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Working papers

The ESRB Working Paper Series is run by the Advisory Scientific Committee. Its purpose is to collate high-quality research on systemic risk and macroprudential policy, thus informing the policymaking activities of the ESRB.

Submissions to the Working Paper Series are welcomed when at least one co-author is affiliated to the ESRB or an ESRB member institution, or when the paper has been presented at an ESRB event. To submit a paper for consideration, email a pdf file to wpseries@esrb.europa.eu

Any views expressed in working papers are those of the authors and do not necessarily reflect the official stance of the ESRB, its member institutions, or any institution to which the authors may be affiliated.

No. 75
18 May 2018
Insurers as asset managers and systemic risk
Ellul, Andrew, Jotikasthira, Chotibhak, Kartasheva, Anastasia, Lundblad, Christian T., Wagner, Wolf

Abstract

JEL Classification

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

G22 : Financial Economics→Financial Institutions and Services→Insurance, Insurance Companies, Actuarial Studies

Abstract

Financial intermediaries often provide guarantees that resemble out-of-the-money put options, exposing them to tail risk. Using the U.S. life insurance industry as a laboratory, we present a model in which variable annuity (VA) guarantees and associated hedging operate within the regulatory capital framework to create incentives for insurers to overweight illiquid bonds (“reach-for-yield”). We then calibrate the model to insurer-level data, and show that the VAwriting insurers’ collective allocation to illiquid bonds exacerbates system-wide fire sales in the event of negative asset shocks, plausibly erasing up to 20-70% of insurers’ equity capital.

No. 74
15 May 2018
Regulating the doom loop
Alogoskoufis, Spyros, Langfield, Sam

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

Euro area governments have committed to break the doom loop between bank risk and sovereign risk. But policymakers have not reached consensus on whether and how to reform the regulatory treatment of banks’ sovereign exposures. To inform policy discussions, this paper simulates portfolio reallocations by euro area banks under scenarios for regulatory reform. Simulations highlight a tension in regulatory design between concentration and credit risk. An area-wide low-risk asset—created by pooling and tranching cross-border portfolios of government debt securities— would resolve this tension by expanding the portfolio opportunity set. Banks could therefore reinvest into an asset that has both low concentration and low credit risk.

No. 73
13 April 2018
Sovereign risk and bank risk-taking
Ari, Anil

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F30 : International Economics→International Finance→General

F34 : International Economics→International Finance→International Lending and Debt Problems

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

Abstract

I propose a dynamic general equilibrium model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and slow recovery from crises. When banks’investment decisions are not contractible, depositors form expectations about bank risk-taking and demand a return on deposits according to their risk. This creates strategic complementarities and possibly multiple equilibria: in response to an increase in funding costs, banks may optimally choose to pursue risky portfolios that undermine their solvency prospects. In a bad equilibrium, high funding costs hinder the accumulation of bank net worth, leading to a persistent drop in investment and output. I bring the model to bear on the European sovereign debt crisis, in the course of which under-capitalized banks in default-risky countries experienced an increase in funding costs and raised their holdings of domestic government debt. The model is quanti…ed using Portuguese data and accounts for macroeconomic dynamics in Portugal in 20102016. Policy interventions face a trade-o¤ between alleviating banks’funding conditions and strengthening risk-taking incentives. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.

No. 72
13 March 2018
Clearinghouse-Five: determinants of voluntary clearing in European derivatives markets
Fiedor, Paweł

Abstract

JEL Classification

C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

Abstract

In the European Union, there is obligation to centrally clear certain credit and interest rate derivative contracts, while other trades can be voluntarily cleared through a central counterparty if the parties to the contract wish to clear it thus. I use a dataset of all newly entered into derivatives contracts in the European Union between March 2016 and June 2017 to show the extent to which central clearing is being used for derivatives belonging to all five major asset classes, and to determine which characteristics of the contracts not under the clearing obligation affect the likelihood they would be centrally cleared on a voluntary basis. I show that currently only around 20% of credit and 40% of interest rate derivatives are centrally cleared, while equity, foreign exchange, and commodity derivatives are barely centrally cleared. I also show that there are significant effects of scale connected with central clearing, both in terms of previous clearing activity of the counterparty and the notional of the specific contract. Finally, I show that various characteristics of the contract, such as the maturity and the type of counterparty involved, also have significant impact on the probability of a trade being centrally cleared, but these effects tend to be ambiguous and depend on the specific combination of factors.

No. 71
1 March 2018
Resolving a Non-Performing Loan crisis: the ongoing case of the Irish mortgage market
McCann, Fergal

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

Abstract

The Irish banking system has in recent years experienced a large build-up in Non-Performing Loans (NPLs) during the crisis followed by a sharp reduction in the 2013-2017 period. In this article I present a recent history of the ongoing resolution of the mortgage arrears crisis in Ireland. Using a large and close to exhaustive panel data set of Irish mortgages from 2008 to 2016, I present a number of new findings on loan transitions between delinquency states, the importance of legacy effects of the crisis in explaining recent entry to arrears, the role of mortgage modification in the reduction in arrears balances, the extent of borrower-lender engagement and the financial vulnerability that remains in pockets of the Irish mortgage market.

No. 70
1 March 2018
The variance risk premium and capital structure
Lotfaliei, Babak

Abstract

JEL Classification

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

G33 : Financial Economics→Corporate Finance and Governance→Bankruptcy, Liquidation

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

Abstract

This paper investigates how the asset-return variance risk premium changes leverage. I find that the premium lowers leverage by increasing risk-neutral bankruptcy probability and costs in a model where asset returns have stochastic variance with risk premium. Empirically, the model calibrations verify significant reduction in optimal leverage, closer to observed leverage than the model without the premium. In model-free regressions, I also document negative correlation between leverage and the variance premium. The most negative correlation is among investment-grade firms with low asset beta and historical variance but high variance premium because their assets have high exposure to market variance premium.

No. 69
19 February 2018
When gambling for resurrection is too risky
Kirti, Divya

Abstract

JEL Classification

G22 : Financial Economics→Financial Institutions and Services→Insurance, Insurance Companies, Actuarial Studies

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

Rather than taking on more risk, US insurers hit hard by the crisis pulled back from risk taking, relative to insurers hit less hard by the crisis. Capital requirements alone do not explain this risk reduction: insurers hit hard reduced risk within assets with identical regulatory treatment. State level US insurance regulation makes it unlikely this risk reduction was driven by moral suasion. Other financial institutions also reduce risk after large shocks: the same approach applied to banks yields similar results. My results suggest that, at least in some circumstances, franchise value can dominate, making gambling for resurrection too risky.

No. 68
16 February 2018
Business cycles and the balance sheets of the financial and non-financial sectors
Villacorta, Alonso

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles

G01 : Financial Economics→General→Financial Crises

Abstract

I propose and estimate a dynamic model of financial intermediation to study the different roles of the condition of banks’ and firms’ balance sheets in real activity. The net worth of firms determines their borrowing capacity both from households and banks. Banks provide risky loans to multiple firms and use their diversified portfolio as collateral to borrow from households. This intermediation process allows additional funds to flow from households to firms. Banks require net worth for intermediation as they are exposed to aggregate risk. The net worth of banks and firms are both state variables. In normal recessions, firm and bank net worth play the same role, so their sum determines the allocation of capital. During financial crises, shocks to bank net worth have an additional effect beyond that in standard financial frictions’ models. This mechanism works through intermediation and affects activity, even if shocks redistribute net worth from banks to firms. I estimate my model and find that the new mechanism accounts for 40% of the fall in output and 80% of the fall in bank net worth during the Great Recession. Finally, the model is consistent with the different dynamics of the share of bank loans in total firm debt and credit spreads during the recessions of 1990, 2001, and 2008.

No. 67
29 January 2018
Positive liquidity spillovers from sovereign bond-backed securities
Dunne, Peter G.

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G24 : Financial Economics→Financial Institutions and Services→Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies

C22 : Mathematical and Quantitative Methods→Single Equation Models, Single Variables→Time-Series Models, Dynamic Quantile Regressions, Dynamic Treatment Effect Models &bull Diffusion Processes

C53 : Mathematical and Quantitative Methods→Econometric Modeling→Forecasting and Prediction Methods, Simulation Methods

C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics

C63 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computational Techniques, Simulation Modeling

Abstract

There are competing arguments about the likely effects of Sovereign Bond-Backed Securitisation on the liquidity of sovereign bond markets. By analysing hedging and diversification opportunities, this paper shows that positive liquidity spillovers would dominate or at least constrain the extent of any negative effects. This relies on dealers using Sovereign Bond-Backed Securities as instruments to hedge inventory risk and it assumes that they diversify their activities widely across euro area sovereign markets. Through a simple arbitrage relation, the existence of low-cost hedging and diversification opportunities limits the divergence of bid-ask spreads between national and SBBS markets. This is demonstrated using estimated SBBS yields ( à la Schönbucher (2003)).

No. 66
29 January 2018
How effective are sovereign bond-backed securities as a spillover prevention device?
Cronin, David, Dunne, Peter G.

