The determinants of bank insolvency risk: evidence from Finland
| DOI | https://doi.org/10.1108/JFRC-02-2019-0021 |
| Pages | 315-335 |
| Date | 27 January 2020 |
| Published date | 27 January 2020 |
| Author | Matias Huhtilainen |
The determinants of bank
insolvency risk: evidence
from Finland
Matias Huhtilainen
Faculty of Social Sciences and Business Studies,
University of Eastern Finland, Joensuu, Finland
Abstract
Purpose –This paper aims to contribute to the literature on the determinants of bank-specificinsolvency
risk.
Design/methodology/approach –By applying a dynamictwo-step System GMM estimator on a novel,
representativepanel of 339 Finnish unlisted cooperative and savingsbanks over the period 2002-2018.
Findings –This study contributesto the literature on the determinants of bank-specific insolvencyrisk by
applying a dynamictwo-step System GMM estimator on a novel, representativepanel of 339 Finnish unlisted
cooperative and savingsbanks over the period 2002-2018. The key findings suggest that Finnish bankshave
become less fragile under the renewedEU banking regulation. In particular, the CRD IV has affected banks’
equity levels. This study also captures the detrimental effect of cost inefficiency as well as a positive
relationshipbetween the income diversification andinsolvency risk. A negative relationship betweenthe GDP
growth rateand the insolvency risk is also reported althoughresults suggest that the effect is notimmediate.
Originality/value –This result is discussed togetherwith other macroeconomic factors. The consequent
conclusion underlines the fundamental significance of overall macroeconomic dynamics. From the
perspective of regulatory harmonization, more research is needed to address the level of homogeneity of
macroeconomicdynamics between different geographicaland cultural regions.
Keywords European union, Risk, Basel, Econometrics, Banking regulation
Paper type Research paper
1. Introduction
Induced by the global financial crisis, the Basel Committee on Banking Supervision
published a revised Basel accord to restore market confidence and address regulatory
shortcomings exposed by the crisis. While the Basel III rules merely provide minimum
requirements applied to internationally active banks, the EU implemented the accord into
legislation through the so-called Single Rulebook for banking (Capital Requirements
Directive 2013/36/EU and the Capital Requirements Regulation (EU) No 575/2013). The so-
called CRD IV package has applied to institutions since 1 January 2014, though the
scheduled implementation phase-in period extends to 2019[1]. CRD IV, in both itself as well
as a part of the holistic structural reform of the EU financial and capital markets, has been
promoted in favor of facilitating banking sector consolidation, increasingtransparency and
enhancing cross-border activity while strengthening the resiliency and stability of the EU
banking sector (Boccuzzi, 2016). As a member state, Finland has complied with the
regulation accordingly.
Unsurprisingly, the applied literature on systemic risk has experienced a substantial
surge in the recent years (Benoit et al., 2017). Studies in this field have addressed, inter alia,
the fundamentally differentnature of systemic risk, the joint failure risk dwelling within the
Determinants
of bank
insolvency risk
315
Received27 February 2019
Revised8 August 2019
19October 2019
Accepted29 November 2019
Journalof Financial Regulation
andCompliance
Vol.28 No. 2, 2020
pp. 315-335
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-02-2019-0021
The current issue and full text archive of this journal is available on Emerald Insight at:
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matrix of correlated returns on assets, and the bank-specific insolvency risk. As an
important regulatory implication, Acharya (2009) showed that bank-level capital
requirements do not necessarily result in a corresponding one-to-one increase in systemic
stability, but in fact may even accentuate the problem. Indeed, the shift in post-crisis
regulatory thinking, as evidenced by the Basel III reform, now puts more emphasis on the
segregation of micro and macro-dimensions of the prudential regulation, and on the
applicability of different regulatory instruments while taking into account the respective
policy domain.
Despite the emerged literature on macroprudential policy, the bank-specific insolvency
risk continues to be of great interest and relevance among researchers and policymakers.
This is since financial distress, self-evidently, results from contagiously transmitted
negative externalitiesgenerated by bank failures. This study contributes to the literature on
bank insolvency risk in two ways. Using representative data on Finnish unlisted
cooperative and savings banks, prior findings regarding some of the bank-specific factors
are replicated and confirmed.Secondly, results suggest that Finnish banks have become less
fragile under the CRD IV regulation. For practicalreasons, “risk”is explicitly defined as the
distance to default. Accordingly,three different accounting-based, time-varying Z-scoresare
constructed in order to capture the insolvency risk in a uniform and compatible manner.
This approach has been supported in the literature due to its pervasive nature unlike, for
instance, another widely used, but visibly more specific measure of credit risk that is
commonly approximated by the ratio of non-performingloans to total gross loans. (Agoraki
et al.,2011).
2. Research scope and related literature
Closely following analogous studies on bank risk, the effects of both bank-specific and
macroeconomic factors are considered. In particular, the research scope is specified by the
following hypotheses:
H1. There exists a positive relationshipbetween inflation rate and insolvency risk.
The evidence in this regard is somewhat ambiguous. Uhde and Heimeshoff (2009) suggest
that the effect of change in inflation rate depends on how strong the surrounding economic
environment is otherwiseand whether banks anticipate the change. Jiménez et al. (2008) find
that higher inflation during the life of the loan reduces credit risk whereas higher inflation
preceding the loan decision implies higherrisk-taking. Baselga-Pascual et al. (2015) and Ben
Bouheni (2014) show that an increase in inflation ratecauses a consequent increase in both
insolvency risk and credit risk. While Ben Jabra et al. (2017) report similar findings on
insolvency risk, they conversely find a negative relationship between inflation rate and
credit risk. Rather than focusingon the effect of interest rates per se, this study includes the
three-month Euribor rate to control for the joint dynamics of inflation and interest rates.
Uhde and Heimeshoff (2009)suggested that since interest rates tend to rise in the presence or
in anticipation of inflation, it might lead to a corresponding increase in net interest income
and profitability.
H2. There exists a negativerelationship between economic growth and insolvencyrisk.
Positive general macroeconomicdevelopment, measured in gross domestic product growth,
improves economic agents’ability to manage and pay back their debt. However, as the
default rates are cyclical innature (for instance Marcucci and Quagliariello, 2008), the credit
expansion duringthe economic boom causes a coincidental increase in lower-quality debtors
JFRC
28,2
316
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