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Financial fragility, macroeconomic shocks and banks’ loan losses: evidence from Europe

  • Pesola, Jarmo

    ()

    (Bank of Finland Research)

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    This paper tests the hypothesis that the more fragile a banking system is, the more likely it is to experience problems when an unexpected shock hits. The empirical framework where this test is conducted is a reduced form model, where macroeconomic factors explain banks’ loan losses. The dependent variable is the ratio of net loan losses to lending in a panel comprising the banking sectors of nine sample countries. An econometric model is estimated on pooled annual data mostly covering the period from the early 1980s to 2002. There are three separate explanatory terms. Two of these include a surprise change both in incomes and real interest rates. Both form a separate cross-product term with lagged aggregate indebtedness. The lagged dependent variable is the third explanatory term possibly capturing the feedback effect from loan losses back to the real economy. The underlying macroeconomic account that this paper puts forward is that loan losses seem basically to be generated by strong adverse aggregate shocks under high exposure of banks to such shocks. The model has been used in connection with stress testing in the Bank of Finland.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0715netti.pdf
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    Paper provided by Bank of Finland in its series Research Discussion Papers with number 15/2007.

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    Length: 38 pages
    Date of creation: 09 Oct 2007
    Date of revision:
    Publication status: Published as Pesola, Jarmo, 'Joint effect of financial fragility and macroeconomic shocks on bank loan losses: Evidence from Europe' in Journal of Banking & Finance, 2011, pages 3134-3144.
    Handle: RePEc:hhs:bofrdp:2007_015
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/

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    1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
    3. Linda Allen & Anthony Saunders, 2003. "A survey of cyclical effects in credit risk measurement model," BIS Working Papers 126, Bank for International Settlements.
    4. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
    5. Barry Eichengreen & Carlos Arteta, 2001. "Banking Crises in Emerging Markets: Presumptions and Evidence," Macroeconomics 0012012, EconWPA.
    6. Jeffrey Sachs & Aaron Tornell & Andres Velasco, 1996. "Financial Crises in Emerging Markets: The Lessons from 1995," NBER Working Papers 5576, National Bureau of Economic Research, Inc.
    7. DellAriccia, Giovanni & Detragiache, Enrica & Rajan, Raghuram G, 2005. "The Real Effect of Banking Crises," CEPR Discussion Papers 5088, C.E.P.R. Discussion Papers.
    8. Paul Louis Ceriel Hilbers & Alfredo Mario Leone & Mahinder Singh Gill & Owen Evens, 2000. "Macroprudential Indicators of Financial System Soundness," IMF Occasional Papers 192, International Monetary Fund.
    9. Pesola, Jarmo, 2001. "The role of macroeconomic shocks in banking crises," Research Discussion Papers 6/2001, Bank of Finland.
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