Khóa luận tốt nghiệp: Monetary Policy and Bank Risk: Does Bank size matter?

VIETNAM NATIONAL UNIVERSITYUNIVERSITY OF ECONOMICS AND BUSINESSFACULTY OF FINANCE AND BANKING GRADUATION THESISMonetary Policy and Bank Risk: Does Bank size matter?. A growing body of re

VIETNAM NATIONAL UNIVERSITYUNIVERSITY OF ECONOMICS AND BUSINESS

FACULTY OF FINANCE AND BANKING

GRADUATION THESISMonetary Policy and Bank Risk: Does Bank size matter?

HA NOI, 2023

I worked on my graduation thesis Her knowledge and support were invaluable in

getting this thesis finished.

I also want to express my sincere gratitude to the University of Economics andBusiness and the Department of Finance and Banking for providing a supportivelearning environment that has enabled us to grow and improve our skills |understand that flaws and faults are unavoidable despite my lack of deductivereasoning and self-prepared information Therefore, in order to further enhancethis graduation thesis, I genuinely wish to receive insightful feedback fromdistinguished educators

I therefore declare that, with the assistance of my advisor, Dr Nguyen Tuong Van,this is my research project The study methodology and conclusions offered in thisthesis are sincere and original to this work of scholarship The author gathered theinformation in the tables which are used for analysis, commentary, and assessmentfrom a variety of sources, as the reference section details

I accept complete responsibility before the council and for the outcome of my thesis if any academic misconduct is found.

Student

Nguyen Thanh Lam

Standard deviation of return on asset

Capital adequacy ratio

Non-accelerating inflation rate of Unemployment

Fixed Effect Model

European Union

United States

LIST OF TABLESTable 1: Variable definitions and sources

Table 2: Descriptive Statistics

Table 3: Correlation Matrix

Table 4: Results of regression method

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1.6 Structure of the Study - - - - << trà 8 CHAPTER 2: LITERATURE REVIEW

2.2 Research ðaJD - LH nọ nọ TT tr

2.2 Theoretical baSÏS - - - nh ngọt 11

2.2.1 Theoretical Framework of Monetary Policy - - - - «+ xxx ri 11 2.2.2 Theoretical Framework of Bank Risk ::ccccceseeeeeeeeeenneeeeeeeeeeneeeeeeeeeenaeeeeeenee 13 2.2.3 The Role of Bank Size in the link between Monetary Policy and Bank Risk 14 CHAPTER 3: RESEARCH METHODOLOGY - Ặ Go nky 16 3.1 Research afA - - - nọ nọ và 16 3.2 Research model and hypothesis - - - cece cece + re 16

3.2.1 Research variables - - - xxx TH ok 16 3.2.2 Research hypothesÏsS - - - + sọ nọ kh 18 3.2.3 Research model - - - - « « « «xxx xxx TT tk kh 20 3.2.4 Research methodology - - - «sgk kh 21

CHAPTER 4: RESULTS AND DISCUSSION L3 1S ng hy 22

4.1 Descriptive statistical amalysis ng kh 22 4.2 Correlation Matrix - - - 5S xxx TT ọ v kh 23

CHAPTER 1: INTRODUCTION

1.1 The urgency of the topic

In recent years, both scholars and policymakers have paid increased attention to the relationship between monetary policy and bank risk-taking A growing body of research on the relationship between monetary policy and bank risk has produced compelling evidence that when central banks loosen monetary

policy, banks take on more risky activities This is because there is a greaterincentive to "search for yield," collateral for bank loans is worth more, and there ismore demand for bank liabilities Since the start of the global financial crisis in2008-2009, central bankers and financial regulators have begun to seriouslyworry about the potentially disastrous effects of monetary policy on financialstability, particularly when ultra-expansionary monetary policy is implementedand sustained in a wide range of countries