Abstract

JEL Classification

C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G17 : Financial Economics→General Financial Markets→Financial Forecasting and Simulation

Abstract

Brunnermeier et al. (2017) propose the introduction of sovereign bond-backed securities (SBBS) in the euro area. That and other papers assess how the securitisation would insulate senior bond holders from actual default-related losses. This paper generalises the assessment by using the VAR-based Diebold and Yilmaz (2012) spillover index methodology to assess potential attenuation of the spillover of shocks in holding-period returns across bond markets due to the introduction of SBBS. This is made possible by employing SBBS yields estimated from historical euro area member state sovereign bond yields using Monte Carlo methods, as described in Sch¨nbucher (2003). A lower spillover o of shocks between SBBS securities compared to what arises between eleven member states’ bond markets is observed. Spillover values fall during the euro area sovereign bond crisis. Gross and net spillovers are lower for a 70-30 tranching than for a 70-20-10 case but in both cases the senior tranche becomes more insulated from shocks in the more junior tranches during periods of financial stress.

No. 65
29 January 2018
Sovereign bond-backed securities: a VAR-for-VaR and Marginal Expected Shortfall assessment
Perea, Maite De Sola, Dunne, Peter G., Puhl, Martin, Reininger, Thomas

Abstract

JEL Classification

E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy

E53 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

Abstract

The risk reducing benefits of the sovereign bond-backed security (SBBS) proposal of Brunnermeier et al (2011, 2016, 2017) have been assessed in terms of the likely losses that different kinds of holders would suffer under simulated default scenarios. However, the effects of mark-to-market losses that may occur when there is rising uncertainty about defaults, or when self-fulfilling destablising dynamics are prevalent, have not yet been examined. We apply the “VAR-for-VaR” method of White, Kim and Manganelli (2015) and the Marginal Expected Shortfall approach of Brownlees and Engle (2012, 2017) to estimated yields of SBBS to assess how ex ante exposures are likely to playout under various securitisation structures. We compare these with exposures of single sovereigns and a diversified portfolio. We find that the senior SBBS has extremely low ex ante tail risk and that, like the lowest-risk single-named sovereigns, it acts as a hedge against extreme adverse movements in the yields on more junior tranches. The mezzanine SBBS has tail risk exposure similar to that of Italian and Spanish bonds. Yields on SBBS appear to be adequate compensation for their risks when compared with single sovereigns or a diversified portfolio.

No. 64
16 January 2018
Short-selling bans and bank stability
Beber, Alessandro, Fabbri, Daniela, Pagano, Marco, Simonelli, Saverio

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

Abstract

In both the subprime crisis and the euro-area crisis, regulators imposed bans on short sales, aimed mainly at preventing stock price turbulence from destabilizing financial institutions. Contrary to the regulators’ intentions, financial institutions whose stocks were banned experienced greater increases in the probability of default and volatility than unbanned ones, and these increases were larger for more vulnerable financial institutions. To take into account the endogeneity of short sales bans, we match banned financial institutions with unbanned ones of similar size and riskiness, and instrument the 2011 ban decisions with regulators’ propensity to impose a ban in the 2008 crisis.

No. 63
16 January 2018
Banks’ maturity transformation: risk, reward, and policy
Bologna, Pierluigi

Abstract

JEL Classification

E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

The aim of this paper is twofold: first, to study the determinants of banks’ net interest margin with a particular focus on the role of maturity transformation, using a new measure of maturity mismatch; second, to analyse the implications for banks of the relaxation of a binding prudential limit on maturity mismatch, in place in Italy until the mid-2000s. The results show that maturity transformation is an important driver of the net interest margin, as higher maturity transformation is typically associated with higher net interest margin. However, there is a limit to this positive relationship as ‘excessive’ maturity transformation — even without leading to systemic vulnerabilities — has some undesirable implications in terms of higher exposure to interest rate risk and lower net interest margin.

No. 62
15 December 2017
The demand for central clearing: to clear or not to clear, that is the question
Bellia, Mario, Panzica, Roberto, Pelizzon, Loriana, Peltonen, Tuomas A.

Abstract

JEL Classification

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

Abstract

This paper analyses whether the post-crisis regulatory reforms developed by globalstandard-setting bodies have created appropriate incentives for different types of market participants to centrally clear Over-The-Counter (OTC) derivative contracts. Beyond documenting the observed facts, we analyse four main drivers for the decision to clear: 1) the liquidity and riskiness of the reference entity; 2) the credit risk of the counterparty; 3) the clearing member’s portfolio net exposure with the Central Counterparty Clearing House (CCP) and 4) post trade transparency. We use confidential European trade repository data on single-name Sovereign Credit Derivative Swap (CDS) transactions, and show that for all the transactions reported in 2016 on Italian, German and French Sovereign CDS 48% were centrally cleared, 42% were not cleared despite being eligible for central clearing, while 9% of the contracts were not clearable because they did not satisfy certain CCP clearing criteria. However, there is a large difference between CCP clearing members that clear about 53% of their transactions and non-clearing members, even those that are subject to counterparty risk capital requirements, that almost never clear their trades. Moreover, we find that diverse factors explain clearing members’ decision to clear different CDS contracts: for Italian CDS, counterparty credit risk exposures matter most for the decision to clear, while for French and German CDS, margin costs are the most important factor for the decision. Moreover, clearing members use clearing to reduce their exposures to the CCP and largely clear contracts when at least one of the traders has a high counterparty credit risk.

No. 61
15 December 2017
Discriminatory pricing of over-the-counter derivatives
Hau, Harald, Hoffmann, Peter, Langfield, Sam, Timmer, Yannick

Abstract

JEL Classification

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

D4 : Microeconomics→Market Structure and Pricing

Abstract

New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.

No. 60
15 December 2017
Crises in the modern financial ecosystem
di Iasio, Giovanni, Pozsar, Zoltan

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We build a moral hazard model to study incentives of financial intermediaries (shortly, bankers) facing a leverage-insurance trade-off in their investment choice. We demonstrate that the choice is affected by two recent transformations of the financial ecosystem bankers inhabit: (i) the rise of institutional savers, such as treasurers of global corporations, which manage huge balances in need for parking space and (ii) the proliferation of balance sheets with asset-liability mismatch, like those of insurance companies and pension funds (ICPFs), which allocate capital to bankers to reach for yield and meet their liabilities offering guaranteed returns. Bankers supply parking space to institutional savers and deliver leverageenhanced returns to ICPFs. When the demand for parking space and the mismatch which ICPFs must bridge are large, the equilibrium allocation is characterized by high leverage and financial crises. We show that post-crisis regulatory reforms, while improving the resiliency of the regulated banking sector, create room for bank disintermediation and do not unambiguously limit systemic risks which can build up in the asset management complex. Both transformations indeed stem from real economy developments (e.g. population ageing, global imbalances, income and wealth inequality, increased sophistication of tax arbitrage). Fiscal and structural reforms that directly address the real economy roots of those secular developments are then essential to complement financial and banking regulations and promote financial stability and balanced growth.

No. 59
1 December 2017
ETF arbitrage under liquidity mismatch
Pan, Kevin, Zeng, Yao

Abstract

JEL Classification

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, we identify a conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.

No. 58
15 November 2017
Syndicated loans and CDS positioning
Aldasoro, Iñaki, Barth, Andreas

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper analyzes banks’ usage of CDS. Combining bank-firm syndicated loan data with a unique EU-wide dataset on bilateral CDS positions, we find that stronger banks in terms of capital, funding and profitability tend to hedge more. We find no evidence of banks using the CDS market for capital relief. Banks are more likely to hedge exposures to relatively riskier borrowers and less likely to sell CDS protection on domestic firms. Lead arrangers tend to buy more protection, potentially exacerbating asymmetric information problems. Dealer banks seem insensitive to firm risk, and hedge more than non-dealers when they are more profitable. These results allow for a better understanding of banks’ credit risk management.

No. 57
15 November 2017
Why are banks not recapitalized during crises?
Crosignani, Matteo

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F33 : International Economics→International Finance→International Monetary Arrangements and Institutions

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

I develop a model where the sovereign debt capacity depends on the capitalization of domestic banks. Low-capital banks optimally tilt their government bond portfolio toward domestic securities, linking their destiny to that of the sovereign. If the sovereign risk is sufficiently high, low-capital banks reduce private lending to further increase their holdings of domestic government bonds, lowering sovereign yields and supporting the home sovereign debt capacity. The model rationalizes, in the context of the eurozone periphery, the increase in domestic government bond holdings, the reduction of bank credit supply, and the prolonged fragility of the financial sector.

