be designed or
improved to prevent banking crises from occurring and to make the system more
resilient.
This thesis uses panel micro-econometric methods to explore factors that could have an impact on financial stability and suggests policies that could be used to
address them. The first essay empirically analyses how the capital buffer held by banks behave over the business cycle after financial factors have been accounted for. Using a large panel of banks for the period 2000-2014, it documents evidence that capital buffers behave more pro-cyclical than previously found in the literature.
Furthermore, it also shows that this relationship is more pronounced for large commercial banks where access to bail-out and equity markets incentivise an increase in
credit exposure and reduced capital reserves accordingly.
The second essay notes that a common feature within a lot of corporate income tax systems is the long-standing bias towards debt finance. That is, the cost of debt has been deductible as an expenditure when calculating taxable profits. An unintended consequence of this tax distortion is the creation of under-capitalized firms - raising default risk in the process. Using a difference-in-differences technique, this essay demonstrates that with a more equal treatment of equity and debt, banks capitalisation significantly improves. The essay takes advantage of the exogenous variation in the fiscal treatment of equity and debt as a result of the introduction of an Allowance for Corporate Equity (ACE) system in Italy, to identify whether an ACE positively impacts banks’ capital structure. The results demonstrate that a move to an unbiased corporate tax environment leads to better capitalised banks, fuelled by equity growth rather than a reduction in lending activities. The change
also triggers a decrease in the risk-taking of ex-ante low capitalised banks.
The third essay analyses the impact of liquid asset holdings on bank profitability. Using a large sample of banks, the essay documents evidence of a non-linear
relationship between additional liquid asset holdings and bank profitability. That is, banks’ profitability is improved with the holding of some liquid assets. However,
evidence suggests that there is a point at which holding further liquid assets diminishes profitability. The essay also finds that growth in credit and asset prices is more important for bank profitability than output growth, suggesting that bank returns respond to the financial and not the business cycle. Another important finding of this essay is that long-term interest rates tend to increase bank profitability, whilst short-term rates tend to lower bank profits - via increasing funding costs. These findings are homogeneous across countries with different development status as these results appear consistent for advanced and emerging market economies.
Overall, the findings from this thesis provide important implications for regulators seeking to provide stability and resilience to the financial system. They provide further evidence that supports the call for the use of countercyclical capital buffers, but more importantly, they highlight the need for a more rigid approach to the
setting of the countercyclical capital buffer rate. The thesis also suggests that an allowance for corporate equity system that eliminates or significantly reduces the
tax-induced distortions in banks, might be worth considering as a macroprudential policy tool that targets capital standard. Finally, it also highlights the importance of finding the right balance between policies geared toward mitigating liquidity risk and maintaining bank profitability.