Theoretically, when economic uncertainty appears, the influence ofmonetary policy on bank risk may be diminished The research on the "risk-taking

channel" contends that expansionary monetary policies tend to increase bank risk

in situations where there is no economic uncertainty The "real option" hypothesis, however, postulates that the issues with inadequate information brought on by uncertainty may make it harder for banks to assess the riskiness of their borrowers

or accurately predict the return of their loan projects Due to this quandary, banks will probably react to monetary policy changes more cautiously When monetary policy is altered, banks may adopt a "wait-and-see" approach and defer making credit decisions, including modifications to their risk-taking methods (such as

changes to their leverage position or re-allocation of their loans among borrowerswith different levels of risk)

With the current urgent situation, this paper investigates the impact ofeconomic uncertainty on the association between monetary policy and bank riskand whether bank size matters in risk-taking behavior

1.2 Research objectives

This study examines the correlation between monetary policy and

bank risk and focuses on whether bank size influences this correlation or

not.

1.3 Research question

This study aims to answer the following question:

- How does Monetary Policy impact on Bank risk?

- Does the relationship between Monetary Policy and Bank Risk differ based

on the size of the bank?

- What are solutions and recommendations to reduce Bank Risk?

1.4 Scope of the study

The study will examine the correlation between Monetary Policy and BankRisk based on secondary data collected from commercial bank financial reports.Besides, the macro data is collected from the World Development Indicator and theIMF The study collects data during the period from 2012 to 2022

1.5 Data and Research Methodology

This study adopts the regression research method in order to detect and

quantify the relationship between Monetary Policy and Bank Risk.

1.6 Structure of the study

The study will discuss the theoretical framework and literature review in

Chapter 2 In Chapter 3, the research model used in the study as well as the sourceand how we collected it in order to do research will be presented Chapter 4 will

describe and interpret the results that I have achieved through running theresearch model and drawing conclusions and recommendations in Chapter 5.

CHAPTER 2: LITERATURE REVIEW

2.1 Literature review

Monetary policy plays an important role in any economy A Key transmissionmechanism of monetary policy is changing the financial costs of firms, which in

turn affects firms’ real activities According to conventional macroeconomic

theory, a tightening monetary policy may increase businesses’ capital costs,resulting in a decline in investment and production (such as real sales), whereas

an expansionary monetary policy may result in lower firms However, the

relationship between a business's costs and targeted production levels—represented by the extent of the firm's market power—determines how sensitive

a firm is to changes in monetary policy (Syverson, 2018) The risk-taking channel

shows how changes in monetary policy have a direct effect on risk tolerance (Borio

and Zhu, 2012) It's interesting that two opposing mechanisms produce

predictions about how monetary policy accommodation and bank risk-taking interact First, according to the search-for-yield mechanism (Rajan, 2006), monetary transmission happens as a result of the correlation between low market rates and anticipated target rates of return Banks may increase their risk appetite and invest in loans and securities with higher risk when faced with declining revenue as a result of reduced rates (Chodorow-Reich, 2014; Borio and Gambacorta, 2017) Second, banks’ net interest margins are compressed due to reduced policy rates and an unusually flat term structure, which reduces overall

bank profitability (Borio et al., 2017, Molyneux et al., 2019) Banks might thus

maintain a higher level of caution and conservative price risk in order to protect

profitability

However, there is no proof that the corporate syndicated loan market wasactive with bank risk-taking during the period of unconventional monetary policy

in the US We discover that through providing reduced spreads to corporations, USbanks do indeed transfer an expansionary unconventional monetary policy to thereal economy The implication is that the Federal Reserve was successful inachieving its goal of loosening credit conditions generally According tocalculations, a one-unit increase in the stance of monetary policy, which coincideswith a 25 basis point drop in the yield on the US 10-year bond, lowers corporate

loan rates by 8 basis points or 3.5%, the spreads (Matthys and Meuleman, 2020).

When monetary policy is expansionary, the loan spread discount is smaller forriskier enterprises when compared to safer ones It appears that the Federal

Reserve's unorthodox monetary policy initiatives have not persuaded banks to relax their lending requirements for risky businesses.