No. 56
1 November 2017
A macro approach to international bank resolution
Schoenmaker, Dirk

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

In the aftermath of the Great Financial Crisis, regulators have rushed to strengthen banking supervision and implement bank resolution regimes. While such resolution regimes are welcome to reintroduce market discipline and reduce the reliance on taxpayer-funded bailouts, the effects on the wider banking system have not been properly considered. This paper proposes a macro approach to resolution, which should consider (i) the contagion effects of bail-in, and (ii) the continuing need for a fiscal backstop to the financial system. For bail-in to work, it is important that bail-inable bank bonds are largely held outside the banking sector, which is currently not the case. Stricter capital requirements could push them out of the banking system. The organisation of the fiscal backstop is crucial for the stability of the global banking system. Single-point-of-entry resolution of international banks is only possible for the very largest countries or for countries working together, including in terms of sharing the burden of a potential bank bailout. The euro area has adopted the latter approach in its Banking Union. Other countries have taken a stand-alone approach, which leads to multiple-point-of-entry resolution of international banks and contributes to fragmentation of the global banking system.

For bail-in to work, it is important that bail-inable bank bonds are largely held outside the banking sector, which is currently not the case. Stricter capital requirements could push them out of the banking system. The organisation of the fiscal backstop is crucial for the stability of the global banking system. Single-point-of-entry resolution of international banks is only possible for the very largest countries or for countries working together, including in terms of sharing the burden of a potential bank bailout. The euro area has adopted the latter approach in its Banking Union. Other countries have taken a stand-alone approach, which leads to multiple-point-of-entry resolution of international banks and contributes to fragmentation of the global banking system

No. 55
20 October 2017
Collateral scarcity premia in euro area repo markets
Ferrari, Massimo, Guagliano, Claudia, Mazzacurati, Julien

Abstract

JEL Classification

E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

Collateral plays a very important role in financial markets. Without easy access to high-quality collateral, dealers and market participants would find it more costly to trade, with a negative impact on market liquidity and the real economy through increased financing costs. The role of collateral has become increasingly significant since the global financial crisis, partly due to regulatory reforms. Using bond-level data from both repo and securities lending markets, this paper introduces a new measure of collateral reuse and studies the drivers of the cost of obtaining high-quality collateral, i.e. the collateral scarcity premium, proxied by specialness of government bond repos. We find that the cost of obtaining high-quality collateral increases with demand pressures in the cash market (short-selling activities), even in calm financial market conditions. In bear market conditions ‒ when good collateral is needed the most ‒ this could lead to tensions in some asset market segments. Collateral reuse may alleviate some of these tensions by reducing the collateral scarcity premia. Yet, it requires transparency and monitoring due to the financial stability risks associated. Finally, we find that the launch of the ECB quantitative easing programme has a statistically significant, albeit limited, impact on sovereign collateral scarcity premia, but this impact is offset by the beginning of the ECB Securities Lending Programme.

No. 54
15 September 2017
Networks of counterparties in the centrally cleared EU-wide interest rate derivatives market
Fiedor, Paweł, Lapschies, Sarah, Orszaghova, Lucia

Abstract

JEL Classification

G10 : Financial Economics→General Financial Markets→General

L14 : Industrial Organization→Market Structure, Firm Strategy, and Market Performance→Transactional Relationships, Contracts and Reputation, Networks

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

We perform a network analysis of the centrally cleared interest rate derivatives market in the European Union, by looking at counterparty relations within both direct (house) clearing and client clearing. Since the majority of the gross notional is transferred within central counterparties and their clearing members, client clearing is often neglected in the literature, despite its significance in terms of net exposures. We find that the client clearing structure is very strongly interconnected and contains on the order of 90% of the counterparty relations in the interest rate derivatives market. Moreover, it is more diverse in terms of geography and sectors of the financial market the counterparties are associated with. Client clearing is also significantly more volatile in time than direct clearing. These findings underline the importance of analysing the structure and stability of both direct and client clearing of the interest rate derivatives market in Europe, to improve understanding of this important market and potential contagion mechanisms within it.

No. 53
1 August 2017
Two Big Distortions: Bank Incentives for Debt Financing
Groenewegen, Jesse, Wierts, Peter

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

H25 : Public Economics→Taxation, Subsidies, and Revenue→Business Taxes and Subsidies

Abstract

Systemically important banks are subject to at least two departures from the neutrality of debt versus equity financing: the tax deductibility of interest payments and implicit funding subsidies. This paper fills a gap in the literature by comparing their mechanism and interaction within a common analytical framework. Findings indicate that both the tax shield and implicit funding subsidy remain large, in the order of up to 1 percent of GDP, despite decreases in recent years. But the underlying mechanisms differ. The tax shield incentivises debt financing as it reduces tax payments to the government. The implicit funding subsidy incentivises debt financing as it lowers private bankruptcy costs. This funding subsidy is passed on to other bank stakeholders. It therefore provides incentives for increases in balance sheet size and risk taking. This, in turn, increases the value of the tax shield. Overall, these results help to explain why systemically important banks are highly leveraged.

No. 52
14 July 2017
Asset encumbrance, bank funding and fragility
Ahnert, Toni, Anand, Kartik, Gai, Prasanna, Chapman, James

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We propose a model of asset encumbrance by banks subject to rollover risk and study the consequences for fragility, funding costs, and prudential regulation. A bank’s choice of encumbrance trades off the benefit of expanding profitable investment funded by cheap long-term secured debt against the cost of greater fragility due to unsecured debt runs. We derive several testable implications about privately optimal encumbrance ratios. Deposit insurance or wholesale funding guarantees induce excessive encumbrance and exacerbate fragility. We show how regulations such as explicit limits on encumbrance ratios and revenueneutral Pigouvian taxes can mitigate the risk-shifting incentives of banks.

No. 51
14 July 2017
The missing links: A global study on uncovering financial network structures from partial data
Anand, Kartik, van Lelyveld, Iman, Banai, Ádám, Friedrich, Soeren, Garratt, Rodney, Hałaj, Grzegorz, Fique, Jose, Hansen, Ib, Martínez Jaramillo, Serafín, Lee, Hwayun, Molina-Borboa, José Luis, Nobili, Stefano, Rajan, Sriram, Salakhova, Dilyara, Silva, Thiago Christiano, Silvestri, Laura, Rubens Stancato de Souza, Sergio

Abstract

JEL Classification

G20 : Financial Economics→Financial Institutions and Services→General

L14 : Industrial Organization→Market Structure, Firm Strategy, and Market Performance→Transactional Relationships, Contracts and Reputation, Networks

D85 : Microeconomics→Information, Knowledge, and Uncertainty→Network Formation and Analysis: Theory

C63 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computational Techniques, Simulation Modeling

Abstract

Capturing financial network linkages and contagion in stress test models are important goals for banking supervisors and central banks responsible for micro- and macroprudential policy. However, granular data on financial networks is often lacking, and instead the networks must be reconstructed from partial data. In this paper, we conduct a horse race of network reconstruction methods using network data obtained from 25 different markets spanning 13 jurisdictions. Our contribution is two-fold: first, we collate and analyze data on a wide range of financial networks. And second, we rank the methods in terms of their ability to reconstruct the structures of links and exposures in networks.

No. 50
30 June 2017
Equity versus bail-in debt in banking: an agency perspective
Mendicino, Caterina, Nikolov, Kalin, Suarez, Javier

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

Abstract

We examine the optimal size and composition of banks’ total loss absorbing capacity (TLAC). Optimal size is driven by the trade-off between providing liquidity services through deposits and minimizing deadweight default costs. Optimal composition (equity vs. bail-in debt) is driven by the relative importance of two incentive problems: risk shifting (mitigated by equity) and private benefit taking (mitigated by debt). Our quantitative results suggest that TLAC size in line with current regulation is appropriate. However, an important fraction of it should consist of bail-in debt because such buffer size makes the costs of risk-shifting relatively less important at the margin.

No. 49
30 June 2017
Wholesale funding dry-ups
Pérignon, Christophe, Thesmar, David, Vuillemey, Guillaume

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

Abstract

We empirically explore the fragility of wholesale funding of banks, using transaction level data on short-term, unsecured certificates of deposits in the European market. We do not observe any market-wide freeze during the 2008-2014 period. Yet, many banks suddenly experience funding dry-ups. Dry-ups predict, but do not cause, future deterioration of bank performance. Furthermore, in periods of market stress, banks with high future performance tend to increase reliance on wholesale funding. Thus, we fail to find evidence consistent with classical adverse selection models of funding market freezes. Our evidence is in line with theories highlighting heterogeneity between informed and uninformed lenders.

No. 48
14 June 2017
Banking integration and house price comovement
Landier, Augustin, Sraer, David, Thesmar, David

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

F65 : International Economics→Economic Impacts of Globalization→Finance

R30 : Urban, Rural, Regional, Real Estate, and Transportation Economics→Real Estate Markets, Spatial Production Analysis, and Firm Location→General

Abstract

The correlation across US states in house price growth increased steadily between 1976 and 2000. This paper shows that the contemporaneous geographic integration of the US banking market, via the emergence of large banks, was a primary driver of this phenomenon. To this end, we first theoretically derive an appropriate measure of banking integration across state pairs and document that house price growth correlation is strongly related to this measure of financial integration. Our IV estimates suggest that banking integration can explain up to one fourth of the rise in house price correlation over this period.

