"Information Value in EU-Wide Bank Stress Test", December 2019

The paper starts with an evaluation of the banks’ solvency information disclosed in the 2018 and 2016 EU-wide stress tests, asking do they add value to the information available in the bank capital ratios observed at the start of the stress exercise? It argues that information from price-to-book, degree of imperfect information on the value of assets and relative holding of domestic government bonds all require a bank-specific approach in the supervisory review and evaluation process (SREP) exercise. In short, one size does not fit all.

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”Digital Disruption and Bank Lending”, in European Economy, Vol. 3 (2), December 2017

The paper assesses the threat posed by digital banking as seen in the context of a long series of financial and technological innovations in the banking sector. It focuses on the economics of banking services and banks’ two main functions – as providers of liquidity and loans – and analyzes whether these could be displaced by peer-to-peer and marketplace lending.

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"The Single Resolution Mechanism in the European Union: Good Intentions and Unintended Evil", Jean Dermine, INSEAD, Singapore in Monetary Economic Issues Today, Festschrift in Honour of Ernst Baltensperger, editor Swiss National Bank, Orell Füssli Verlag, Zurich, 2017.

Following the global financial crisis of 2008, a new architecture for global financial markets has emerged. It aims to sever the link between bank losses, state aid, and sovereign risk, and put an end to the doctrine of ‘too big to fail’ and moral hazard, thanks to the privatization of losses. As of January 2016, the European Union has been operating the single resolution mechanism (SRM)for banks in the eurozone countries. In our opinion, in its current form the SRM creates an unintended evil: a significant increase in the likelihood of bank runs. Since this is the prime cause of financial crises around the world, there is an urgent need to address this shortcoming. Five alternative solutions are discussed.

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"Digital Banking and Market Disruption, A Sense of Déjà Vu?", Financial Stability Review, Banque de France, N°20, April 2016.

The Paper assesses the threat posed by digital banking as seen in the context of a long series of innovations in the banking sector that includes telephone banking, payment cards, the development of capital markets, internet, smart-phones, and cloud computing. If focuses on the economics of banking services and banks' two main functions - as providers of liquidity and loans - and analyzes whether these could be displaced by peer-to-peer and marketplace lending.

Digital banking is currently one of the main strategic issues faced by banks in terms of threats and opportunities. It raises also public policy issues: its impact on the profitability and solvency of banks, the protection of borrowers and investors, and the systemic importance of the new players, the Fintechs starts-up specialized in financial services.

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"Fund Transfer Pricing for Bank Deposits, the Case of Products with Undefined Maturity", The Capco Institute Journal of Financial Transformation, Vol. 43, May 2016.

The paper presents a pedagogical yet rigorous analysis of fund transfer pricing for deposits with undefined maturity. The objective is to identify the conditions needed to convert the case of deposits with undefined maturity into one with a single effective maturity. This in turn allow us to identify the many circumstances under which the practice of conversion into a single effective maturity is not warranted. Attention is called to the context in which the choice of a maturity is made: pricing, evaluation of performance, and hedging of interest rate risk on deposits with undefined maturity.

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“Basel III Leverage Ratio Requirement and the Probability of Bank Runs”, Journal of Banking and Finance, April 2015.

A new argument for the Basel III leverage ratio requirement is proposed: the need to limit the risk of a bank run when there is imperfect information on the value of a bank’s assets. In addition to screening and monitoring borrowers, banks provide liquidity insurance with the supply of short-term deposits withdrawable on demand. The maturity mismatch creates the risk of a disorderly bank run which can be exacerbated by imperfect information about the value of bank assets. It is shown in a stylized Basel III framework that capital regulation should incorporate a liquidity risk component. Credit risk diversification and/or a reduced probability of loan default which leads to a reduction of Basel III regulatory capital will increase the probability of a bank run. The leverage ratio rule puts a floor on the Basel III risk-weighted capital ratio, allowing the limitation of such a risk.

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”Bank Corporate Governance, Beyond the Global Financial Crisis”, (Journal of) Financial Markets, Institutions and Instruments, November 2013.

Following up on the publication of the Walker Report (2009) in the United Kingdom, international organizations such as the Basel Committee (2010), the OECD (2010), and the European Union (2010) have proposed guidelines to improve bank corporate governance and, more specifically, risk governance. These international reports vary widely on what the prime objective of bank corporate governance should be, with one group recommending a shareholder-based approach, and the other a stakeholder-based one. Moreover, the focus of these reports is exclusively on risk avoidance, with little guidance as to how an acceptable level of risk should be defined. Drawing on insights from economics and finance, this paper is intended to contribute to the debate on bank corporate governance.