The risk profile of banks is a key area of concern for policymakers becausebanks’ risk-taking activities not only have an impact on the economy but alsoestablish the systemic risk of the banking sector The macroeconomic environment

in which a bank operates and its own strategic decisions mostly define a bank's riskprofile Without taking borrower risk into account, the strength of monetary policytransmission is impacted by bank heterogeneity Banks with higher-qualitycurrent loan portfolios and greater reliance on non-interest income are lesslucrative when lending spreads are reduced more in response to expansionarymonetary policy In reaction to an expansionary monetary policy, banks with anexisting loan portfolio of high-quality loans could be able to afford to receive lower

spreads Banks may be protected from the detrimental impact of unconventional

monetary policy on net interest margins due to their larger reliance on interest income The risk-taking channel's dynamics are more complex Studies

non-demonstrate that different levels of borrower risk are priced differently by heterogeneous banks Only for the safer companies do banks with lower capitalization, smaller sizes, and lower profits reduce spreads more aggressively.

In contrast to stronger banks, weaker banks initially see smaller spreads as a result

of the expansionary monetary policy Spreads are adjusted upward more quickly

by weaker banks than by banks with stronger fundamentals The risk-taking

channel's dynamics are more complex Studies demonstrate that different levels of

borrower risk are priced differently by heterogeneous banks (Matthys andMeuleman, 2020) Only for the safer companies do banks with lower capitalization,smaller sizes, and lower profits reduce spreads more aggressively In contrast tostronger banks, weaker banks initially see smaller spreads as a result of theexpansionary monetary policy Spreads are adjusted upward more quickly by

weaker banks than by banks with stronger fundamentals as firm risk increases.

2.2 Research gap

In general, the study illustrates the influence of monetary policy on bank riskin-depth, such as the effect on bank risk-taking behavior and whether it is the bankwith a larger size or smaller size offers solutions The study also provided thetheoretical thesis of monetary policy and bank risk The methods used include datacollection, analysis, and practical research methods

2.2 Theoretical basis

2.2.1 Theoretical Framework of Monetary Policy

Most people agree that monetary policy has a significant impact on macroeconomic performance Regarding the formulation and implementation of monetary policy, there are nevertheless notable differences According to the new

classical model, monetary policy simply affects inflation and has no long-term

consequences on real wages, growth, unemployment, or income distribution The

neo-Keynesian model does not alter growth, but it does permit monetary policy tohave long-term consequences on real wages, unemployment, and incomedistribution Monetary policy can influence growth as well as all of these othervariables according to the Post Keynesian model (Palley, 2007) These distinctionsclarify the importance of the theoretical framework for monetary policy as well asthe ongoing debate over how monetary policy should be carried out This paperhas chosen to focus on the Post Keynesian model as it provides a multi-dimensional

perspective.

Unemployment Unemployment Unemployment Unemployment

rate rate rate

trate

n= flu, iat) Ì wip=wu,k) + I=I(wpu) + g=g(Lu), +

+

Inflation Real Profit Growth

rate wage rate

Figure 1: The Post-Keynesian model

Source: Thomas I Palley (2007) Macroeconomics and monetary policy: competing

theoretical frameworks, Journal of Post Keynesian Economics, 30:1, 61-78

In Figure 1, the Post Keynesian model is shown The Phillips curve and thewage curve are displayed in the two panels on the left The profit and growth rate

functions are displayed in the two panels on the right There is a nonlinear profit

rate Because the wage cost effect is subordinated to the demand effect, the profit

rate initially increases as the unemployment rate decreases But as profit

compression kicks in at lower unemployment rates, wage cost impacts take the

front stage The shape of the wage curve is a vital factor because it drives the

curvature of the profit and growth rate functions The profit rate and growth rate

will typically peak at a comparatively high unemployment rate if the pay curve

increases early and strongly In this case, pay limitation may boost employment

and growth; the policy issue is to keep the wage curve "high but flat."