No. 47
14 June 2017
The real effects of bank capital requirements
Fraisse, Henri, Lé, Mathias, Thesmar, David

Abstract

JEL Classification

E51 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Money Supply, Credit, Money Multipliers

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We measure the impact of bank capital requirements on corporate borrowing and investment using loanE level data. The Basel II regulatory framework makes capital requirements vary across both banks and across firms, which allows us to control for firm level credit demand shocks and bankE level credit supply shocks. We find that a 1 percentage point increase in capital requirements reduces lending by 10%. Firms can attenuate this reduction by substituting borrowing across banks, but only partially. The resulting reduction in borrowing capacity impacts investment, but not working capital: Fixed assets are reduced by 2.6%, but lending to customers is unaffected.

No. 46
9 June 2017
Simulating fire-sales in a banking and shadow banking system
Calimani, Susanna, Hałaj, Grzegorz, Żochowski, Dawid

Abstract

JEL Classification

C63 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computational Techniques, Simulation Modeling

D85 : Microeconomics→Information, Knowledge, and Uncertainty→Network Formation and Analysis: Theory

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

We develop an agent based model of traditional banks and asset managers. Our aim is to investigate the channels of contagion of shocks to asset prices within and between the two financial sectors, including the effects of fire sales and their impact on financial institutions’ balance sheets. We take a structural approach to the price formation mechanism as in Bluhm, Faia and Kranen (2014) and introduce a clearing mechanism with an endogenous formation of asset prices. Both types of institutions hold liquid and illiquid assets and are funded via equity and deposits. Traditional banks are interconnected in the money market via mutual interbank claims, where the rate of return is endogenously determined through a tatonnement process. We show how in such a set-up an initial exogenous liquidity shock may lead to a fire-sale spiral. Banks, which are subject to capital and liquidity requirements, may be forced to sell an illiquid security, which impacts its, endogenously determined, market price. As the price of the security decreases, both agents update their equity and adjust their balance sheets by making decisions on whether to sell or buy the security. This endogenous process may trigger a cascade of sales leading to a fire-sale. We find that, first, mixed portfolios banks act as plague-spreader in a context of financial distress. Second, higher bank capital requirements may aggravate contagion since they may incentivise banks to hold similar assets, and choose mixed portfolios business model which is also characterized by lower levels of voluntary capital buffer. Third, asset managers absorb small liquidity shocks but they exacerbate contagion when liquid buffers are fully utilised.

No. 45
9 June 2017
Use of unit root methods in early warning of financial crises
Virtanen, Timo, Tölö, Eero, Virén, Matti, Taipalus, Katja

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

Abstract

In several recent studies unit root methods have been used in detection of financial bubbles in asset prices. The basic idea is that fundamental changes in the autocorrelation structure of relevant time series imply the presence of a rational price bubble. We provide cross-country evidence for performance of unit-root-based early warning systems in ex-ante prediction of financial crises in 15 EU countries over the past three decades. We find especially high performance for time series that are explicitly related to debt, which issue signals a few years in advance of a crisis. Combining signals from multiple time series further improves the predictions. Our results suggest an early warning tool based on unit root methods provides a valuable accessory in financial stability supervision.

No. 44
2 May 2017
Compressing over-the-counter markets
D'Errico, Marco, Roukny, Tarik

Abstract

JEL Classification

C61 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Optimization Techniques, Programming Models, Dynamic Analysis

D53 : Microeconomics→General Equilibrium and Disequilibrium→Financial Markets

D85 : Microeconomics→Information, Knowledge, and Uncertainty→Network Formation and Analysis: Theory

G01 : Financial Economics→General→Financial Crises

G10 : Financial Economics→General Financial Markets→General

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

Abstract

In this paper, we show both theoretically and empirically that the size of over-the-counter (OTC) markets can be reduced without affecting individual net positions. First, we find that the networked nature of these markets generates an excess of notional obligations between the aggregate gross amount and the minimum amount required to satisfy each individual net position. Second, we show conditions under which such excess can be removed. We refer to this netting operation as compression and identify feasibility and efficiency criteria, highlighting intermediation as the key element for excess levels. We show that a tradeoff exists between the amount of notional that can be eliminated from the system and the conservation of original trading relationships. Third, we apply our framework to a unique and comprehensive transaction-level dataset on OTC derivatives including all firms based in the European Union. On average, we find that around 75% of market gross notional relates to excess. While around 50% can in general be removed via bilateral compression, more sophisticated multilateral compression approaches are substantially more efficient. In particular, we find that even the most conservative multilateral approach which satisfies relationship constraints can eliminate up to 98% of excess in the markets.

No. 43
2 May 2017
Coherent financial cycles for G-7 countries: Why extending credit can be an asset
Schüler, Yves S., Hiebert, Paul H., Peltonen, Tuomas A.

Abstract

JEL Classification

C54 : Mathematical and Quantitative Methods→Econometric Modeling→Quantitative Policy Modeling

E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

G01 : Financial Economics→General→Financial Crises

Abstract

Failing to account for joint dynamics of credit and asset prices can be hazardous for countercyclical macroprudential policy. We show that composite financial cycles, emphasising expansions and contractions common to credit and asset prices, powerfully predict systemic banking crises. Further, the joint consideration yields a more robust view on financial cycle characteristics, reconciling an empirical puzzle concerning cycle properties when using two popular alternative methodologies: frequency decompositions and standard turning point analysis. Using a novel spectral approach, we establish the following facts for G-7 countries (1970Q1-2013Q4): Relative to business cycles, financial cycles differ in amplitude and persistence – albeit with heterogeneity across countries. Average financial cycle length is around 15 years, compared with 9 years (6.7 excluding Japan) for business cycles. Still, country-level business and financial cycles relate occasionally. Across countries, financial cycle synchronisation is strong for most countries; but not for all. In contrast, business cycles relate homogeneously.

No. 42
3 April 2017
A dynamic theory of mutual fund runs and liquidity management
Zeng, Yao

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

G33 : Financial Economics→Corporate Finance and Governance→Bankruptcy, Liquidation

D92 : Microeconomics→Intertemporal Choice→Intertemporal Firm Choice, Investment, Capacity, and Financing

Abstract

I model an open-end mutual fund investing in illiquid assets and show that the fund’s endogenous cash management can generate shareholder runs even with a flexible NAV. The fund optimally re-builds its cash buffers at time t + 1 after outflows at t to prevent future forced sales of illiquid assets. However, cash rebuilding at t + 1 implies predictable voluntary sales of illiquid assets, generating a predictable decline in NAV. This generates a first-mover advantage, leading to runs. A time-inconsistency problem aggravates runs: the fund may want to pre-commit not to re-build cash buffers but cannot credibly do so absent a commitment device.

No. 41
3 April 2017
Financial frictions and the real economy
Pietrunti, Mario

Abstract

JEL Classification

C15 : Mathematical and Quantitative Methods→Econometric and Statistical Methods and Methodology: General→Statistical Simulation Methods: General

E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G01 : Financial Economics→General→Financial Crises

Abstract

This paper investigates in a non-linear setting the impact on the real economy of frictions stemming from the financial sector. We develop a medium scale DSGE model with a banking sector where an occasionally binding constraint on banks’ capital induces a relevant non-linearity. The model - estimated on Italian data from 1999 to 2015 via a likelihood-free method - is able to generate business cycle asymmetries as in actual data that cannot replicated by linear models. Lastly, the role of macroprudential policies in smoothing the cycle is discussed

No. 40
15 March 2017
Mapping the interconnectedness between EU banks and shadow banking entities
Abad, Jorge, D'Errico, Marco, Killeen, Neill, Luz, Vera, Peltonen, Tuomas A., Portes, Richard, Urbano, Teresa

Abstract

JEL Classification

F65 : International Economics→Economic Impacts of Globalization→Finance

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

This paper provides a unique snapshot of the exposures of EU banks to shadow banking entities within the global financial system. Drawing on a rich and novel dataset, the paper documents the cross-sector and cross-border linkages and considers which are the most relevant for systemic risk monitoring. From a macroprudential perspective, the identification of potential feedback and contagion channels arising from the linkages of banks and shadow banking entities is particularly challenging when shadow banking entities are domiciled in different jurisdictions. The analysis shows that many of the EU banks’ exposures are towards non-EU entities, particularly US-domiciled shadow banking entities. At the individual level, banks’ exposures are diversified although this diversification leads to high overlap across different types of shadow banking entities.

No. 39
14 March 2017
Decomposing financial (in)stability in emerging economies
Lepers, Etienne , Sánchez Serrano, Antonio

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F65 : International Economics→Economic Impacts of Globalization→Finance

G01 : Financial Economics→General→Financial Crises

G15 : Financial Economics→General Financial Markets→International Financial Markets

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

The build-up of risks in advanced economies has seen a lot of research efforts in the recent years, while similar research efforts on emerging economies have not been so strong and, when undertaken, have focused mostly on its international dimension. Simultaneously, the financial system of the emerging economies has substantially developed and deepened. In our paper, we construct an index of vulnerabilities in emerging countries, relying solely on data available at international organisations. We group indicators around four poles: valuation and risk appetite, imbalances in the non-financial sector, financial sector vulnerabilities, and global vulnerabilities. On purpose, we depart from early warning models or any other kind of complex econometric constructs. Simplicity and usability are the two key characteristics we have tried to embed into our index of vulnerabilities. We use the results to try to create a narrative of the evolution of vulnerabilities in emerging economies from 2005 to the third quarter of 2015, using innovative data visualisation tools as well as correlations and Granger causalities. We complement our analysis with a comparison between our index of vulnerabilities and the Credit-to-GDP gap.

