Global Housing Cycles. By Deniz Igan and Prakash Loungani

Global Housing Cycles. By Deniz Igan and Prakash Loungani
IMF Working Paper No. 12/217
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26229.0

Summary: Housing cycles and their impact on the financial system and the macroeconomy have become the center of attention following the global financial crisis. This paper documents thecharacteristics of housing cycles in a large set of countries, and examines the determinants of house price movements. Empirical analysis shows that house price dynamics are mostly driven by income and demographics but fluctuations in these fundamentals and credit conditions can create deviations from the implied equilibrium path. We conclude with a discussion of the macroeconomic implications of house price corrections.

Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo

Measuring Systemic Liquidity Risk and the Cost of Liquidity Insurance. By Tiago Severo
IMF Working Paper No. 12/194
Jul 31, 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012194

Summary: I construct a systemic liquidity risk index (SLRI) from data on violations of arbitrage relationships across several asset classes between 2004 and 2010. Then I test whether the equity returns of 53 global banks were exposed to this liquidity risk factor. Results show that the level of bank returns is not directly affected by the SLRI, but their volatility increases when liquidity conditions deteriorate. I do not find a strong association between bank size and exposure to the SLRI - measured as the sensitivity of volatility to the index. Surprisingly, exposure to systemic liquidity risk is positively associated with the Net Stable Funding Ratio (NSFR). The link between equity volatility and the SLRI allows me to calculate the cost that would be borne by public authorities for providing liquidity support to the financial sector. I use this information to estimate a liquidity insurance premium that could be paid by individual banks in order to cover for that social cost.

Excerpts:

Introduction

Liquidity risk has become a central topic for investors, regulators and academics in the aftermath of the global financial crisis. The sharp decline of real estate prices in the U.S.  and parts of Europe and the consequent collapse in the values of related securities created widespread concerns about the solvency of banks and other financial intermediaries. The resulting increase in counterparty risk induced investors to shy away from risky short-term funding markets [Gorton and Metrick (2010)] and to store funds in safe and liquid assets, especially U.S. government debt. The dry-up in funding markets hit levered financial intermediaries involved in maturity and liquidity transformation hard [Brunnermeier (2009)], propagating the initial shock through global markets.

Central bankers in major countries responded to the contraction in liquidity by pumping an unprecendented amount of funds into securities and interbank markets, and by creating and extending liquidity backstop lines to rescue troubled financial intermediaries.  Such measures have exposed public finances, and ultimately taxpayers, to the risk of substantial losses. Understanding the origins of systemic liquidity risk in financial markets is, therefore, an invaluable tool for policymakers to reduce the chance of facing these very same challenges again in the future. In particular, if public support in periods of widespread distress cannot be prevented—due to commitment problems—supervisors and regulators should ensure that financial intermediaries are properly monitored and charged to reflect the contingent benefits they enjoy.

The present paper brings three contributions to the topic of systemic liquidity risk:

1) It produces a systemic liquidity risk index (SLRI) calculated from violations of “arbitrage” relationships in various securities markets.

2) It estimates the exposure of 53 global banks to this aggregate risk factor.

3) It uses the information in 2) to devise an insurance system where banks pre-pay for the costs faced by public authorities for providing contingent liquidity support.

Results indicate that systemic illiquidity became a widespread problem in the aftermath of Lehman’s bankruptcy, and it only recovered after several months. Systemic liquidity risk spiked again during the Greek sovereign crisis in the second quarter of 2010, albeit at much more moderate levels. Yet, the renewed concerns regarding sovereign default in peripheral Europe observed in the last quarter of 2010 did not induce global liquidity shortfalls.

In terms of exposures of individual institutions, I find that, in general, systemic liquidity risk does not affect the level of bank stock returns on a systematic fashion.  However, liquidity risk is strongly correlated with the volatility of bank stocks: system wide illiquidity is associated with riskier banks. Estimates also show that U.S. and U.K. banks were relatively more exposed to liquidity conditions compared to Japanese institutions, with continental European banks lying in the middle of the distribution. More specifically, the results indicate that U.S. and U.K. banks’ stocks became much more volatile relative to their Asian peers when liquidity evaporated. This likely reflects the higher degree of maturity transformation and the reliance on very short-term funding by Anglo-Saxon banks. A natural question is whether bank specific characteristics beyond geographic location reflect the different degrees of exposure to liquidity risk.