There are several important implications in this model First off, there is no natural rate of growth or NAIRU The real salary is procyclical, to start with Growth

in the economy can be driven by profits as well as wages (Bhaduri and Marglin,

1990) Economic growth is wage-led when unemployment is high and profit-led

when unemployment is low The model has significant policy ramifications as well

Monetary policy influences not only inflation but also the real wage, the rate of

unemployment, the rate of profit, and the rate of growth, in contrast to the new

classical model Monetary policy is crucial and contentious because of this The soledrawback to an expansionary policy at high unemployment rates is higherinflation greater salaries and lower unemployment, however, might have to giveway to greater inflation and slower development when the jobless rate declines.That might turn into a messy issue.

2.2.2 Theoretical Framework of Bank Risk

Any decision-making process must include the identification and analysis of

risks as failing to do so or estimating them incorrectly may have unintended consequences for a number of stakeholders Bank risk-taking is defined as policies

that increase risk through any of the various channels While taking risks is still a

major part of what banks do, research has shown that taking too many risks is the main cause of bank failures Many bank failures have occurred recently all around

the world, but especially in emerging market nations (Bell and Pain, 2000) Banksare highly leveraged financial institutions where leverage exists as a factor ofproduction According to Bebchuk & Spamann (2009) and John, Mehran, & Qian(2010), leverage magnifies the benefits of increasing bank risk for highly leveragedbanks, hence amplifying worries about risk-taking This is because leverage

enhances the option value of government guarantees to shareholders Some of the

commonly used proxies for bank risk will be further discussed below

Losses resulting from the negative effects of market fluctuations on the value

of banks' positions both on and off the balance sheet are captured by market risk Since losses on banks' trading books during the recent crisis had depleted bank capital and raised worries about financial stability, recent regulatory reforms have

concentrated on the framework used by banks to assess market risk (BaselCommittee on Banking Supervision, 2013) Value-at-risk (VaR) and projected

shortfall are two tail risk metrics that have been used in previous research to quantify market risk and forecast expected losses in the event of a tail event (Ellul

& Yerramilli, 2013) ( Chen, Steiner, & Whyte, 2006) Stock volatility is anotheroften-used metric Second, leverage risk is defined as the risk arising from banksholding low amounts of capital to support their corporations Book capital ratios,

such as risk-adjusted or high-quality (Tier-1) capital ratios, are frequently used toquantify leverage risk (Flannery & Rangan, 2007; Gropp & Heider, 2010).Furthermore, the volatility of asset returns resulting from a bank's investingactivity is referred to as portfolio risk The ratio of risk-weighted assets to assets

or book- or market-based measures of asset volatility have been used in previous

research to assess the portfolio risk of banks (Vallascas & Hagendorff, 2013).

Lastly, a composite measure of bank risk that includes hazards from

financing and investing activities is called default risk Previous research has

concentrated on assessing default risk using two different methods: the based measure Hagendorff & Vallascas (2011), which is based on Merton's structural distance-to-default model, or the accounting-based Z-score (Houston,

market-Lin, market-Lin, & Ma, 2010; Laeven & Levine, 2009) In a similar vein, banks may alsoimplement practices that cause the public to bear the expense of default Researchhas attempted to quantify risk shifting by valuing the government's financial safetynet to shareholders as the cost of a taxpayer-underwritten put option (Hovakimian

and that size has little effect on banks' univariate risk (as determined by VaR) We

also discover that since the start of the crisis in the EU and globally, systemic risk

has dramatically increased for banks of all sizes According to Pais and Stork(2013), the systemic risk associated with large banks in the EU has increasedsubstantially more than that of small banks.