No. 38
10 March 2017
Flight to liquidity and systemic bank runs
Robatto, Roberto

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

E51 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Money Supply, Credit, Money Multipliers

G20 : Financial Economics→Financial Institutions and Services→General

Abstract

This paper presents a general equilibrium, monetary model of bank runs to study monetary injections during financial crises. When the probability of runs is positive, depositors increase money demand and reduce deposits; at the economy-wide level, the velocity of money drops and deflation arises. Two quantitative examples show that the model accounts for a large fraction of (i) the drop in deposits in the Great Depression, and (ii) the $400 billion run on money market mutual funds in September 2008. In some circumstances, monetary injections have no effects on prices but reduce money velocity and deposits. Counterfactual policy analyses show that, if the Federal Reserve had not intervened in September 2008, the run on money market mutual funds would have been much smaller.

No. 37
10 March 2017
SRISK: a conditional capital shortfall measure of systemic risk
Brownlees, Christian, Engle, Robert F.

Abstract

JEL Classification

C22 : Mathematical and Quantitative Methods→Single Equation Models, Single Variables→Time-Series Models, Dynamic Quantile Regressions, Dynamic Treatment Effect Models &bull Diffusion Processes

C23 : Mathematical and Quantitative Methods→Single Equation Models, Single Variables→Panel Data Models, Spatio-temporal Models

C53 : Mathematical and Quantitative Methods→Econometric Modeling→Forecasting and Prediction Methods, Simulation Methods

G01 : Financial Economics→General→Financial Crises

G20 : Financial Economics→Financial Institutions and Services→General

Abstract

We introduce SRISK to measure the systemic risk contribution of a financial firm. SRISK measures the capital shortfall of a firm conditional on a severe market decline, and is a function of its size, leverage and risk. We use the measure to study top US financial institutions in the recent financial crisis. SRISK delivers useful rankings of systemic institutions at various stages of the crisis and identifies Fannie Mae, Freddie Mac, Morgan Stanley, Bear Stearns and Lehman Brothers as top contributors as early as 2005-Q1. Moreover, aggregate SRISK provides early warning signals of distress in indicators of real activity.

No. 36
13 February 2017
Credit conditions, macroprudential policy and house prices
Kelly, Robert, McCann, Fergal, O'Toole, Conor

Abstract

JEL Classification

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

R31 : Urban, Rural, Regional, Real Estate, and Transportation Economics→Real Estate Markets, Spatial Production Analysis, and Firm Location→Housing Supply and Markets

Abstract

We provide a micro-empirical link between the large literature on credit and house prices and the burgeoning literature on macroprudential policy. Using loan-level data on Irish mortgages originated between 2003 and 2010, we construct a measure of credit availability which varies at the borrower level as a function of income, wealth, age, interest rates and prevailing market conditions around Loan to Value ratios (LTV), Loan to Income ratios (LTI) and monthly Debt Service Ratios (DSR). We deploy a property-level house price model which shows that a ten per cent increase in credit available leads to an 1.5 per cent increase in the value of property purchased. Coefficients from this model are then used to fit values under scenarios of macroprudential restrictions on LTV, LTI and DSR on credit availability and house prices in Ireland for 2003 and 2006. Our results suggest that macroprudential limits would have had substantial impacts on house prices, and that both the level at which they are set and the timing of their introduction is a crucial determinant of their impact on housing values.

No. 35
13 February 2017
Addressing the safety trilemma: a safe sovereign asset for the eurozone
van Riet, Ad

Abstract

JEL Classification

F33 : International Economics→International Finance→International Monetary Arrangements and Institutions

F34 : International Economics→International Finance→International Lending and Debt Problems

G15 : Financial Economics→General Financial Markets→International Financial Markets

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

H70 : Public Economics→State and Local Government, Intergovernmental Relations→General

Abstract

At the 25th anniversary of the Maastricht Treaty, this paper reviews the merits of introducing a safe sovereign asset for the eurozone. The triple euro area crisis showed the costly consequences of ignoring the ‘safety trilemma’. Keeping a national safe sovereign asset (the German bund) as the cornerstone of the financial system is incompatible with having free capital mobility and maintaining economic and financial stability in a monetary union. The euro area needs a single safe sovereign asset. However, eurobonds are only foreseen after full fiscal integration. To address the safety trilemma member countries must therefore act as the joint sovereign behind the euro and choose from two options. First, they could establish a credible multipolar system of safe national sovereign assets. For this purpose, they could all issue both senior and junior tranches of each national government bond in a proportion such that the expected safety of the senior tranche is the same across countries while the junior tranche would absorb any sovereign default risk. Additional issuance of national GDP-linked bonds could insure governments against a deep recession that might lead to a self-fulfilling default and thereby help to make the junior tranche less risky. The second option is that the member countries together produce a common safe sovereign asset for a truly integrated and stable monetary union by creating synthetic eurobonds comprising both a safe senior claim and a risky junior claim on a diversified portfolio of national government bonds. This appears a more effective solution to the safety trilemma – especially when euro area governments would also issue national GDP-linked bonds – but it requires flanking measures to control for moral hazard.

No. 34
13 February 2017
Resolution of international banks: can smaller countries cope?
Schoenmaker, Dirk

Abstract

JEL Classification

F30 : International Economics→International Finance→General

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

The stability of a banking system ultimately depends on the strength and credibility of the fiscal backstop. While large countries can still afford to resolve large global banks on their own, small and medium-sized countries face a policy choice. This paper investigates the impact of resolution on banking structure. The financial trilemma model indicates that smaller countries can either conduct joint supervision and resolution of their global banks (based on single point of entry resolution) or reduce the size of their global banks and move to separate resolution of these banks’ national subsidiaries (based on multiple point of entry resolution). Euro-area countries are heading for joint resolution based on burden sharing, while the UK and Switzerland have implemented policies to downsize their banks.

No. 33
22 December 2016
How does risk flow in the credit default swap market?
D'Errico, Marco, Battiston, Stefano, Peltonen, Tuomas A., Scheicher, Martin

Abstract

JEL Classification

G10 : Financial Economics→General Financial Markets→General

G15 : Financial Economics→General Financial Markets→International Financial Markets

Abstract

We develop a framework to analyse the Credit Default Swaps (CDS) market as a network of risk transfers among counterparties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counterparties: i) Ultimate Risk Sellers (URS), ii) Dealers (indirectly connected to each other), iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counterparty risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011 −2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and thatt the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.

No. 32
21 December 2016
Financial contagion with spillover effects: a multiplex network approach
Peralta, Gustavo, Crisóstomo, Ricardo

Abstract

JEL Classification

C63 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Computational Techniques, Simulation Modeling

D85 : Microeconomics→Information, Knowledge, and Uncertainty→Network Formation and Analysis: Theory

G01 : Financial Economics→General→Financial Crises

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

Abstract

This paper presents a comprehensive model of financial contagion encompassing both direct and indirect transmission channels. We introduce direct contagion through a 2-layered multiplex network to account for the distinct dynamics resulting from collateralized and uncollateralized transactions. Moreover, the spillover effects of fire sales, haircut prociclicality and liquidity hoarding are specifically considered through indirect transmission channels. This framework allows us to analyze the determinants of systemic crisis and the resilience of different financial network configurations. Our first experiment demonstrates the benefits of counterparty diversification as a way of reducing systemic risk. The second experiment highlights the positive effect of higher initial capital and liquidity levels, while stressing the potentially counterproductive impact of rapidly increasing the minimum capital and liquidity ratios, particularly in times of stress. The third experiment examines the possibility of controlling the maximum haircut rates, although the impact of this measure is modest compared to other alternatives. Finally, our last experiment evidences the fundamental role played by fire sales and market liquidity in either leading or mitigating systemic crises.

No. 31
21 December 2016
The (unintended?) consequences of the largest liquidity injection ever
Crosignani, Matteo, Faria-e-Castro, Miguel, Fonseca, Luís

Abstract

JEL Classification

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

Abstract

We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank’s three-year Long-Term Refinancing Operation incentivized Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This “collateral trade” effect is large, as banks purchased short-term bonds equivalent to 8.4% of amount outstanding. The resumption of public debt issuance is consistent with a strategic reaction of the debt agency to the observed yield curve steepening.

