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Title: Risk Mitigating versus Risk Shifting: Evidence from Banks Security Trading in Crises

Author(s): José Luis Peydró, Andrea Polo and Enrico Sette

Publication Date: November 2020

Keyword(s): bank capital, concentration risk, COVID-19, held to maturity, interbank funding, risk shifting, risk weights, trading book and uncertainty

Programme Area(s): Financial Economics

Abstract: We show that risk mitigating incentives dominate risk shifting incentives in fragile banks. Risk shifting could be particularly severe in banking since it is the most opaque industry and banks are one of the most leveraged corporations with very low skin in the game. To analyze this question, we exploit security trading by banks during financial crises, as banks can easily and quickly change their risk exposure within their security portfolio. However, in contrast with the risk shifting hypothesis, we find that less capitalized banks take relatively less risk after financial market stress shocks. We show this using the supervisory ISIN-bank-month level dataset from Italy with all securities for each bank. Our results are over and above capital regulation as we show lower reach-for-yield effects by less capitalized banks within government bonds (with zero risk weights) or within securities with the same rating and maturity in the same month (which determines regulatory capital). Effects are robust to controlling for the covariance with the existence portfolio, and less capitalized banks, if anything, reduce concentration risk. Further, effects are stronger when uncertainty is higher, despite that risk shifting motives may be then higher. Moreover, three separate tests â?? based on different accounting portfolios (trading book versus held to maturity), the distribution of capital and franchise value â?? suggest that bank own incentives, instead of supervision, are the main drivers. Results are confirmed if we consider other sources of balance sheet fragility and different measures of risk-taking. Finally, evidence from the recent COVID-19 shock corroborates findings from the Global Financial Crisis and the Euro Area Sovereign Crisis.

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Bibliographic Reference

Peydró, J, Polo, A and Sette, E. 2020. 'Risk Mitigating versus Risk Shifting: Evidence from Banks Security Trading in Crises'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15473