Bond market development and bank stability: Evidence from emerging markets

Highlights

• We investigate how bond market development shapes banks’ risk taking using a bank level sample from 26 emerging markets.

• We find that larger bond markets are related to lower liquidity and portfolio risk, and higher overall stability of banks.

• We find new evidence of a complementary relationship between bond market development and bank soundness.

Abstract

We investigate how bond market development shapes banks’ risk taking in terms of portfolio structure, liquidity risk, and overall bank risk. Exploiting a bank-level database of 26 emerging markets, we find that larger bond markets are associated with stronger bank liquidity positions, lower portfolio risk of banks, and higher overall stability of banks. The effect of bond market development on bank risk taking remains robust across different levels of bank size and capital sufficiency. Overall, we find new evidence of a complementary relationship between bond market development and bank soundness.

Introduction

Risk management is vital to the successful operation of banks, which, in turn, promotes the soundness of financial institutions and systematic financial stability. Both the 1997/98 Asian financial crisis and the global financial crisis (GFC) showed how financial stability can be challenged and the real economy can be harmed when the financial sector, in particular banks, failed to function as a liquidity provider (Acharya and Mora, 2015). During a crisis, credit from banks drops significantly due to financial stress associated with drawdowns of existing credit lines and runs by short-term depositors (Drehmann and Nikolaou, 2013; Ivashina and Scharfstein, 2010). Hong et al. (2014) further suggest that during a systematic liquidity shortage, the affected banks may become insolvent, which worsens the aggregate liquidity situation and thus causes contagious bank failures.

Recent evidence points to the importance of portfolio structure and liquidity management in the resilience of the banking sector. Cornett et al. (2011) find that banks with stable funding sources continue to lend even during crisis, while banks with less liquid asset portfolios tend to reduce credit and reinforce their asset liquidity during financial crises. The Basel Committee on Banking Supervision (BCBS) (2010a) notes that during the “liquidity phase” of the GFC, many banks faced liquidity difficulties even if they held a sufficient capital buffer. This prompted the committee to introduce a framework for liquidity risk management. Imbierowicz and Rauch (2014) suggest that liquidity risk contributes to bank failures independently from credit risk.

Liquidity risk reflects the maturity mismatch that is naturally embedded in the business model of banks. Diamond and Rajan (2001) model bank business structure and show that banks create liquidity by financing long-term projects with short-term demand deposits. Their ability to match illiquid loans with liquid deposits lies in their collection skills and demand deposit issuances. Diamond and Rajan (2005) further show that such a business structure exposes banks to a natural maturity mismatch between demand deposits and loan assets. The maturity mismatch arising from liquidity transformation and creation is the main reason for banks to hold liquidity reserves and for regulators to monitor bank liquidity risk. The risk that liquidity demand cannot be met affects banks’ continuous operation and exacerbates systematic financial instability.

Although maturity mismatch and liquidity management have been identified as a major source of bank risks, the literature that articulates the factors affecting bank portfolio structure and liquidity risk is relatively sparse. However, a number of studies consistently find that a weak portfolio structure and heightened maturity mismatch exposes banks to greater risks. On the liability side, greater reliance on deposits as a source of funding is related to the underpricing of risks and greater risk-taking. (Acharya and Naqvi, 2012; Khan et al., 2017) Vazquez and Federico (2015) find that weak funding structure significantly contributes to bank failure during crisis. On the asset side, the illiquid nature of bank loans creates incentives for banks to convert illiquid assets to liquid assets via refinancing such as loan sales and securitization. However, such refinancing cannot reduce overall banking sector risks. (Wagner, 2007; Casu et al., 2011)

All these studies point to the importance of stable funding in liability portfolio (Acharya and Naqvi, 2012; Khan et al., 2017) and liquid assets in asset portfolio (Wagner, 2007; Casu et al., 2011) in mitigating maturity mismatches and reducing liquidity risk in bank balance sheets. However, the impact of bond markets, a major source of liquid assets, diversified risky assets and stable funding, on bank risks has not been examined in the literature.

We contribute to the literature by providing novel and direct evidence on the role of bond market development in shaping bank portfolio structure and risk profile via investment and financing instruments that mitigate maturity mismatches in bank balance sheets. According to Diamond and Rajan (2001), “narrow banking” helps enhance financial stability by matching illiquid assets with longer-maturity liabilities and by reducing bank liquidity risk taking. Bond markets provide assets that can be used to reduce maturity mismatches and improve liquidity management. Government bonds serve as a liquid asset and corporate bonds serve as stable liability as well as diversified risky asset.