Our four main conclusions are as follows. Firstly, the debate on bank governance should concern not only the boards but also the governance of banking supervision with clearly identified accountability principles. Secondly, since biases for short-term profit maximization are numerous in banking, boards of banks should focus on long-term value creation. Thirdly, board members and banking supervisors should pay special attention to cognitive biases in risk identification and measurement. Fourthly, a value-based approach to risk taking must take into account the probability of stress scenarios and the associated costs of financial distress. Mitigation of these costs should be addressed explicitly in the design of bank strategy.

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”Banking Regulations after the Global Crisis, Good Intentions and Unintended Evil,” European Financial Management, May 2013.

More stringent regulations on bank capital, liquidity, compensation and corporate structure have been passed to increase the resilience of the global banking system. In this essay, we analyze the impact of the capital and liquidity regulations and call attention to the fact that the banks’ responses might create unintended evil: a reduced supply of bank loans, incentives to securitize assets and move financial intermediation to shadow banking, and adverse incentives on bank risk monitoring.

The conclusion is that privately-based mechanisms that put most creditors at risk are the best way to increase the safety and soundness of banking markets. It is argued that interbank debt should be put at risk because banks have a comparative advantage in risk monitoring. As putting short-term interbank at risk increases the danger of sudden deposit withdrawals, a mechanism is needed to extend the maturity of short-term debt at the time of a credit-led panic.

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”Fund Transfer Pricing for Deposits and Loans, Foundation and Advanced”, Journal of Financial Perspectives, March 2013.

Fund transfer pricing (FTP) is fundamental to evaluate the profitability of deposits and loans. Following the global banking crisis, this paper seeks to draw attention to five issues that have been previously ignored: rationing on the interbank market, the creation of a Basel III contingency liquidity buffer, the necessity to adjust fund transfer pricing to the credit riskiness of specific assets of the bank, the need to include a liquidity premium in the case of long-term funding, and finally the choice of a consistent methodology to incorporate the credit spread on the bank’s own debt due to the perceived risk of bank default.

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”In Banking, is Small Beautiful?” (Journal of) Financial Markets, Institutions and Instruments, 2010 (with D. Schoenmaker)

The state-led resolution of the 2007-2009 financial crisis has proven to be costly. Calls are being heard in Belgium, the Netherlands and Switzerland to cap the size of domestic banks. Is small beautiful? In this policy paper, we first match bailing out cost data to the relative size of banks for a sample of 14 countries and 29 banks. An important observation is that some countries with relatively small banks faced large bailout cost when correlated systemic risk affected many banks. Secondly, we call to the attention that capping the size of banks can have an unintended effect: a lack of credit risk diversification. Risk diversification is needed to reduce the costs of financial distress, which are quite significant in the banking industry. If reducing public bailout costs is the right objective, capping the size of banks is not the best tool. So as to keep large banks that provide highly skilled employment opportunities in a services economy, we discuss four policy options that help to ensure financial stability: independence and accountability of bank supervisors, prompt corrective action mechanisms, burden sharing across countries, and an end to the too-big-to-fail doctrine.

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”Bank Valuation, with an Application to the Implicit Duration of non-Maturing Deposits”, in International Journal of Banking, Accounting and Finance, 2010

The purpose of the tutorial paper is to present a model to value banks. Three traditional models are summarized briefly first. Next, a ‘fundamental’ bank valuation model is introduced. Based on sound economics and finance principles, it allows to identify the various sources of value and to derive managerial implications such as the measurement of interest rate risk on non-maturing deposits. A first contribution includes the breakdown of the value of equity into two parts: a liquidation value and a franchise value. A second contribution is to call the attention to the corporate bond market, instead of the equity market, to find adequate risk premium to value banks. The valuation model concerns on-balance sheet banking business, such as deposit taking and lending. Off-balance sheet business, such as advisory services, can be valued with standard corporate finance tools.

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“Avoiding International Financial Crises, an Incomplete Reform Agenda”, in Understanding the Financial Crisis: Investment, Risk and Governance, eds S. Thomsen, C. Rose, and O. Risager, SimCorp, 2009. (DKsim)

After a brief review of the origin of the subprime crisis, we argue that the set of reforms proposed recently by national and international groups to reduce the risk of global banking crises constitutes an incomplete reform agenda. Three important issues remain, in our opinion, to be addressed:

• Accountability of bank supervisors and regulators
• An end to the too-big-to fail doctrine
• A satisfactory regime for the supervision and bailing out of international financial groups

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"Blueprint for a New International Financial Order", November 2008

An international conference on a new financial order will take place soon. This note is making three points.1) an international supervisory body is premature when taxpayers money is collected at the national level. 2) capital regulation should not be confused with liquidity regulation. Too high capital ratios can lead banks to increase risk-taking. 3) Finally, the repetition of crisis calls for stronger private incentives to control risk. It is only when bank’s debt will be at risk that proper attention will be given to risk control. The too-big-too-fail doctrine must be abandoned.

