Thursday, February 9, 2012

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach. By German Lopez-Espinosa, Antonio Moreno, Antonio Rubia, and Laura Valderrama
IMF Working Paper No. 12/46
Feb 2012

Summary: In this paper we identify some of the main factors behind systemic risk in a set of international large-scale complex banks using the novel CoVaR approach. We find that short-term wholesale funding is a key determinant in triggering systemic risk episodes. In contrast, we find no evidence that a larger size increases systemic risk within the class of large global banks. We also show that the sensitivity of system-wide risk to an individual bank is asymmetric across episodes of positive and negative asset returns. Since short-term wholesale funding emerges as the most relevant systemic factor, our results support the Basel Committee’s proposal to introduce a net stable funding ratio, penalizing excessive exposure to liquidity risk.


That financial markets move more closely together during times of crisis is a well-documented fact. Conditional correlations among assets are much higher when market returns are low in periods of financial stress; see, among others, King and Wadhwani (1990) and Ang, Chen and Xing (2006). Co-movements typically arise from common exposures to shocks, but also from the propagation of distress associated with a decline in the market value of assets held by individual institutions, a phenomenon we dub balance sheet contraction and which is of particular concern in the financial industry. The recent crisis has shown how the failure of large individual credit institutions can have dramatic effects on the overall financial system and, eventually, spread to the real economy. As a result, international financial policy institutions are currently designing a new regulatory framework for the so-called systemically important financial institutions in order to ensure global financial stability and prevent, or at least mitigate, future episodes of systemic contagion.

In this paper, building on a global system of international financial institutions that comprises the largest banks in a sample of 18 countries, we analyze the main determinants of systemic contagion from an individual institution to the international financial system, i.e., the empirical drivers of tail-risk interdependence. We restrict our attention to a set of large-scale, complex institutions that are the target of current regulation efforts and that would likely be considered too-big-to-fail by central banks. These firms are characterized by their large capitalization, global activity, cross-border exposures and/or representative size in the local industry. Using data spanning the 2001-2009 period, we explicitly measure the contribution of the balance-sheet contraction of these institutions to international financial distress. As regulators seek for meaningful measures of interconnectedness (Walter 2011), this paper contributes to the current debate on prudential regulatory requirements by showing formal evidence that short-term wholesale funding is a major driver of systemic risk in global banking.

Financial institutions use wholesale funding to supplement retail deposits and expand their balance sheets. These funds are typically raised on a short-term rollover basis with instruments such as large-denomination certificates of deposits, brokered deposits, central bank funds, commercial paper and repurchase agreements. Whereas it is agreed that wholesale funding provides certain managerial advantages (see Huang and Ratnovski, 2011, for a discussion), the effects on systemic risk of an overreliance on these liabilities were under-recognized prior to the recent financial crisis. Banks with excessive short-term funding ratios are typically more interconnected to other banks, exposed to a large degree of maturity mismatch and more vulnerable to market conditions and liquidity risk. These features can critically increase the vulnerability of interbank markets and money market mutual funds which act as wholesale providers of liquidity and, eventually, of the whole financial system. The empirical analysis on this paper provides clear evidence on the major role played by short-term wholesale funding to spread systemic risk in global markets.

Additionally, we explore the possibility that the contribution to systemic risk may be asymmetric, i.e. that it depends on whether the market value of a bank’s balance sheet is increasing or decreasing. Because a distressed institution is likely to generate larger externalities on the rest of the financial system when its balance sheet is contracting, an empirical analysis of tail risk-dependence within a financial system should distinguish between episodes of expanding and contracting balance sheets. We deal with this previously unaddressed but key issue, finding strong evidence supporting the existence of asymmetric patterns. Finally, we also analyze the effects of the 2008-2009 global financial crisis on systemic risk and assess the impact of public recapitalizations directly targeted at individual banks.