In the USA, the systemic risk posed by US Large and Complex Banking Organizations (designated as such by the Federal Reserve) is examined in De Nicolo and Kwast's 2002 study Systemic risk or interdependency, is defined as the

relationship between stock returns They also examine how interdependencies

have changed over time and how consolidation has affected them They discovered that over time, the systemic risk associated with major US banks rose According

to their analysis, consolidation played a role in partially explaining the rise in systemic risk that occurred at the start of the 1990s, but its influence on systemic

risk decreased as the decade progressed There is also a special status called “Toobig to fail” affecting large banks, which is the expectation that they will always bebailed out for fear of the consequences to the financial system This expectationimplies that retail depositors are explicitly covered by the insurance, in addition towholesale and interbank depositors, who are covered implicitly This expectationhas recently extended to include "too complex" or "too interconnected"institutions In September 2008, the Federal Reserve chose not to save LehmanBrothers, preferring that a smooth liquidation would help rebuild marketconfidence However, it assisted JP Morgan in taking over Bear Stearns and savedFannie Mae and Freddie Mac

The bank's failure exposed the issues brought on by the growing reliance of

some financial institutions and markets on one another, sending shockwavesacross financial markets and institutions around the globe Due to the special status

that large banks enjoy, there is little incentive for large uninsured creditors to keep

an eye on the risk-taking of these institutions or to punish them appropriately As aresult, the managers of these institutions can take advantage of this by raising the risk and maximizing leverage at the bank in the hopes of earning higher returns.

According to Jorion (2009), for instance, large banks that were implicated in therecent crisis failed to properly manage their risk because of misaligned incentives,meaning they believed authorities would save them as they were too big to fail

Consequently, resources are misallocated, as large banks have an unfair advantagethrough lower funding costs (because of the implicit protection) than smallerbanks even if they carry similar or higher levels of risk.

These findings about the risk of large banks have intriguing policy

implications: while consolidation and growing financial institutions may reduce

individual risk due to diversification, the market will not effectively discipline large banks if it believes the banks have a good chance of being rescued (i.e., the risk is not priced appropriately by debt holders, so shareholders are incentivized to take

on more risk) Large financial institutions, yet, appear to also have higher systemic risk due to their increased similarity and exposure to market-wide risks as a group The higher risk of large banks is relevant because the rescue or failure of large

banks has higher costs for the real economy

CHAPTER 3: RESEARCH METHODOLOGY

3.2 Research model and hypothesis

and oROA denotes the standard deviation of ROA In the context of measuring bank

risk, the Z-score is a statistical tool that can be used to assess the financial healthand stability of a bank Edward Altman developed it in the 1960s as a means to

predict corporate bankruptcy, but it has since been adapted for evaluating the risk

of banks

For the independent variables, I use a group of industry and bank variables

to enhance the fit of my model The former group contains the proxies for banksize, leverage, deposit, loan, liquidity, and monetary policy | measure bank size

using the natural logarithm of total assets According to Kaufman (2014), bank size can have controversial effects on bank risk Larger banks often have more

diversified portfolios and a wider range of business activities which can help

mitigate risk by diversification As a result, larger banks may have lower risk compared to smaller banks To measure bank leverage, I use the ratio of total debt

to total equity Bank leverage, which refers to the use of debt to finance a bank's

operations and investments, has a significant influence on bank risk According to

Adrian, Boyachenko, and Giannone (2019), the study examines the relationship

between bank leverage and risk-taking behavior in the U.S banking sector,highlighting the potential risks associated with higher leverage The ratio of liquidassets to total assets can be used to calculate bank liquidity The risk associatedwith liquidity affects the stability and management of banks Banks must have aliquidity buffer to guard against risk Liquidity risk can lead to bankruptcy throughboth individual and systemic mechanisms (Khan et al., 2017) For bank loans, I usethe ratio of total non-performing loans to total loans Study shows that higherlevels of non-performing loans or loans with higher default probabilities increase

a bank’s credit risk and overall riskiness (Dechow, Sloan, and Sweeney 1996) Bank

deposits provide a stable source of funding for banks, which can help support theirlending and investment activities Stable deposit funding can contribute to a bank's

overall financial stability and reduce liquidity risk That is why I include bank deposits in my model by using the ratio of total loans to total deposits Finally, to measure monetary policy, I use the average yield of Federal fund rates in the US Monetary policy decisions, such as changes in interest rates, can directly impact a bank's profitability and risk profile.