The new challenges of global banking and finance

Abstract

The economic downturn caused by the Covid-19 pandemic has brought unprecedented uncertainty to the global banking system. Banks are facing critical market challenges driven by uncertain monetary policies, deterioration in credit quality, and regulation and compliance pressures. These challenges highlight the importance of better understanding the new role of financial intermediations in facilitating efficient capital allocations and economic development. This article reviews the related literature on monetary policy uncertainty, bank performance, digital finance, and introduces articles on these themes. Finally, we propose potential areas for future research.

KEYWORDS:

• Monetary policy uncertainty
• banking
• sustainable finance
• cryptocurrency

1. Introduction

Functioning as financial intermediaries for capital allocations, banks are believed to be the pivotal engine of a country’s overall economic growth (Mckinnon 1973). ‘When banks efficiently mobilize and allocate funds, this lowers the cost of capital to firms, boosts capital formation, and stimulates productivity growth’ (Levine 2004). Prior literature demonstrates a positive relationship between efficient financial intermediaries and economic development. Using cross country data of 80 countries from 1960 to 1989, King and Levine (1993) show that a sound financial system is strongly associated with current and future economic efficiencies. Further, Levine, Loayza, and Beck (2000) confirm that better-functioning financial intermediaries can ameliorate capital market failures and enhance economic development. However, undermining confidence in the banking system can disrupt its role in facilitating efficient capital allocation and economic development. Instability in the banking system can result in great damaging effects to real economic growth.

Since the Global Financial Crisis (GFC), the banking system has been subject to significant monetary policy uncertainties. To boost economic recovery, central banks initially responded by cutting policy interest rates sharply. This can impact bank performance, as illustrated in the pioneering study of Ho and Saunders (1981) who illustrate that interest rate volatility can have a significant negative impact on bank net interest margins (NIMs). Demirgüç-Kunt and Huizinga (1999) also show that high real interest rates are associated with higher NIMs and profitability, especially in emerging economies. English (2002) looks at the link between interest rate risk exposure and bank margins across ten Organisation for Economic Co-operation and Development (OECD) countries over the period 1979–1999 and concludes that a steep yield curve is associated with high NIMs.¹ A more recent study by Claessens, Coleman, and Donnelly (2018) confirms that low interest rates have an adverse influence on bank profitability, based on a sample of 3,385 banks across 47 countries over the period 2005–2013.

To take unconventional monetary policy a step further, several central banks have introduced negative interest rate policy (NIRP) since 2012, aiming at additional monetary accommodation. The primary objective for countries adopting NIRP is to stimulate bank lending. However, Heider, Saidi, and Schepens (2018) find that banks that rely on deposit funding are reluctant to reduce deposit rates when policy rates turn negative due to the risk of losing their deposit base. When deposit interest rates remain sticky, it puts a pressure on banks’ profit margins, causing them to shift their focus to fee-based services.

In their theoretical study, Brunnermeier and Koby (2016) suggest that monetary policy may have unintended contractionary effects on lending due to bank capital constraints, bank business models, and market competition. Molyneux et al. (2020) present an empirical investigation of the Brunnermeier and Koby (2016) ‘reversal rate hypothesis’. The results confirm that banks in NIRP-adopter countries reduce lending significantly compared to those in countries that do not adopt the policy. Given that banks need to hold deposit rates steady to maintain their deposit funding base, NIRP has an adverse influence on bank profitability, which further reduces credit growth.

Recently, in response to soaring inflation, global central banks aggressively raised interest rates. Higher interest rates support bank profits, but deteriorating asset quality and rising funding costs create new challenges to the banking system. Flannery (1981) finds that a sharp increase in market interest rate may induce a significant number of banking failures and pose a threat to banking system stability. Higher interest rates prompt banks to tighten their lending standards (Adrian and Shin 2009; Acharya and Naqvi 2012; Borio and Zhu 2012). Jiménez et al. (2012) demonstrate that a tightening of monetary policy and a worsening of economic conditions significantly reduce lending by distressed banks. In addition, Jiménez et al. (2014) suggest that bank capitalisation plays a crucial role in the transmission of monetary policy. When monetary policy is loosened, under-capitalised banks are more likely to increase their risk-taking and make riskier loans.

