Bank Interest Margin, Multiple Shadow Banking Activities, and Capital Regulation

Abstract

Abstract:In this paper, we develop a contingent claim model to evaluate a bank's equity and liabilities that integrates the premature default risk conditions with loan rate-setting behavioral mode and multiple shadow banking activities under capital regulation. The barrier options theory of corporate security valuation is applied to the contingent claims of a bank. The barrier reports that default can occur at any time before the maturity date. We focus on a type of earning-asset portfolio, consisting of balance-sheet banking activities of loans and liquid assets and shadow banking activities of wealth management products (WMPs) and entrusted loans (ELs). The optimal bank interest margin, i.e., the spread between the loan rate and the deposit rate, is derived and analyzed. The results provide an alternative explanation for the decline in bank interest margins, which better fits the narrative evidence on bank spread behavior under capital regulation in particular during a financial crisis. Raising either WMPs or ELs leads to a transfer of wealth from equity holders to the debt holders, and hence increases the deposit insurance liabilities. We also show that the multiple shadow banking activities of WMPs and ELs captured by scope equities may produce superior return performance for the bank. Tightened capital requirements may reinforce the superior return performance by a surge in shadow banking activities that makes the bank less prudent and more prone to risk-taking at a reduced margin, thereby adversely affecting banking stability. We demonstrate that financial disturbance may be created because of the potential for shadow banking activities to spill over to regular banking activities and damage the real economy.

The Impact of Fintech Startups on Financial Institutions' Performance and Default Risk

“…A wealth of literature has investigated the performance of financial institutions. In the past decade, research has examined the determinants of financial institutions' performance, analyzing how firms address corporate governance issues (Aebi et al, 2012;Peni and Vähämaa, 2012;Zheng and Das, 2018), master the diversification of their business activities (Berger et al, 2010;Brahmana et al, 2018;Chen et al, 2018;Kim et al, 2020), deal with external regulation (Naceur and Omran, 2011;Psillaki and Mamatzakis, 2017), react to monetary policies (Mamatzakis and Bermpei, 2016;Gambacorta and Shin, 2018), deal with the legal and institutional framework (Kalyvas and Mamatzakis, 2017;Bitar and Tarazi, 2019;El Ghoul et al, 2021), generate intellectual capital (Talavera et al, 2018;Nawaz, 2019;Adesina, 2021), and engage in shadow banking activities (Tan, 2017;Lin et al, 2018). Given the all-embracing and massive development of the fintech sector in the past decade, it seems worthwhile also to investigate how fintech start-up formations affect financial institutions' performance.…”

Shadow banking and non-performing loans: international evidence

“…Tan (2017) notes that traditional banks conduct shadow banking activities to boost profitability. Lin et al (2018) and Fang et al (2019) show that the involvement of conventional banks in shadow banking activities leads to superior performance. In addition to its impact on profitability, shadow banking activities also affect traditional banks’ cost efficiency.…”

Editorial for Special Issue “Finance, Financial Risk Management and their Applications”

“…Their findings showed that the NFNE futures exhibit superior effectiveness as an instrument for hedging stock sector exposures, compared with the TAIEX and Taiwan 50 futures. The ninth paper entitled "Bank Interest Margin, Multiple Shadow Banking Activities, and Capital Regulation by Lin et al (2018) investigates a contingent claim model to evaluate a bank's equity and liabilities that integrates the premature default risk conditions with loan rate-setting behavioral mode and multiple shadow banking activities under capital regulation. The authors focused on a type of earning asset portfolio, consisting of balance sheet banking activities of loans and liquid assets and shadow banking activities of wealth management products (WMPs) and entrusted loans (ELs).…”