Our study builds on the novel procedure put forward by Adrian and Brunnermeier (2009), the so-called CoVaR methodology, and generalizes it in several ways in order to deal with the characteristics of a sample of international banks and to address the asymmetric patterns that may underlie tail dependence. The main empirical findings of our analysis can be summarized as follows. First, we find that short-term wholesale funding is the most significant balance sheet determinant of individual contributions to global systemic risk. An increase of one percentage point in this variable leads to an increase in the contribution to systemic risk of 40 basis points of quarterly asset returns. These results support regulatory initiatives aimed at increasing bank liquidity buffers to lessen asset-liability maturity mismatches as a mechanism to mitigate individual liquidity risk, such as the liquidity coverage ratio standard recently laid out by the Basel Committee on Banking Supervision under the new Basel III regulatory framework.3 This paper shows that these provisions may also help to reduce the likelihood of systemic contagion. By contrast, we find little evidence that, within the class of large-scale banks, either relative size or leverage is helpful in predicting future systemic risk after accounting for short-term wholesale funding.

Second, our analysis shows that individual balance sheet contraction produces a significant negative spillover on the Value-at-Risk (VaR) threshold of the global index. Whereas the sensitivity of left tail global returns to a shock in an institution’s market valued asset returns is on average about 0.3, the elasticity conditional on an institution having a shrinking balance sheet is almost three times larger. This result reveals a strong degree of asymmetric response that has not been discussed in the extant literature and which turns out to be larger the more systemic the bank is when its balance sheet is contracting. Therefore, controlling for balance sheet contraction is crucial to rank financial institutions by their contribution to systemic risk.

Third, restricting attention to balance sheet contraction episodes, the credit crisis added up 0.1 percentage points to the co-movement between individual and global asset returns while recapitalization during the crisis period dampened co-movement by 0.2 percentage points.  Furthermore, the timing of recapitalization also matters for systemic risk. Banks that received prompt recapitalization in Q4 2008 proved able to improve their relative position during the crisis period, whereas banks that were rescued by public authorities later in Q4 2009 became relatively more systemic during the crisis period. Finally, the marginal contribution of an individual bank to overall systemic risk increases from 0.76 quarterly percent returns in an average quarter to 0.92 in a quarter characterized by money market turbulence. These results highlight the relevance of crisis episodes in measuring systemic risk and of policy actions in controlling it.

Concluding remarks and policy recommendations
In this paper we examine some of the main factors driving systemic risk in a global framework. We focus on a set of large-scale, international complex institutions which would in principle be deemed too-big-to-fail by national regulators and which are therefore of mayor interest for policy makers. For this class of firms, the evidence based on the CoVaR methodology suggests that short-term wholesale funding –a variable strongly related to interconnectedness and liquidity risk exposure-, is positively and significantly related to systemic risk, whereas other features of the firm, such as leverage or relative size, do not seem to provide incremental information over wholesale funding. This suggests that this latter variable subsumes to a large extent most of the relevant information on systemic risk conveyed by other firm characteristics. We also uncover the relevant role played by asymmetric responses when assessing the impact of individual institutions on system-wide risk, as we find that the sensitivity of system returns to individual bank returns is much higher in periods of balance sheet deleveraging.

Regulators are currently developing a methodological framework within the context of Basel III that attempts to embody the main factors of systemic importance; see Walter (2011). These factors are categorized as size, interconnectedness, substitutability, global activity and complexity, and will serve as a major reference to determine the amount of additional capital requirements and funding ratios for systemically important financial institutions. Our analysis provides formal empirical support to the Basel Committee’s proposal to penalize excessive exposures to liquidity risk by showing that short-term wholesale funding, a variable capturing interconnectedness, largely contributes to systemic risk. Furthermore, since our findings suggest that some factors are much more important than others in determining systemic risk contributions, an optimal capital buffer structure on systemic banks could in principle be designed by suitably weighting the different driving factors as a function of their relative importance. This is an interesting topic for further research. Similarly, the evidence in this paper also offers empirical support to justify the theoretical models that acknowledge the premise that wholesale funding can generate large systemic risk externalities; see, for instance, Perotti and Suarez (2011) for a recent analysis and references therein.

Given the relevance of liquidity strains as a contributing factor to systemic risk, the regulation of systemic risk could be strengthened by giving incentives to disclose contingent short-term liabilities, in particular those related to possible margin calls under credit default swap contracts and repo funding. Our study also points at the role of large trading books as a source of systemic risk –for those banks which were recapitalized during the crisis. As a result, the 2010 revamp of the Basel II capital framework to cover market risk associated with banks’ trading book positions will not only decrease individual risk but will also contribute to mitigate systemic risk.