I start the quest for those bank characteristics by looking at the importance of bank size for liquidity risk exposure. Market participants, policymakers and academics have highlighted the role of size and interconnectedness as a source of systemic risk. To verify this claim, I form quintile portfolios of banks based on market capitalization and test whether there are significant differences in the sensitivity of their return volatility to the SLRI. The estimates suggest that size has implications for liquidity risk, but the relationship is highly non-linear. The association between size and sensitivity to liquidity conditions is only relevant for the very large banks, and it becomes pronounced only when liquidity conditions deteriorate substantially.

Recently, the Basel Committee on Banking Supervision produced, for the first time, a framework (based on balance sheet information) to regulate banks’ liquidity risk. In particular, it proposed two liquidity ratios that shall be monitored by supervisors: the Liquidity Coverage Ratio (LCR), which indicates banks’ ability to withstand a short-term liquidity crisis, and the Net Stable Funding Ratio (NSFR), which measures the long-term, structural funding mismatches in a bank. Forming quintile portfolios based on banks' NSFR, I find that, if anything, the regulatory ratio is positively associated with the exposure to the SLRI. In other words, banks with a high NSFR (the ones deamed to be structurally more liquid) are in fact slightly more sensitive to liquidity conditions. This counterintuitive result needs to be qualified. As noted later, the SLRI captures short-term liquidity stresses, whereas the NSFR is designed as a medium to long-term indicator of liquidity conditions. Certainly, it would be more appropriate to test the performance of LCR instead. However, the data necessary for its computation are not readily available.

The link between bank stock volatility and the SLRI allows me to calculate the cost faced by public authorities for providing liquidity support for banks. Relying on the contingent claims approach (CCA), I use observable information on a bank’s equity and the book value of its liabilities to back out the unobserved level and volatility of its assets. I then estimate by how much the level and volatility of implied assets change as liquidity conditions deteriorate, and how such changes affect the price of a hypothetical put option on the bank’s assets. Because the price of this put indicates the cost of public support to banks, variations in the put due to fluctuations in the SLRI provide a benchmark for charging banks according to their exposure to systemic liquidity risk, a goal that has been advocated by many experts on bank regulation. 


http://www.imf.org/external/pubs/cat/longres.aspx?sk=26131.0

Austerity Debate a Matter of Degree -- In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart

Austerity Debate a Matter of Degree. By Stephen Fidler
In Europe, Opinions Differ on Depth, Timing of Cuts; International Monetary Fund Has Change of Heart
Wall Street Journal, February 17, 2012
http://online.wsj.com/article/SB10001424052970204792404577227273553955752.html

Excerpts

In the U.S., the debate about whether the government should start cutting its budget deficit opens up a deep ideological divide. Many countries in Europe don't have that luxury.

True, there may be questions about how hard to cut budgets and how best to time the cuts, but with government-bond investors going on strike, policy makers either don't have a choice or feel they don't. Budget austerity is also a recipe favored by Germany and other euro-zone governments that hold the Continent's purse strings.

Once upon a time, the International Monetary Fund, which also provides bailout funds and lend its crisis management expertise to euro-zone governments, would have been right there with the Germans: It never handled a financial crisis for which tough austerity wasn't the prescribed medicine. In Greece, however, officials say the IMF supported spreading the budget pain over a number of years rather than concentrating it at the front end.

That is partly because overpromising the undeliverable hurts government credibility, which is essential to overcoming the crisis. But it is also because the IMF's view has shifted.

"Over its history, the IMF has become less dogmatic about fiscal austerity being always the right response to a crisis," said Laurence Ball, economics professor at Johns Hopkins University, and a part-time consultant to the IMF.

These days, the fund worries more than it did about the negative impact that cutting budgets has on short-term growth prospects—a traditional concern of Keynesian economists.

"Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1% of [gross domestic product] typically reduces GDP by about 0.5% within two years and raises the unemployment rate by about 0.3 percentage point," the IMF said in its 2010 World Economic Outlook:

But that isn't the full story. In the first place, the IMF agrees that reducing government debt—which is what austerity should eventually achieve—has long-term economic benefits. For example, in a growing economy close with strong employment, reduced competition for savings should lower the cost of capital for private entrepreneurs.

That suggests that, where bond markets give governments the choice, there is a legitimate debate to be had about timing of austerity. The IMF economic models suggest it will be five years before the "break-even" point when the benefits to growth of cutting debt start to exceed the "Keynesian" effects of austerity.

There is an alternative hypothesis that has a lot of support in Germany, and among the region's central bankers. This is the notion that budget cutbacks stimulate growth in the short term, often referred to as the "expansionary fiscal contraction" hypothesis.

Manfred Neumann, professor emeritus of economics at the Institute for Economic Policy at the University of Bonn, said the view is also called the "German hypothesis" since it emerged from a round of German budget cutting in the early 1980s.

