A bank's balance sheet provides a snapshot of operations and financial soundness, yet details such as assets and liabilities go largely ignored by macroeconomics and finance communities. An EU initiative is exploring balance sheets to gain insight into their impact on the financial industry and economy.
Commercial bank balance sheets can lead to a better understanding of bank dynamics and market valuation as well as systemic risk. Such key macro-finance developments can prove invaluable in the pervading economic climate if not for their fragmentation.
With this in mind, the aim of the EU-funded EMAIFAP (Exploiting macro-accounting information for asset pricing, systemic risk and monetary policy analysis) project is threefold: understand and measure the impact of bank leverage and asset risk position on their stock market valuation; identify balance sheet variables that are key to improving or mitigating systemic risk in the financial system and policy implications of the findings; and understand and assess the transmission mechanism of monetary policy into banks' balance sheets.
Halfway through its four-year period, the first two objectives have been addressed by examining several impacts. Project partners investigated the effect of leverage and connectedness between bank dealers on European contagion in the credit default swap market. They studied the impact bank-specific factors have on an institution's solvency risk and its contribution to systemic risk. The team also studied the impact of commonality in mutual fund holdings on stock market contagion.
Overall, findings show that the connectedness of key players in stock and credit markets fuel systemic risk or financial instability. They also demonstrate that these connections and their consequences on the valuation of financial assets can be identified. This will lead to the development of more optimal tools to mitigate such effects.
Ongoing work in EMAIFAP will continue to shed light on the causes of systemic risk and how monetary policy is transferred to banks, and from banks to businesses and then consumers. This will ultimately drive the debate forward among policymakers and economic researchers about the need to re-orient the regulatory framework toward a macroprudential perspective in the post-financial crisis world.