No. 30
17 November 2016
Exposure to international crises: trade vs. financial contagion
Grant, Everett

Abstract

JEL Classification

E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles

F40 : International Economics→Macroeconomic Aspects of International Trade and Finance→General

F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics

F44 : International Economics→Macroeconomic Aspects of International Trade and Finance→International Business Cycles

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

Abstract

I identify new patterns in countries’ economic performance over the 2007-2014 period based on proximity through distance, trade, and finance to the US subprime mortgage and Eurozone debt crisis areas. To understand the causes of the cross-country variation, I develop an open economy model with two transmission channels that can be shocked separately: international trade and finance. The model is the first to include a government and heterogeneous firms that can default independently of one another and has a novel endogenous cost of sovereign default. I calibrate the model to the average experiences of countries near to and far from the crisis areas. Using these calibrations, disturbances on the order of those observed during the late 2000s are separately applied to each channel to study transmission. The results suggest credit disruption as the primary contagion driver, rather than the trade channel. Given the substantial degree of financial contagion, I run a series of counterfactuals studying the efficacy of capital controls and find that they would be a useful tool for preventing similarly severe contagion in the future, so long as there is not capital immobility to the degree that the local sovereign can default without suffering capital flight.

No. 29
14 November 2016
Predicting vulnerabilities in the EU banking sector: the role of global and domestic factors
Behn, Markus, Detken, Carsten, Peltonen, Tuomas A., Schudel, Willem

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We estimate a multivariate early-warning model to assess the usefulness of private credit and other macro-financial variables in predicting banking sector vulnerabilities. Using data for 23 European countries, we find that global variables and in particular global credit growth are strong predictors of domestic vulnerabilities. Moreover, domestic credit variables also have high predictive power, but should be complemented by other macro-financial indicators like house price growth and banking sector capitalization that play a salient role in predicting vulnerabilities. Our findings can inform decisions on the activation of macroprudential policy measures and suggest that policy makers should take a broad approach in the analytical models that support risk identification and calibration of tools.

No. 26
20 October 2016
Using elasticities to derive optimal bankruptcy exemptions
Dávila, Eduardo

Abstract

JEL Classification

D52 : Microeconomics→General Equilibrium and Disequilibrium→Incomplete Markets

E21 : Macroeconomics and Monetary Economics→Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy→Consumption, Saving, Wealth

D14 : Microeconomics→Household Behavior and Family Economics→Household Saving; Personal Finance

Abstract

This paper studies the optimal determination of bankruptcy exemptions for risk averse borrowers who use unsecured contracts but have the possibility of defaulting. I show that, in a large class of economies, knowledge of four variables is sufficient to determine whether a bankruptcy exemption level is optimal, or should be increased or decreased. These variables are: the sensitivity to the exemption level of the interest rate schedule offered by lenders to borrowers, the borrowers’ leverage, the borrowers’ bankruptcy probability, and the change in bankrupt borrowers’ consumption. An application of the framework to US data suggests that the optimal bankruptcy exemption is higher than the current average bankruptcy exemption, but of the same order of magnitude.

No. 28
20 October 2016
Financial intermediation, resource allocation, and macroeconomic interdependence
Ozhan, Galip Kemal

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F32 : International Economics→International Finance→Current Account Adjustment, Short-Term Capital Movements

F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics

G15 : Financial Economics→General Financial Markets→International Financial Markets

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

Abstract

This paper studies the role of the financial sector in a↵ecting domestic resource allocation and cross-border capital flows. I develop a quantitative, two-country, macroeconomic model in which banks face endogenous and occasionally binding leverage constraints. Banks lend funds to be invested in tradable or non-tradable sector capital and there is international financial integration in the market for bank liabilities. I focus on news about economic fundamentals as the key source of fluctuations. Specifically, in the case of positive news on the valuation of non-traded sector capital that turn out to be incorrect at a later date, the model generates an asymmetric, belief-driven boom-bust cycle that reproduces key features of the recent Eurozone crisis. Bank balance sheets amplify and propagate fluctuations through three channels when leverage constraints bind: First, amplified wealth e↵ects induce jumps in import-demand (demand channel). Second, changes in the value of non-tradable sector assets alter bank lending to tradable sector firms (intra-national spillover channel). Third, domestic and foreign households re-adjust their savings in domestic banks, and capital flows further amplify fluctuations (international spillover channel). A common central bank’s unconventional policies of private asset purchases and liquidity facilities in response to unfulfilled expectations are successful at ameliorating the economic downturn.

No. 27
20 October 2016
(Pro?)-cyclicality of collateral haircuts and systemic illiquidity
Glaser, Florian, Panz, Sven

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G18 : Financial Economics→General Financial Markets→Government Policy and Regulation

G01 : Financial Economics→General→Financial Crises

Abstract

Procyclicality of collateral haircuts and margins has become a widely proclaimed behavior and is currently discussed not only by academic literature but also by regulatory authorities in Europe. Procyclicality of haircuts is assumed to be a trigger of liquidity spirals due to its tightening effect of collateral portfolio values in times of market distress. However, empirical evidence on this topic is quite sparse and the discussions are primarily driven by insights derived from theoretical models. Nonetheless, oversight bodies are discussing macroprudential haircut add-ons in order to curb with the potential effects of procyclicality in distressed periods. Based on a unique data set provided by a large European Central Counterparty we construct a measure of systemic illiquidity of bond collaterals and analyze the relationship between haircuts, the development of periods with explosive behavior and systemic illiquidity. We estimate the noise of bond yields to measure systemic illiquidity with and without considering haircuts. We then apply an explosive roots bubble detection technique to identify irrational periods of each of these two time series and to a combination of both. Finally, we propose a quantitative trigger and design for macroprudential haircut add-ons. Our results confirm that (1) bond collateral markets face irrational, i.e. bubble-like illiquidity during periods of systemic distress. The results indicate that (2) haircuts are not amplifying or increasing with systemic illiquidity. (3) The proposed haircut add-on mechanism exhibits desirable features to mitigate systemic illiquidity during lasting periods of distress.

No. 23
19 September 2016
Liquidity transformation in asset management: Evidence from the cash holdings of mutual funds
Chernenko, Sergey, Sunderam, Adi

Abstract

JEL Classification

G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors

Abstract

We study liquidity transformation in mutual funds using a novel data set on their cash holdings To provide investors with claims that are more liquid than the underlying assets, funds engage in substantial liquidity management. Specifically, they hold substantial amounts of cash, which they use to accommodate inflows and outflows rather than transacting in the underlying portfolio assets. This is particularly true for funds with illiquid assets and at times of low market liquidity. We provide evidence suggesting that mutual funds’ cash holdings are not large enough to fully mitigate price impact externalities created by the liquidity transformation they engage in.

No. 22
19 September 2016
Arbitraging the Basel securitization framework: Evidence from German ABS investment
Efing, Matthias

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G24 : Financial Economics→Financial Institutions and Services→Investment Banking, Venture Capital, Brokerage, Ratings and Ratings Agencies

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper provides evidence for regulatory arbitrage within the class of asset-backed securities (ABS) based on individual asset holding data of German banks. I find that banks operating with tight regulatory constraints exploit the low risk-sensitivity of rating-contingent capital requirements for ABS. Unlike unconstrained banks they systematically pick the securities with the highest yield and the lowest collateral performance among ABS with the same regulatory risk weight. This reaching for yield allows constrained banks to increase the return on the capital required for an ABS investment by a factor of four.

No. 21
19 September 2016
ESBies: Safety in the tranches
Brunnermeier, Markus K., Langfield, Sam, Pagano, Marco, Reis, Ricardo, Van Nieuwerburgh, Stijn, Vayanos, Dimitri

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G01 : Financial Economics→General→Financial Crises

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

The euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to-safety capital flows. European Safe Bonds (ESBies), a union-wide safe asset without joint liability, would help to resolve these problems. We make three contributions. First, numerical simulations show that ESBies would be at least as safe as German bunds and approximately double the supply of euro safe assets when protected by a 30%-thick junior tranche. Second, a model shows how, when and why the two features of ESBies—diversification and seniority—can weaken the diabolic loop and its diffusion across countries. Third, we propose a step-by-step guide on how to create ESBies, starting with limited issuance by public or private-sector entities.

No. 25
19 September 2016
Macroeconomic effects of secondary market trading
Neuhann, Daniel

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

Abstract

This paper develops a theory of the secondary market trading of financial securitities in which endogenous asset market dynamics generate periods of growing aggregate credit volumes and falling credit standards even in the absence of “financial shocks.” Falling credit standards in turn lead to excess risk exposure in the aggregate, precipitating future crises. The credit cycle is triggered by low interest rates, and longer booms lead to sharper crises. Saving gluts and expansionary monetary policy thus lead to financial fragility over time. Pro-cyclical regulation of secondary market traders, such as asset managers or hedge funds, can improve welfare even when such traders are not levered.

No. 24
19 September 2016
Macroprudential policy with liquidity panics
Garcia-Macia, Daniel, Villacorta, Alonso

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We analyze the optimality of macroprudential policies in an environment where the role of the banking sector is to efficiently allocate liquid assets across firms. Informational frictions in the banking sector can lead to an interbank market freeze. Firms react to the breakdown of the banking system by inefficiently accumulating liquid assets by themselves. This reduces the demand for bank loans and bank profits, which further disrupts the financial sector and increases the probability of a freeze, inducing firms to hoard even more liquid assets. Liquidity panics provide a new rationale for stricter liquidity requirements, as this policy alleviates the informational frictions in the banking sector and paradoxically can end up increasing aggregate investment. On the contrary, policies encouraging bank lending can have the opposite effect.

