Large banks rely mainly on off-balance sheet liquidity creation to recover from underperformance while smaller banks adjust their equity capital, according to new research from Suliman S. Olayan School of Business, American University of Beirut.
The research conducted by Professor Wassim Dbouk and Professor Lawrence Kryzanowski, reveals unique insights into the actions taken by banks to enhance profitability and stability in the face of underperformance.
The research delves into the reaction of U.S. banks to instances of underperformance, specifically focusing on Return on Equity (ROE). The study investigates the relationship between underperformance and three crucial aspects of bank operations: liquidity creation, equity capital, and loan loss provisions.
The research reveals:
- Banks respond to underperformance by adapting their structures in the subsequent quarter, showing remarkable agility in their operations.
- Enhanced on-balance and off-balance sheet liquidity creation is a common strategy adopted by banks to boost profitability and improve their financial standing.
- Banks demonstrate a commitment to strengthening their financial position by increasing equity capital in response to underperformance.
- Quality of loans is addressed through a strategic reduction in non-discretionary loan loss provisions, signalling a growing confidence in the loan portfolio’s stability.
- Banks signal their capacity to overcome underperformance by increasing discretionary loan loss provisions, displaying a proactive approach to risk management.
According to Professor Wassim Dbouk: “Our research highlights distinct strategies based on bank size. Large banks primarily utilise off-balance sheet liquidity creation as a key recovery tool, optimising their balance between profitability and stability. Medium-size and small banks however, lean towards adjusting equity capital to bolster safety and security in the wake of underperformance.”
The implications of this study are far-reaching, offering valuable insights into how banks adapt and innovate to navigate challenges and uncertainties. By strategically fine-tuning liquidity creation, equity capital, and loan loss provisions, banks can effectively manage underperformance and emerge stronger than before.
The research is published in the paper “Keeping up with the Joneses? Evidence from Peer Performance in the Banking Industry”.
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