Motivated by the lack of direct evidence on how bond markets affect bank risk taking, we attempt to understand the following research questions: First, does bond market development promote bank stability by lowering banks’ overall risk and strengthening their portfolio structures and liquidity positions? Second, does the bond market’s role in shaping bank risk taking differ across bank size and capital sufficiency level? Finally, does bond market structure matter? In particular, do different bond markets, in particular government bond markets and corporate bond markets, influence risk taking in different ways?

This paper empirically examines the role of bond markets on bank risk taking using a database of 432 banks in 26 emerging markets from 2006 to 2016. Focusing on five widely used proxies of bank risk taking, we find that bond market development significantly lowers risk in banks’ asset and liability portfolios, strengthens bank liquidity positions, and increases bank stability. Specifically, a 1% increase in bond market size is associated with 0.04 %, 0.03 %, and 0.05 % decrease in banks’ risky asset ratio, deposit ratio, and liquidity risk ratio (LRR), respectively. A 1% increase in bond market size is also related to 0.53 % and 0.32 % increase in banks’ NSFR and Z-score, respectively. Further investigation indicates that the role of bond market in bank risk taking is not sensitive to bank size and capital sufficiency.

Moreover, the benefit of bond market development becomes more prominent after the implementation of BASEL III. Evidence shows that bond market development positively contributes to banks’ liquidity positions regardless of the implementation of BASEL III. However, after the implementation of BASEL III, banks from economies with larger bond markets show a significantly higher Z-score than those in economies with relatively small bond markets.

Furthermore, bond market structure matters. Government bonds and corporate bonds contribute to reducing bank risk taking in different ways. In particular, government bond serves as a source of liquid assets which allow banks to expand their assets portfolios without breaching regulatory constraints on liquidity. Meanwhile, more developed corporate bond market serves dual roles in lowering bank risk taking. Banks can issue corporate bonds as a stable funding source which mitigates maturity mismatches in their balance sheet. At the same time, banks can invest in corporate bonds as new risky asset class which offers more scope for sector and geographic diversification than loan assets. Overall, we find that the bond market plays a complementary role to the banking sector by offering more instruments for asset–liability management. The bond market thus provides banks with more scope to manage their risk, which benefits their stability and resilience.

Our findings entail important policy implications. While capital markets have grown rapidly in recent decades, many developed and emerging economies, especially those in Europe and Asia, still have bank dominated financial systems. Therefore, direct evidence on how capital markets affect the banking sector and boost financial stability is useful for policy makers. Some argue that capital market development could disrupt the role of banks in liquidity creation i.e., disintermediation. For example, Dang (2020) finds that when banks engage in non-traditional businesses to earn more income from fees and commissions, they create less liquidity. However, Berger and Bouwman (2009) show that banks’ ability to create liquidity does not decline as the capital market evolves. Fig. 1 illustrates capital market development and bank credit growth in emerging markets from 2006 to 2017. Capital market development, especially bond market development, does not seem to hinder the expansion of bank credit to the private sector.

In addition, bond market development has been advocated as an effective way to mitigate the maturity mismatch problems in the financial system after the 1997/98 Asian financial crisis. The past two decades witnessed rapid expansion of emerging East Asian bond markets. After two decades of rapid development, the aggregate size of local currency bond markets in ASEAN plus the People’s Republic of China; Hong Kong, China; and the Republic of Korea has become comparable in size to the euro-denominated European bond market by 2018 (Fig. 2).

While local currency bond markets mitigated currency mismatches and stabilized foreign exchange markets against external shocks (Park et al., 2018), little is known about the role of bond market in mitigating maturity mismatches. In this paper, we present direct evidence of how bond market development promotes banking stability by mitigating maturity mismatches. Such evidence strengthens the case for a diversified, balanced and resilient financial sector, especially in emerging markets that heavily rely on bank loans as a major financing channel. In line with Berger and Bouwman (2009), we find that the banks’ liquidity creation is not weakened by capital markets development. Instead, banks benefit from bond market development via more investment and financing instruments.

The remainder of this study is organized as follows. Section 2 discusses the theoretical background, empirical design, and sample construction. Empirical evidence and extended analysis are presented and analyzed in sections 3,4, and 5. Section 6 concludes.