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“Bank Loan-Loss Provisioning, Central Bank Rules vs. Estimation: The Case of Portugal”, Journal of Financial Stability, Vol. 4 (1), 2008 (with C. Neto de Carvalho)

A fair level of provisions on bad and doubtful loans is an essential input in mark-to-market accounting, and in the calculation of bank profitability, capital and solvency. Loan-loss provisioning is directly related to estimates of loan-loss given default (LGD). A literature on LGD on bank loans is developing but, surprisingly, it has not been exploited to address, at the micro level, the issue of provisioning at the time of default, and after the default date. For example, in Portugal, the central bank imposes a mandatory provisioning schedule based on the time period since a loan is declared ‘non-performing’. The dynamic schedule is ‘ad hoc’, not based on empirical studies. The purpose of the paper is to present an empirical methodology to calculate a fair level of loan-loss provisions, at the time of default and after the default date. To illustrate, a dynamic provisioning schedule is estimated with micro-data provided by a Portuguese bank on recoveries on non-performing loans. This schedule is then compared to the regulatory provisioning schedule imposed by the central bank.

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ALM in Banking, in Handbook of Asset and Liability Management, Volume 2: Applications and Case Studies, North Holland Handbooks in Finance, eds. S.A. Zenios and W.T. Ziemba, Elsevier Science B.V. , 2007

The main purpose of the chapter is to discuss Asset & Liability Management, the control of value creation and risks in a bank. This chapter is innovative in two ways. First, unlike the usual practice of restricting ALM to the control of interest rate and liquidity risks, we propose a framework to analyze both value creation and the control of risks. Second, rather than discuss the ALM issues one by one in an independent manner, the chapter provides a microeconomic-based valuation model of a bank. This allows an integrated discussion of fund transfer pricing, deposit pricing (fixed and undefined maturities), loan pricing, the evaluation of credit risk provisions, the measurement of interest rate risk for fixed and undefined maturities, the diversification of risks, and the allocation of economic capital.

Besides a comprehensive summary of the literature on ALM in Banking, the chapter makes six contributions related to transfer pricing, risk-adjusted pricing of loans, provisioning of credit risk, the relevant maturity to price and hedge deposits with uncertain maturities, the after-tax valuation of equity, and the hedging of economic profit.

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“European Banking Integration, Don’t Put the Cart before the Horse”, (Journal of) Financial Markets, Institutions and Instruments, Vo. 15 (2), 2006

This paper reviews the progress in European banking integration over the last twenty years, and evaluates the current system of banking supervision and deposit insurance based on ‘home country’ control. The public policy implications to draw from the paper are threefold: First, after a relatively slow start, European banking integration is gaining momentum, in terms of cross-border flows, market share of foreign banks in several domestic markets, and cross-border M&As of significant size. If this trend continues, the issue of adequate supervision and safety nets in an integrated European banking market will become even more pressing. Second, although until recently banks have relied mostly on subsidiary structures to go cross-border, this is changing with the recent creation of the European company statute, which facilitates cross-border branch banking. A review of the case of the Scandinavian bank, Nordea Bank AB, helps to understand some remaining barriers to integration, and the supervisory issues raised by branch banking. Third, it is argued that the principle of ‘home country’ supervision is unlikely to be adequate in the future for large international banks. Because the closure of an international bank would be likely to have cross-border spillovers, and because some small European countries might be unable to finance the bail-out of their very large banks, centralization, or at least Europe-wide coordination, of the decision to close or bail-out international banks is needed. This raises the issue of European funding of bail-out costs, European banking supervision, and European deposit insurance.

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"How to Measure Recoveries and provisions on Bank Lending, Methodology and Empirical Evidence , in Recovery Risk: The Next Challenge in Credit Risk Management", editors E. Altman, A. Resti and A. Sironi, Risk Books, 2005

Estimates of loan losses-given-default are essential parameters to price credit risk, to calculate a fair level of provision, and to evaluate bank profitability and solvency. The empirical literature on credit risk has relied mostly on the corporate bond market to estimate losses in the event of default. The reason for this is that, as bank loans are private instruments, few micro data on loan losses and cash flow recovery are publicly available. The main contribution of this chapter is to provide a mortality-based methodology to calculate loan losses-given-default and provisioning on impaired bank loans. The methodology is then applied to a unique set of micro-data on distressed loans of a European bank.