Further, big banks are adopting new technologies by making significant investments in fintech companies, as well as becoming partners and suppliers. The traditional financial market is transforming into one that includes token financing, pricing, and trading. A couple of influential studies focus on the field of ‘tokennomics’ – namely, economies that involve cryptocurrencies. For instance, Griffin and Shams (2020) investigate a specific digital currency, Tether (a cryptocurrency pegged to the U.S. dollar) and its influence on Bitcoin prices. They find that Bitcoin prices are significantly affected by Tether over market downturns, and emphasise that unbacked digital money inflates cryptocurrency prices. Cong, Li, and Wang (2021) show that token values play an important role in reflecting platform adoption, user participation, and the linked network externality effects. They find that the introduction of tokens in the pricing model not only lowers effective carry cost of conducting platform transactions but also reduces the volatility of the user base. Another related stream of studies focuses on the initial coin offering (ICO), a unique way to raise funds on digital platforms from a crowd of investors by offering digital tokens/coins. The raised funds are used for production and services that are constructed using blockchain technologies. Pioneering work has documented that the soundness of financial systems, public equity markets, and advanced digital technology development is significantly and positively related to the number of ICOs (Huang, Meoli, and Vismara 2020). The determinants of ICOs include ICO characteristics, venture characteristics, and team characteristics (see, for example, Fisch 2019; Momtaz 2021a; Colombo et al. 2022; Huang, Vismara, and Wei 2022), the effect of regulatory bans on the issuance of ICOs (Bellavitis, Cumming, and Vanacker 2022), and ICO performance (Fisch and Momtaz 2020; Momtaz 2021b; Lyandres, Palazzo, and Rabetti 2022).

Overall, existing literature finds that monetary policy uncertainty significantly contributes to bank failures and financial instability. The recent sharp increase in interest rates may provide some support to bank margins in the short run, but banks may also face higher credit risks in the medium to long term. There is a need to better understand the soundness of the financial system given these challenges faced by banks. As to the digital currency market, digital financing, and digital platforms, these have been growing fast over the past years, suggesting that these areas will provide new insights and fuel research activity in the near future. The remainder of this section is organised as follows. Section 2 discusses the articles included in this special issue. Section 3 concludes by discussing possible future research directions.

2. Articles in this special issue

Following the European Journal of Finance’s standard double-blind review process, six papers have been accepted for publication in this special issue, which covers a wide range of banking and digital finance-related topics. In particular, the special issue covers topics such as the banking sector’s risk and stability during the pandemic, the bail-in regime, exchange rates forecast in a negative interest rate environment, and digital currencies markets. In this section, we summarise the findings and implications of these papers.

An effective regime helps increase Credit Default Swaps (CDS) spreads and decrease equity returns due to the increased probability of bank failure without bail-out intervention (Schäfer, Schnabel, and Weder di Mauro 2016). Hahn, Momtaz, and Wieandt (2022) investigate the market effects of regulatory events associated with the implementation of a bail-in regime for failing European banks. Using a seemingly unrelated regressions (SUR) framework, they examine the effects of key European bail-in regime events on bank CDS spreads and equity returns, including the Bank Recovery and Resolution Directive – BRRD, the Single Resolution Mechanism Regulation – SRM-R, and other related events. In number, there are 34 regulatory events considered. Their empirical analysis is based on daily data from 2009 to 2017 for 260 financial institutions. In contrast to the regulator’s intention, the authors document a general tightening of CDS spreads and an increase in equity returns, indicating that the new regulatory regime does not effectively mitigate the issue of Implicit Government Guarantees (IGGs) in European banking. In addition, their study concludes that the newly implemented regulation has heterogeneous effects on different subsamples of European banks, which has significant policy implications for enhancing banking and financial stability in the euro area.

On a different topic, Trinh, Cao, and Elnahass (2022) examine a timely research question regarding bank tail risk during the Covid-19 pandemic. Firm tail risk, also known as extreme event risk, is the possibility that a company will incur extremely large losses as a result of infrequent but severe events. Due to its potential impact on a company’s financial performance and stability, firm tail risk has been widely studied in corporate finance and banking research. Prior research has demonstrated that firms with greater tail risk are more likely to experience failure and financial distress (Diemont, Moore, and Soppe 2016; Srivastav et al. 2017). This is especially the case for the banking sector, as the failure of a large financial institution can have spillover effects on the entire financial system and economy. Using a sample of 868 listed banks in 98 countries between 2002 and 2020, Trinh, Cao, and Elnahass (2022) document that the Covid-19 pandemic increases the likelihood that the global banking sector will experience significant tail risk. However, banks with greater profitability and financial stability are better able to prepare for the crisis and, as a result, are less likely to experience extreme equity devaluations. In light of the pandemic, the authors contend that financial stability acts as a ‘vaccine’ against the tail risk of banks. In general, the results are more pronounced in middle-income economies and countries with greater financial freedom.

