Tuesday, November 22, 2011

Has the global banking system become more fragile over time?

Has the global banking system become more fragile over time? By Deniz Anginer & Asli Demirguc-Kunt

Abstract: This paper examines time-series and cross-country variations in default risk co-dependence in the global banking system. The authors construct a default risk measure for all publicly traded banks using the Merton contingent claim model, and examine the evolution of the correlation structure of default risk for more than 1,800 banks in more than 60 countries. They find that there has been a significant increase in default risk co-dependence over the three-year period leading to the financial crisis. They also find that countries that are more integrated, and that have liberalized financial systems and weak banking supervision, have higher co-dependence in their banking sector. The results support an increase in scope for international supervisory co-operation, as well as capital charges for "too-connected-to-fail" institutions that can impose significant externalities.


The last decade has seen a tremendous transformation in the global financial sector. Globalization, innovations in communications technology and de-regulation have led to significant growth of financial institutions around the world. These trends had positive economic benefits and have led to increased productivity, increased capital flows, lower borrowing costs, and better price discovery and risk diversification. But the same trends have also led to greater linkages across financial institutions around the world as well as an increase in exposure of these institutions to common sources of risk. The recent financial crisis has demonstrated that financial institutions around the world are highly inter-connected and that vulnerabilities in one market can easily spread to other markets outside of national boundaries.

In this paper we examine whether the global trends described above have led to an increase in co-dependence in default risk of commercial banks around the world. The growing expansion of financial institutions beyond national boundaries over the past decade has resulted in these institutions competing in increasingly similar markets, exposing them to common sources of market and credit risk. During the same period, rapid development of new financial instruments has created new channels of inter-dependency across these institutions. Both increased interconnections and common exposure to risk makes the banking sector more vulnerable to economic, liquidity and information shocks. There is substantial theoretical literature that models the various channels through which such shocks can culminate in a systemic banking crisis (see for instance Bhattacharya and Gale 1987, Allen and Gale 2000, Diamond and Rajan 2005; and focusing on the recent crisis, Brunnermeier 2009, Danielsson, Shin, and Zigrand 2009, Battiston et al. 2009 among others.) To examine whether the global banking sector has become more interdependent and more fragile to shocks, we construct a default risk measure for all publicly traded banks using the Merton (1974) contingent claim model. We compute weekly time series of default probabilities for over 1,800 banks in over 60 countries and examine the evolution of the correlation structure of default risk over the 1998 – 2010 time period.

Our empirical findings show that there has been a substantial increase in co-dependence in default risk of publicly traded banks starting around the beginning of 2004 leading up to the global financial crisis starting in the summer of 2007. Although we observe an overall trend towards convergence in default risk globally, this trend has been much stronger for North American and European banks. We also find that increase in co-dependence has been higher for banks that are larger (with greater than 50 billion in assets). We also examine variation in co-dependence across countries. We find that countries that are more integrated, have liberalized financial systems and weak banking supervision have higher co-dependence in their banking sector.

Increased co-dependence in credit risk in the banking sector has important implications for capital regulations. In the aftermath of the sub-prime crisis of 2007/08, there has been renewed interest in macro-prudential regulation and supervision of the financial system. There has also been a growing consensus to adjust capital requirements to better reflect an individual bank‟s contribution to the risk of the financial system as a whole (Brunnermeier, Crockett, Goodhart, Persaud, and Shin 2009, Financial Stability Forum 2009a, 2009b). Recently a number of papers have tried to measure and quantify systemic risk inherent in the global banking sector. Adrian and Brunnermeier (2009), Huang, Zhou, and Zhou (2009), Chan-Lau and Gravelle (2005), Avesani et al. (2006), and Elsinger and Lehar (2008), use a portfolio credit risk approach to compute the contribution of an individual bank to the risk of a portfolio of banks. Our paper is related to this strand of literature, but our focus is not on quantifying systemic risk of large financial institutions but rather to examine time series trends for a large cross-section of banks. A number of papers have examined the correlation structure of equity returns of a subsample of banks. De Nicolo and Kwast (2002) find rising correlations between bank stock returns in the U.S. from 1988 and 1999. Schuler (2002) find similar results for Europe using a sample from 1980 to 2001. Hawkesby, Marsh and Stevens (2005) analyze co-movements in equity returns for a set of US and European large complex financial institutions using several statistical techniques and find a high degree of commonality. This paper is also related to the literature that studies contagion in financial markets (see among others Forbes and Rigobon 2002, Kee-Hong Bae and Stulz 2003) and also the literature that examines the impact of globalization on convergence of asset prices (Bekeart and Wang 2009, Longin and Solnik 1995, Bekaert and Harvey 2000, and Bekaert, Hodrick and Zhang 2009).

This paper differs from the existing literature in three respects. First, our empirical analyses cast a wider net than the existing literature which focuses only in a particular region or a country and covers a shorter time period. Second we examine time series trends in co-dependence and test for structural changes over time. Finally, we examine cross-country differences in co-dependence and link the differences to measures of financial and economic openness and regulatory frameworks in different countries.

Policymakers may be able to draw important implications from our analysis. Co-dependence in bank default risk has important consequences for systemic stability. We find increasing co-dependence in banks located in different national jurisdictions. Although we do find that strong banking supervision tends to reduce co-dependence in a given country, our results call for banking supervisory co-operation at a global level. This is especially true for larger banks which have grown more interconnected over the past decade.