No. 20
8 August 2016
Multiplex interbank networks and systemic importance – An application to European data
Aldasoro, Iñaki, Alves, Iván

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

D85 : Microeconomics→Information, Knowledge, and Uncertainty→Network Formation and Analysis: Theory

C67 : Mathematical and Quantitative Methods→Mathematical Methods, Programming Models, Mathematical and Simulation Modeling→Input?Output Models

Abstract

Research on interbank networks and systemic importance is starting to recognise that the web of exposures linking banks balance sheets is more complex than the single-layer-of-exposure approach. We use data on exposures between large European banks broken down by both maturity and instrument type to characterise the main features of the multiplex structure of the network of large European banks. This multiplex network presents positive correlated multiplexity and a high similarity between layers, stemming both from standard similarity analyses as well as a core-periphery analyses of the different layers. We propose measures of systemic importance that fit the case in which banks are connected through an arbitrary number of layers (be it by instrument, maturity or a combination of both). Such measures allow for a decomposition of the global systemic importance index for any bank into the contributions of each of the sub-networks, providing a useful tool for banking regulators and supervisors in identifying tailored policy instruments. We use the dataset of exposures between large European banks to illustrate that both the methodology and the specific level of network aggregation matter in the determination of interconnectedness and thus in the policy making process.

No. 19
25 July 2016
Strategic complementarity in banks’ funding liquidity choices and financial stability
Silva, André

Abstract

JEL Classification

G20 : Financial Economics→Financial Institutions and Services→General

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper examines whether banks’ liquidity and maturity mismatch decisions are affected by the choices of competitors and the impact of these coordinated funding liquidity policies on financial stability. Using a novel identification strategy where interactions are structured through decision networks, I show that banks do consider their peers’ liquidity choices when determining their own. This effect is asymmetric and not present in bank capital choices. Importantly, I find that these strategic funding liquidity decisions increase both individual banks’ default risk and overall systemic risk. From a macroprudential perspective, the results highlight the importance of explicitly regulating systemic liquidity risk.

No. 18
13 July 2016
Cyclical investment behavior across financial institutions
Timmer, Yannick

Abstract

JEL Classification

F32 : International Economics→International Finance→Current Account Adjustment, Short-Term Capital Movements

G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions

G15 : Financial Economics→General Financial Markets→International Financial Markets

G20 : Financial Economics→Financial Institutions and Services→General

Abstract

This paper examines the investment behavior of different financial institutions in debt securities with a particular focus on their response to price changes. For identification, we use security-level data from the German Microdatabase Securities Holdings Statistics. Our results suggest that banks and investment funds may destabilize the market by responding in a pro-cyclical manner to price changes. In contrast, insurance companies and pension funds buy securities when their prices fall and vice versa. While investment funds and banks sell securities that are trading at a discount and whose prices are falling, they buy securities that are trading at premium and whose prices are rising. The opposite is the case for insurance companies and pension funds. This counter-cyclical investment behavior of insurance companies and pension funds may stabilize markets whenever prices have been pushed away from fundamentals. Since our results suggest that institutions with impermanent balance sheet characteristics may exacerbate price dynamics, it is of crucial importance for financial stability to monitor the investor base as well as the balance sheets of both levered and non-levered investors.

No. 17
12 July 2016
Assessing the costs and benefits of capital-based macroprudential policy
Behn, Markus, Gross, Marco, Peltonen, Tuomas A.

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We develop an integrated Early Warning Global Vector Autoregressive (EW-GVAR) model to quantify the costs and benefits of capital-based macroprudential policy measures. Our findings illustrate that capital-based measures are transmitted both via their impact on the banking system’s resilience and via indirect macro-financial feedback effects. The feedback effects relate to dampened credit and asset price growth and, depending on how banks move to higher capital ratios, can account for up to a half of the overall effectiveness of capitalbased measures. Moreover, we document significant cross-country spillover effects, especially for measures implemented in larger countries. Overall, our model helps to understand how and through which channels changes in capitalization affect bank lending and the wider economy and can inform policy makers on the optimal calibration and timing of capital-based macroprudential instruments.

No. 16
28 June 2016
Bank recapitalizations and lending: A little is not enough
Homar, Timotej

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper analyzes the effect of bank recapitalizations on lending, funding and asset quality of European banks between 2000 and 2013. Controlling for market implied capital shortfall of banks, we find that banks that receive a sufficiently large recapitalization increase lending, attract more deposits and clean up their balance sheets. In contrast, banks that receive a small recapitalization relative to their capital shortfall reduce lending and shrink assets. These results suggest recapitalizations need to be large enough to lead to new lending.

No. 15
28 June 2016
Credit default swap spreads and systemic financial risk
Giglio, Stefano

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper measures the joint default risk of financial institutions by exploiting information about counterparty risk in credit default swaps (CDS). A CDS contract written by a bank to insure against the default of another bank is exposed to the risk that both banks

default. From CDS spreads we can then learn about the joint default risk of pairs of banks. From bond prices we can learn the individual default probabilities. Since knowing individual and pairwise probabilities is not sufficient to fully characterize multiple default

risk, I derive the tightest bounds on the probability that many banks fail simultaneously.

No. 14
28 June 2016
Catering to investors through product complexity
Célérier, Claire, Vallée, Boris

Abstract

JEL Classification

I22 : Health, Education, and Welfare→Education and Research Institutions→Educational Finance, Financial Aid

G10 : Financial Economics→General Financial Markets→General

D18 : Microeconomics→Household Behavior and Family Economics→Consumer Protection

D12 : Microeconomics→Household Behavior and Family Economics→Consumer Economics: Empirical Analysis

Abstract

This study investigates the rationale for issuing complex securities to retail investors. We focus on a large market of investment products targeted exclusively at households: retail structured products in Europe. We develop an economic measure of product complexity in this market via a text analysis of 55,000 product payoff formulas. Over the 2002–2010 period, product complexity increases, risky products become more common, and product headline rates diverge from the prevailing interest rates as the latter decline. The complexity of a product is positively correlated with its headline rate and risk. Complex products appear more profitable to the banks distributing them, have a lower expost performance, and are more frequently sold by banks targeting low-income households. These empirical facts are consistent with banks strategically using product complexity to cater to yield-seeking households.

No. 13
9 June 2016
Banks' exposure to interest rate risk and the transmission of monetary policy
Gomez, Matthieu, Landier, Augustin, Sraer, David, Thesmar, David

Abstract

JEL Classification

E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

Abstract

We show that the cash-flow exposure of banks to interest rate risk, or income gap, affects the transmission of monetary policy shocks to bank lending and real activity. We first use a large panel of U.S. banks to show that the sensitivity of bank profits to interest rates increases significantly with measured income gap, even when banks use interest rate derivatives. We then document that, in the cross-section of banks, income gap predicts the sensitivity of bank lending to interest rates. The effect of income gap is larger or similar in magnitudes to that of previously identified factors, such as leverage, bank size or even asset liquidity. To alleviate the concern that this result is driven by the endogenous matching of banks and firms, we use loan-level data and compare the supply of credit to the same firm by banks with different income gap. This analysis allows us to trace the impact of banks’ income gap on firm borrowing capacity, investment and employment, which we find to be significant.

No. 12
3 June 2016
Extreme risk interdependence
Polanski, Arnold, Stoja, Evarist

Abstract

JEL Classification

C12 : Mathematical and Quantitative Methods→Econometric and Statistical Methods and Methodology: General→Hypothesis Testing: General

C14 : Mathematical and Quantitative Methods→Econometric and Statistical Methods and Methodology: General→Semiparametric and Nonparametric Methods: General

C52 : Mathematical and Quantitative Methods→Econometric Modeling→Model Evaluation, Validation, and Selection

Abstract

We define tail interdependence as a situation where extreme outcomes for some variables are informative about such outcomes for other variables. We extend the concept of multiinformation to quantify tail interdependence, decompose it into systemic and residual interdependence and measure the contribution of a constituent to the interdependence of a system. Further, we devise statistical procedures to test: a) tail independence, b) whether an empirical interdependence structure is generated by a theoretical model and c) symmetry of the interdependence structure in the tails. We outline some additional extensions and illustrate this framework by applying it to several datasets.

No. 11
2 May 2016
Bank exposures and sovereign stress transmission
Altavilla, Carlo, Pagano, Marco, Simonelli, Saverio

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F30 : International Economics→International Finance→General

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

Abstract

Using novel monthly data for 226 euro-area banks from 2007 to 2015, we investigate the causes and effects of banks’ sovereign exposures during and after the euro crisis. First, in the vulnerable countries, the publicly owned, recently bailed out and less strongly capitalized banks reacted to sovereign stress by increasing their domestic sovereign holdings more than other banks, suggesting that their choices were affected both by moral suasion and by yield-seeking. Second, their exposures significantly amplified the transmission of risk from the sovereign and its impact on lending. This amplification of the impact on lending cannot be ascribed to spurious correlation or reverse causality.