To identify an exogenous determinant of financial stability, Klomp (2014) investigates the relationship between large-scale natural hazards and bank risk and discovers that natural disasters can stress and threaten a bank’s existence by adversely affecting its solvency. According to Noth and Schüwer (2018), weather-related natural disasters significantly weaken the stability of banks with business activities in affected regions. Brei, Mohan, and Strobl (2019) investigate the impact of hurricanes on various components of bank balance sheets in seven Eastern Caribbean countries from 2001 to 2012. They discover that after hurricane strikes, banks face deposit withdrawals and a negative funding shock, to which they respond by reducing lending supply and drawing on liquid assets. Do, Phan, and Nguyen (2022) extend the existing literature by focusing on 907 domestic/local banks and the Spatial Hazard Events and Losses Database for the United States from 2010 to 2019. They confirm that natural disasters reduce bank stability because total deposit and equity (capital) become more volatile, and banks are more likely to increase lending margins and provision for loan losses. As a result, banks lose competitiveness, ROA suffers, and Z-score falls. Nonetheless, strong corporate governance and prudential strategy aid bank recovery in the aftermath of these extreme weather events. Finally, Do, Phan, and Nguyen (2022) investigate the non-linear effect of natural disasters on banking stability. The results suggest that the Z-score initially decreases as natural hazards cause increasing damage up to a certain threshold; however, once that threshold is exceeded, the Z-score begins to improve due to the combined effect of government assistance programmes.

Moving away from bank failure and financial stability, Molinas, Binner, and Tong (2022) focus on examining the role and significance of Divisia monetary aggregates and associated User Cost Price indices as superior monetary policy forecasting tools. Their study seeks to extend the experiment conducted by Barnett and Kwag (2006) by applying it to the Euro/US dollar, US dollar/Yuan, and Euro/Yuan exchange rates in a negative interest rate environment. Using quarterly data, Molinas, Binner, and Tong (2022) compare the performance of Divisia monetary aggregates with traditional simple-sum aggregates in a number of theoretical models and a Bayesian VAR to forecast the exchange rates between the euro, the dollar, and the yuan over a range of time horizons. The results suggest that in a negative interest rate environment with a floating exchange rate, Superior Divisia monetary aggregates consistently outperform their simple sum counterparts and the benchmark random walk. Their paper builds on solid theoretical foundations and is the first of its kind to investigate the role and importance of Divisia monetary aggregates and concomitant User Cost Price indices as superior monetary policy forecasting tools in a negative interest rate environment.

Given the growing trend for investing in digital assets in investment portfolios, Huang, Han, et al. (2022) examine the diversification benefits of cryptocurrency asset categories. As a relatively new and largely uncorrelated asset class, the price movements of cryptocurrencies are not strongly correlated with those of stocks, bonds, and commodities. The inclusion of cryptocurrencies in a portfolio could reduce risk and enhance returns. However, due to their short track record and highly volatile nature, estimating the inputs for portfolio models that include cryptocurrencies is more difficult than when only conventional assets are considered. Their study employs several estimation and portfolio techniques that account for estimation error inputs. The authors extend the analysis by taking into account the effects of the increased economic uncertainty in the post-Covid-19 period, as the diversification benefits are especially important for investors in volatile market conditions. Specifically, to mitigate estimation risk, the Bayes-Stein model without short-selling and variance-based constraints has been applied. The inputs are estimated using Lasso regression, elastic net regression, the shrunken Wishart stochastic volatility model, and Gaussian random projection. Their empirical analysis uses 320 weekly returns of nine categories of cryptocurrency assets² over the period 14th November – 25th December 2020. They find that all but two categories offer significant out-of-sample diversification advantages. More importantly, the lower an investor’s risk aversion, the more beneficial cryptocurrencies are as portfolio diversifiers. During uncertain economic environments, as in the period following the Covid-19 pandemic, cryptocurrencies offer the same diversification benefits as they do in more stable economic environments. Their study provides a systematic examination of the out-of-sample diversification benefits of cryptocurrencies, taking estimation risk into account.

An ICOs white paper sets out the details of the project, plan and roadmap of how the cryptocurrency will develop. These are technical and mainly contain software codes and the process procedure for the development of crypto/Blockchain projects. Such white papers have been identified to have a signal effect on ICO success (Adhami, Giudici, and Martinazzi 2018; Fisch 2019). These have evolved to include venture information, token distribution and allocation details, marketing and strategic planning for products and services, and venture team member information. Thewissen, Shrestha, et al. (2022) identify that ICO white papers are informative, particularly the thematic contents are found to significantly affect ICO success. Following that, Thewissen, Thewissen, et al. (2022) examine the impact of the linguistic errors found in business communication on the ability to raise capital. The study combines finance literature and English linguistics to explore the relationship between formal and grammatical errors in business communication and investor behaviour. Prior research shows that narratives and language help leverage resources by conveying a firm’s identity (Lounsbury and Glynn 2001). Style, tone, and readability impact investment decisions (Henry 2008; Boudt and Thewissen 2019). In Thewissen, Thewissen, et al. (2022), thirteen distinct error subcategories relating to spelling and grammar were identified, using a sample of 546 ICO white papers. The error-annotated data are then subject to regression analyses, which confirm that linguistic errors discourage potential investments in initial coin offerings. In particular, the analyses reveal the existence of ‘high penalty’ versus ‘low penalty’ errors, which result in greater versus lesser financial investment losses for ICOs. Further, their results suggest that when ICO white papers are (1) written in native English-speaking countries and (2) from countries without cryptocurrency regulation, the negative impact of language errors is amplified. Experiment results indicate that this relationship is not based on the characteristics of entrepreneurs or investors.

