Oil Prices and Banking Instability: A Jump-Diffusion Model for Bank Capital Structure

Abstract

We develop an empirical model of bank capital structure to study the impact of large oil shocks on overleveraging of banks which presents severe challenges for banks’ balance sheet management. The measure of overleveraging builds on the Stein (2012) model by adding a jump-diffusion component that captures the jump size and intensity of predictors such as oil prices and political instability. Overleveraging is derived and estimated for a sample of six banks in three oil-producing countries and Western countries using the Markov Chain Monte Carlo (MCMC) method, for the years 2006-2016. The estimation of the optimal debt shows that most of the banks in this context had a high optimal debt around 2008, overlapping with the oil price shock. In addition, most of the predictors, namely oil prices and political instability factors proxied by terrorism, political corruption, and military expenses, regularly appeared in volatility and jump intensity factors.

Fiscal Policies for a Low-Carbon Economy

“…Expansions in oil prices are expected to benefit renewable energy sectors relative to carbon-intensive sectors, while reductions are expected to harm, as both sectors can be viewed as substitutes. This result is similar to the study by Semmler & Issa (2019), who study in parallel the performance of banks with respect to oil price changes.…”