No. 10
2 May 2016
Systemic risk in clearing houses: Evidence from the European repo market
Boissel, Charles, Derrien, François, Örs, Evren, Thesmar, David

Abstract

JEL Classification

E58 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Central Banks and Their Policies

E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

Abstract

How do crises affect Central clearing Counterparties (CCPs)? We focus on CCPs that clear and guarantee a large and safe segment of the repo market during the Eurozone sovereign debt crisis. We start by developing a simple framework to infer CCP stress, which can be measured through the sensitivity of repo rates to sovereign CDS spreads. Such sensitivity jointly captures three effects: (1) the effectiveness of the haircut policy, (2) CCP member default risk (conditional on sovereign default) and (3) CCP default risk (conditional on both sovereign and CCP member default). The data show that, during the sovereign debt crisis of 2011, repo rates strongly respond to movements in sovereign risk, in particular for GIIPS countries, indicating significant CCP stress. Our model suggests that repo investors behaved as if the conditional probability of CCP default was very large.

No. 9
2 May 2016
Regime-dependent sovereign risk pricing during the euro crisis
Delatte, Anne-Laure, Fouquau, Julien, Portes, Richard

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

F34 : International Economics→International Finance→International Lending and Debt Problems

G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates

H63 : Public Economics→National Budget, Deficit, and Debt→Debt, Debt Management, Sovereign Debt

C23 : Mathematical and Quantitative Methods→Single Equation Models, Single Variables→Panel Data Models, Spatio-temporal Models

Abstract

Previous work has documented a greater sensitivity of long-term government bond yields to fundamentals in Euro area stress countries during the euro crisis, but we know little about the driver(s) of regimeswitches. Our estimates based on a panel smooth threshold regression model quantify and explain them: 1) investors have penalized a deterioration of fundamentals more strongly from 2010 to 2012; 2) a key indicator of regime switch is the premium of the financial credit default swap index: the higher the bank credit risk, the higher the extra premium on fundamentals; 3) after ECB President Draghi’s speech in July 2012, it took one year to restore the non-crisis regime and suppress the extra premium.

No. 8
20 April 2016
Double bank runs and liquidity risk management
Ippolito, Filippo, Peydró, José-Luis, Polo, Andrea, Sette, Enrico

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

By providing liquidity to depositors and credit line borrowers, banks are exposed to doubleruns on assets and liabilities. For identification, we exploit the 2007 freeze of the European interbank market and the Italian Credit Register. After the shock, there are sizeable, aggregate double-runs. In the cross-section, pre-shock interbank exposure is (unconditionally) unrelated to post-shock credit line drawdowns. However, conditioning on firm observable and unobservable characteristics, higher pre-shock interbank exposure implies more post-shock drawdowns. We show that is the result of active pre-shock liquidity risk management by more exposed banks granting credit lines to firms that run less in a crisis.

No. 7
12 April 2016
Bail-in expectations for European banks: Actions speak louder than words
Schäfer, Alexander, Schnabel, Isabel, Weder di Mauro, Beatrice

Abstract

JEL Classification

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

The declared intention of policy makers is that future bank restructuring should be conducted through bail-in rather than bail-out. Over the past years there have been a few cases of European banks being restructured where creditors were bailed in. This paper exploits these events to investigate the market reactions of stock prices and credit default swap (CDS) spreads of European banks in order to gauge the extent to which it is expected that bail-in will indeed become the new regime. We find evidence of increased CDS spreads and falling stock prices most notably after the bail-in in Cyprus. However, bail-in expectations appear to depend on the sovereign’s fiscal strength, i. e., reactions are stronger for banks in countries with limited fiscal space for bail-out. Moreover, actual bail-ins lead to stronger market reactions than the legal implementation of bank resolution regimes, supporting the saying that actions speak louder than words.

No. 6
24 March 2016
Cross-country exposures to the Swiss franc
Bénétrix, Agustín S., Lane, Philip R.

Abstract

JEL Classification

F31 : International Economics→International Finance→Foreign Exchange

O24 : Economic Development, Technological Change, and Growth→Development Planning and Policy→Trade Policy, Factor Movement Policy, Foreign Exchange Policy

Abstract

This paper first documents the foreign currency exposures of Switzerland in the 2002-2012 period. We find that the large scale of the Swiss international balance sheet means that movements in the Swiss Franc generate large cross-border valuation

effects. Second, we examine the Swiss Franc holdings of the rest of the world and highlight differences in exposures between advanced and emerging economies.

No. 5
24 March 2016
Securities trading by banks and credit supply: Micro-evidence from the crisis
Abbassi, Puriya, Iyer, Rajkamal, Peydró, José-Luis, Tous, Francesc R.

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We analyze securities trading by banks during the crisis and the associated spillovers to the supply of credit. We use a proprietary dataset that has the investments of banks at the security level for 2005-2012 in conjunction with the credit register from Germany. We find that – during the crisis – banks with higher trading expertise (trading banks) increase their investments in securities, especially in those that had a larger price drop, with the strongest impact in low-rated and long-term securities. Moreover, trading banks reduce their credit supply, and the credit crunch is binding at the firm level. All of the effects are more pronounced for trading banks with higher capital levels. Finally, banks use central bank liquidity and government subsidies like public recapitalization and implicit guarantees mainly to support trading of securities. Overall, our results suggest an externality arising from fire sales in securities markets on credit supply via the trading behavior of banks.

No. 4
11 March 2016
Capital market financing, firm growth, and firm size distribution
Didier, Tatiana, Levine, Ross, Schmukler, Sergio L.

Abstract

JEL Classification

F65 : International Economics→Economic Impacts of Globalization→Finance

G00 : Financial Economics→General→General

G10 : Financial Economics→General Financial Markets→General

G31 : Financial Economics→Corporate Finance and Governance→Capital Budgeting, Fixed Investment and Inventory Studies, Capacity

G32 : Financial Economics→Corporate Finance and Governance→Financing Policy, Financial Risk and Risk Management, Capital and Ownership Structure, Value of Firms, Goodwill

L25 : Industrial Organization→Firm Objectives, Organization, and Behavior→Firm Performance: Size, Diversification, and Scope

Abstract

How many and which firms issue equity and bonds in domestic and international markets, how do these firms grow relative to non-issuing firms, and how does firm performance vary along the firm size distribution (FSD)? To evaluate these questions, we construct a new dataset by matching data on firm-level capital raising activity with balance sheet data for 45,527 listed firms in 51 countries. Three main patterns emerge from the analysis. (1) Only a few large firms issue equity or bonds, and among them a small subset has raised a large proportion of the funds raised during the 1990s and 2000s. (2) Issuers grow faster than non-issuers in terms of assets, sales, and employment, i.e., firms do not simply use securities markets to adjust their financial accounts. (3) The FSD of issuers evolves differently from that of non-issuers, tightening among issuers and widening among non-issuers.

No. 3
11 March 2016
How excessive is banks’ maturity transformation?
Segura, Anatoli, Suarez, Javier

Abstract

JEL Classification

G01 : Financial Economics→General→Financial Crises

G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

We quantify the gains from regulating maturity transformation in a model of banks which finance long-term assets with non-tradable debt. Banks choose the amount and maturity of their debt trading off investors’ preference for short maturities with the risk of systemic crises. Pecuniary externalities make unregulated debt maturities inefficiently short. The calibration of the model to Eurozone banking data for 2006 yields that lengthening the average maturity of wholesale debt from its 2.8 months to 3.3 months would produce welfare gains with a present value of euro 105 billion, while the lengthening induced by the NSRF would be too drastic.

No. 2
23 February 2016
Macroprudential supervision: From theory to policy
Schoenmaker, Dirk, Wierts, Peter

Abstract

JEL Classification

E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy

G01 : Financial Economics→General→Financial Crises

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

Financial supervision focuses on the aggregate (macroprudential) in addition to the individual (microprudential). But an agreed framework for measuring and addressing financial imbalances is lacking. We propose a holistic approach for the financial system as a whole, beyond banking. Building on our model of financial amplification, the financial cycle is the key variable for measuring financial imbalances. The cycle can be curbed by leverage restrictions that might vary across countries. We make concrete policy proposals for the design of macroprudential instruments to simplify the current framework and make it more consistent.

No. 1
23 February 2016
Macro-Financial Stability Under EMU
Lane, Philip R.

Abstract

JEL Classification

E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy

E65 : Macroeconomics and Monetary Economics→Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook→Studies of Particular Policy Episodes

G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation

Abstract

This paper examines the cyclical behaviour of country-level macro-financial variables under EMU. Monetary union strengthened the covariation pattern between the output cycle and the financial cycle, while macro-financial policies at national and area-wide levels were insufficiently counter-cyclical during the 2003-2007 boom period. We critically examine the policy reform agenda required to improve macro-financial stability.