3. Future research directions

As we noted earlier, the economic downturn caused by the Covid-19 pandemic has brought unprecedented uncertainty to the global banking system. Banks are facing critical market challenges driven by deterioration in credit quality, uncertain monetary policies, and mounting regulation and compliance pressures. Covid-19 has also prompted the rise of online/remote services as well as advancement of sustainable finance. Financial intermediaries and institutional investors around the world are under increasing pressure to adjust their responsibilities in allocating funding resources toward economic development that is sustainable. Banks play an important role in the transition to a low-carbon, sustainable economy by funding and supporting environmentally and socially responsible projects and enterprises. Since Environmental, Social, and Governance (ESG) factors have become more integrated into the investment and capital allocation frameworks of financial institutions, banks are more likely to incorporate ESG criteria into credit granting. As a result, firms with inferior ESG performance will typically incur greater lending spreads. Prior research demonstrates that ESG-related concerns are linked to loan spread, with greater ESG risk correlating to greater loan spreads (Chava 2014; Hauptmann 2017). The positive relationship between ESG risk and loan spread is strengthened when lenders are committed as responsible banks (Degryse et al. 2021).

As financial intermediaries, banks can acquire a constant flow of information from their borrowers. The comparative cost advantages in information production enable them to undertake superior debt-related monitoring (Diamond 1984, 1991). Newton et al. (2022) find that firms with higher ESG risk borrow less from banks than from markets, potentially to avoid bank monitoring and scrutiny. Since banks are able to efficiently monitor borrowers and detect firms’ misbehaviours easily through strict monitoring compared with public debtholders (Ben-Nasr 2019), firms with high ESG risk, (particularly those not easily detected) have strong incentives to hide their misbehaviours by avoiding the reliance on bank loans. Supporting this finding, Houston and Shan (2022) suggest that the bank relationship is a mechanism for promoting corporate ESG policies. Only a few studies have been conducted to investigate whether banks are effective in facilitating sustainability and helping firms move towards more sustainable growth. Future studies could explore the mechanism by which financial intermediation can shape and promote sustainable corporate growth.

In addition, we encourage investigations in another important field – the digital finance and cryptocurrency market – as growing and increasingly important parts of global banking and finance. For instance, improving sustainability orientation helps ESG start-ups to trade at a better valuation premium than non-ESG start-ups (Mansouri and Momtaz 2022). However, understanding the institutional channels through which the role of ESG plays in Blockchain-crowdfunding projects is yet to be confirmed. We also know little about how investors distinguish the components of ESG when making investment decisions. Further work is needed to investigate how ESG shapes the incentives of investors in both traditional and new digital currency markets.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Notes on contributors

Winifred Huang

Winifred Huang is an Associate Professor of Finance at the School of Management, University of Bath. She currently serves on the Editorial Boards of the Entrepreneurship Theory and Practice, the British Accounting Review and the Small Business Economics.

Philip Molyneux

Philip Molyneux is a visiting Professor at the University of Leeds. His main area of research is on the structure and efficiency of banking markets and he has published widely in this area. He has also published a variety of texts on banking areas and in the past has acted as a consultant to: New York Federal Reserve Bank, World Bank, European Commission, UK Treasury; Citibank Private Bank, Barclays Wealth, McKinsey & co, Credit Suisse and various other international banks and consulting firms.

Steven Ongena

Steven Ongena is Professor of Banking at the University of Zurich. Professor Ongena's papers have been published in leading academic journals in finance and economics. He has received numerous awards for his research and serves as a research consultant for several European central banks.

Ru Xie

Ru Xie is an Associate Professor of Finance at School of Management, University of Bath. Her research output has attracted policy-makers' attention and has been featured in more than 100 major media outlets including Financial Times, Bloomberg, CNN, NBC, Fortune etc. Her previous research has been published in leading international academic journals.

Notes

1 The ten industrial countries are Australia, Canada, Germany, Italy, Japan, Norway, Sweden, Switzerland, United Kingdom, and United States.

2 The authors use the most popular cryptocurrency asset categories listed in https://cryptoslate.com/coins/, which are Smart Contracts, DEX coins, Interoperability, Privacy coins, PoW coins, PoS coins, dPoS coins, Masternode coins, and Tokens.