Three essays on banks' financial stability: the role of off-balance sheet activities

This thesis includes three empirical studies that aim at evaluating the US bank holding companies’ (BHCs) financial soundness after the 2007-2009 Global Financial Crisis (GFC) through the lens of off-balance sheet (OBS) activities. First, it examines the implication of additional regulation and market scrutiny (stress testing) on banks’ adoption of OBS activities. Then, considering Risk-Based Capital (RBC) requirements under the Basel III accord, it assesses the presence of potential regulatory arbitrage. Second, this study examines the effects of OBS activities on default risk, considering the role of “too big to fail” (TBTF) banks, to assess differences in default risk between large and small banks. Finally, this research explores the effects of OBS activities on banks’ margins and profits under a low-for-long interest rate environment. The empirical analysis developed in each of the three studies provides the following results. First, the findings document a negative effect of stress tests on banks’ adoption of OBS activities, indicating that they are discouraged from engaging in OBS activities.

Moreover, regulatory arbitrage behaviour is present for banks that are capital constrained. Second, OBS activities reduce default risk for small banks, suggesting diversification benefits. However, those activities increase default risk for TBTF banks, suggesting a moral hazard behaviour. That dynamic is reversed when incorporating the moderating effects of capital level: higher capital leads to safer OBS activities for TBTF banks, while more capital increases default risk for small banks through OBS channels. Third, the empirical evidence shows that banks’ margins are compressed to a greater extent than overall profits under a low interest rate environment. This adverse effect is more pronounced when a bank heavily engages in OBS activities, indicating cross-selling or an “originate-to-distribute” behaviour when low interest rates persist for an extended period of time. The main remarks highlighted by the empirical evidence provided in this thesis is that stress tests combined with RBC requirements serve as an effective tool to mitigate banks risk taking through the OBS channels and enhance TBTF banks financial soundness. However, moral hazard behaviour emerges when a TBTF bank is constrained by regulatory capital and interest rates near zero; low capitalised banks engage more in riskier OBS activities to avoid additional regulation and earn higher profits.