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"Bank Loan Losses-Given-Default", a Case Study, Journal of Banking & Finance, 2005

The empirical literature on credit risk has relied mostly on the corporate bond market to estimate losses in the event of default. The reason for this is that, as bank loans are private instruments, few data on loan losses are publicly available. The contribution of this paper is to apply mortality analysis to a unique set of micro-data on defaulted bank loans of a European bank. The empirical results relate to the timing of recoveries on bad and doubtful bank loans, the distribution of cumulative recovery rates, their economic determinants and the direct costs incurred by that bank on recoveries on bad and doubtful loans.

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STRATEGIC MANAGEMENT IN BANKING, In Medio Virtus, in 25th SUERF Colloquium:Competition and Profitability in European Financial Services: Strategic, Systemic, and Policy Issues”, eds M. Balling, F. Lierman and A. Mullineux, Routledge, 2006

In this essay, I argue that banks must keep an adequate balance between short and long term profitability/growth, and between focus and diversification. The case of the British bank Lloyds TSB is analyzed over the period 1984-2004.

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European Banking, Past, Present and Future, 2002

In April 1983, a White Paper on financial integration by the European Commission called for further work to be done in order to achieve a better allocation of savings and investment in the European Community. Twenty years into the integration of European banking markets, we review the impact of the legislation on the banking industry, the commercial banks, their customers, and regulators. A review of this twenty-year period will hopefully help to better understand the dynamics of the transformation and potential future developments.

We attempt to better understand the remaining barriers to the creation of a truly single European banking market, and address the relevant public policy issues. In particular, we argue that the concept of a bank with a single license operating with cross-border branches is more a myth than a reality.

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"A Note on Banking Efficiency in Portugal, New vs Old banks", Journal of Banking & Finance, 2006

Following entry into the European Community in 1986, Portugal transformed rapidly its repressed banking system. with deregulation, the opening of borders, the granting of new banking licenses, and privatization. In a more competitive banking system, one would expect a priori an increase in operational efficiency. This paper attempts to quantify the magnitude of efficiency gains over the years 1990 to 1995. Moreover, the paper documents the relative efficiency performance of new domestic banks. Not hampered by a legacy of inefficiency from the past, they could operate nearer the efficiency frontier. The case of Portugal provides unique information on the joint effect of deregulation and the granting of new banking licenses on the change in operational efficiency of a previously repressed banking system.
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CREDIT RISK AND DEPOSIT INSURANCE PREMIUM, a Note, Jean Dermine and Fatma Lajeri, Journal of Economics & Business, 53, 2001

Previous research on market-based evaluation of deposit insurance premia has modeled the bank as a corporate firm with risky assets and insured liabilities. No attempt was made to analyze explicitly the risk characteristics of bank assets. The purpose of this note is to model bank lending explicitly and calculate loan-risk sensitive insurance premia. The lending function of banks creates the need to model equity as a 'capped' call option. A simulation exercise shows that market-based estimates of insurance premium which ignore the cap lead to significant underestimation.

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European Capital Markets with a Single Currency, by Jean Dermine and Pierre Hillion, Oxford University Press, 1999
The book commissioned by the European Capital Markets Institute (ECMI) includes the contributions of fourteen specialists drawn from various fields of research: banking, economics and finance.

The Economics of Bank Mergers in the European Union, a Review of the Public Policy Issues@, Jean Dermine, September 1999

A very large merger wave in the banking sector has taken place in Europe and the United States over the last ten years. This raises a set of questions to different parties. Banks= shareholders and managers need to identify the potential sources of economic gain derived from a merger or an acquisition. As concerns public policy makers, they need to assess how bank mergers -be they domestic intra-industry, across- industry, or cross-border- affect their mission of protecting investors and ensuring financial stability, an appropriate level of competition, and the competitiveness of national firms in international financial markets. Moreover, as the banking world is becoming increasingly international, there is a need to reassess the structure of bank regulation and supervision which has been historically assumed by each nation State.

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Bank Mergers in Europe, the Public Policy Issues, Jean Dermine, Journal of Common Market Studies, 2000, pp 409-425

A very large merger wave in the banking industry has taken place in Europe over the last fifteen years. Public policy makers need to assess how bank mergers -be they domestic intra-industry, across-industry, or cross-border- affect their mission of protecting investors and ensuring financial stability, an appropriate level of competition, and the competitiveness of national firms. Moreover, as the banking world is becoming increasingly international, there is a need to reassess the structure of bank regulation and supervision which has been assumed historically by each nation State.

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