President Obama can't win by running a constructive campaign, and he won't be able to govern if he does win a second term

The Hillary Moment. By Patrick H Caddell & Douglas E Schoen
President Obama can't win by running a constructive campaign, and he won't be able to govern if he does win a second term.

When Harry Truman and Lyndon Johnson accepted the reality that they could not effectively govern the nation if they sought re-election to the White House, both men took the moral high ground and decided against running for a new term as president. President Obama is facing a similar reality—and he must reach the same conclusion.

He should abandon his candidacy for re-election in favor of a clear alternative, one capable not only of saving the Democratic Party, but more important, of governing effectively and in a way that preserves the most important of the president's accomplishments. He should step aside for the one candidate who would become, by acclamation, the nominee of the Democratic Party: Secretary of State Hillary Clinton.

Never before has there been such an obvious potential successor—one who has been a loyal and effective member of the president's administration, who has the stature to take on the office, and who is the only leader capable of uniting the country around a bipartisan economic and foreign policy.

Certainly, Mr. Obama could still win re-election in 2012. Even with his all-time low job approval ratings (and even worse ratings on handling the economy) the president could eke out a victory in November. But the kind of campaign required for the president's political survival would make it almost impossible for him to govern—not only during the campaign, but throughout a second term.

Put simply, it seems that the White House has concluded that if the president cannot run on his record, he will need to wage the most negative campaign in history to stand any chance. With his job approval ratings below 45% overall and below 40% on the economy, the president cannot affirmatively make the case that voters are better off now than they were four years ago. He—like everyone else—knows that they are worse off.

President Obama is now neck and neck with a generic Republican challenger in the latest Real Clear Politics 2012 General Election Average (43.8%-43.%). Meanwhile, voters disapprove of the president's performance 49%-41% in the most recent Gallup survey, and 63% of voters disapprove of his handling of the economy, according to the most recent CNN/ORC poll.

Consequently, he has to make the case that the Republicans, who have garnered even lower ratings in the polls for their unwillingness to compromise and settle for gridlock, represent a more risky and dangerous choice than the current administration—an argument he's clearly begun to articulate.

One year ago in these pages, we warned that if President Obama continued down his overly partisan road, the nation would be "guaranteed two years of political gridlock at a time when we can ill afford it." The result has been exactly as we predicted: stalemate in Washington, fights over the debt ceiling, an inability to tackle the debt and deficit, and paralysis exacerbating market turmoil and economic decline.

If President Obama were to withdraw, he would put great pressure on the Republicans to come to the table and negotiate—especially if the president singularly focused in the way we have suggested on the economy, job creation, and debt and deficit reduction. By taking himself out of the campaign, he would change the dynamic from who is more to blame—George W. Bush or Barack Obama?—to a more constructive dialogue about our nation's future.

Even though Mrs. Clinton has expressed no interest in running, and we have no information to suggest that she is running any sort of stealth campaign, it is clear that she commands majority support throughout the country. A CNN/ORC poll released in late September had Mrs. Clinton's approval rating at an all-time high of 69%—even better than when she was the nation's first lady. Meanwhile, a Time Magazine poll shows that Mrs. Clinton is favored over former Massachusetts Gov. Mitt Romney by 17 points (55%-38%), and Texas Gov. Rick Perry by 26 points (58%-32%).

But this is about more than electoral politics. Not only is Mrs. Clinton better positioned to win in 2012 than Mr. Obama, but she is better positioned to govern if she does. Given her strong public support, she has the ability to step above partisan politics, reach out to Republicans, change the dialogue, and break the gridlock in Washington.

President Bill Clinton reached a historic agreement with the Republicans in 1997 that led to a balanced budget. Were Mrs. Clinton to become the Democratic nominee, her argument would almost certainly have to be about reconciliation and about an overarching deal to rein in the federal deficit. She will understand implicitly the need to draw up a bipartisan plan with elements similar to her husband's in the mid-to-late '90s—entitlement reform, reform of the Defense Department, reining in spending, all the while working to preserve the country's social safety net.

Having unique experience in government as first lady, senator and now as Secretary of State, Mrs. Clinton is more qualified than any presidential candidate in recent memory, including her husband. Her election would arguably be as historic an event as the election of President Obama in 2008.

By going down the re-election road and into partisan mode, the president has effectively guaranteed that the remainder of his term will be marred by the resentment and division that have eroded our national identity, common purpose, and most of all, our economic strength. If he continues on this course it is certain that the 2012 campaign will exacerbate the divisions in our country and weaken our national identity to such a degree that the scorched-earth campaign that President George W. Bush ran in the 2002 midterms and the 2004 presidential election will pale in comparison.

We write as patriots and Democrats—concerned about the fate of our party and, most of all, our country. We do not write as people who have been in contact with Mrs. Clinton or her political operation. Nor would we expect to be directly involved in any Clinton campaign.

If President Obama is not willing to seize the moral high ground and step aside, then the two Democratic leaders in Congress, Sen. Harry Reid and Rep. Nancy Pelosi, must urge the president not to seek re-election—for the good of the party and most of all for the good of the country. And they must present the only clear alternative—Hillary Clinton.

Mr. Caddell served as a pollster for President Jimmy Carter. Mr. Schoen, who served as a pollster for President Bill Clinton, is author of "Hopelessly Divided: The New Crisis in American Politics and What It Means for 2012 and Beyond," forthcoming from Rowman and Littlefield.