"The positive effect of austerity is much stronger than most people believe," he said. The explanation for the beneficial impact is that cutting government debt generates an improvement in confidence among households and entrepreneurs, he said.

The IMF concedes there may be something in this for countries where people are worried about the risk that the government might default—but only up to a point. It concedes that fiscal retrenchment in such countries "tends to be less contractionary" than in countries not facing market pressures—but doesn't conclude that budget cutting in such circumstances is actually expansionary.

Each side of the debate invokes its own favored study. Support for the "German hypothesis" comes from two Harvard economists with un-German names—Alberto Alesina and Silvia Ardagna. But their critics, who include Mr. Ball, say their sample includes many irrelevant episodes for which their model fails to correct—including, for example, the U.S. "fiscal correction" that was born out of the U.S. economic boom of the late 1990s.

Mr. Alesina didn't respond to an email asking for comment, but Mr. Neumann said he isn't confident that studies, such as the IMF's, that appear to refute the hypothesis manage to isolate the effects of the austerity policy from other effects of a financial crisis.

Some of the IMF's conclusions, however, bode ill for the euro zone's budget cutters.

The first is that the contractionary effects of fiscal retrenchment are often partly offset by an increase in exports—but less so in countries where the exchange rate is fixed. Second, the pain is greater if central banks can't offset the fiscal austerity through a stimulus in monetary policy. With interest rates close to zero in the euro zone, such a stimulus is hard to achieve. Third, when many countries are cutting budgets at the same time, the effect on economic activity in each is magnified.

If you are a government in budget-cutting mode, there are, however, better and worse ways of doing it. The IMF says spending cuts tend to have less negative impact on the economy than tax increases. However, that is partly because central banks tend to cut interest rates more aggressively when they see spending cuts.

Mr. Neumann sees an austerity hierarchy. It is better to cut government consumption and transfers, including staff costs, than government investment—though it may be harder politically. If you are raising taxes, better to raise those with no impact on incentives—such as inheritance or wealth taxes—than those that hurt incentives, such as income or payroll taxes.

Raising sales or value-added taxes may have less impact on incentives—but have other undesirable effects, such as increasing inflation, that could deter central banks from easing policy.

Macro-prudential Policy in a Fisherian Model of Financial Innovation

Macro-prudential Policy in a Fisherian Model of Financial Innovation. By Bianchi, Javier; Boz, Emine; Mendoza, Enrique G.
IMF Working Paper No. 12/181
Jul 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26051.0

Summary: The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs played a central role in the 2008 financial crisis. This paper develops a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study the effects of macro-prudential policy. Financial innovation enhances the ability of agents to collateralize assets into debt, but the riskiness of this new regime can only be learned over time. Beliefs about transition probabilities across states with high and low ability to borrow change as agents learn from observed realizations of financial conditions. At the same time, the collateral constraint introduces a pecuniary externality, because agents fail to internalize the effect of their borrowing decisions on asset prices. Quantitative analysis shows that the effectiveness of macro-prudential policy in this environment depends on the government's information set, the tightness of credit constraints and the pace at which optimism surges in the early stages of financial innovation. The policy is least effective when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.

Excerpts:

Policymakers have responded to the lapses in financial regulation in the years before the 2008 global financial crisis and the unprecedented systemic nature of the crisis itself with a strong push to revamp financial regulation following a "macro-prudential" approach. This approach aims to focus on the macro (i.e. systemic) implications that follow from the actions of credit market participants, and to implement policies that influence behavior in "good times" in order to make financial crises less severe and less frequent. The design of macro-prudential policy is hampered, however, by the need to develop models that are reasonably good at explaining the macro dynamics of financial crises and at capturing the complex dynamic interconnections between potential macro-prudential policy instruments and the actions of agents in credit markets.

The task of developing these models is particularly challenging because of the fast pace of financial development. Indeed, the decade before the 2008 crash was a period of significant financial innovation, which included both the introduction of a large set of complex financial instruments, such as collateralized debt obligations, mortgage backed securities and credit default swaps, and the enactment of major financial reforms of a magnitude and scope unseen since the end of the Great Depression. Thus, models of macro-prudential regulation have to take into account the changing nature of the financial environment, and hence deal with the fact that credit market participants, as well as policymakers, may be making decisions lacking perfect information about the true riskiness of a changing financial regime.

This paper proposes a dynamic stochastic general equilibrium model in which the interaction between financial innovation, credit frictions and imperfect information is at the core of the financial transmission mechanism, and uses it to study its quantitative implications for the design and effectiveness of macro-prudential policy. In the model, a collateral constraint limits the agents' ability to borrow to a fraction of the market value of the assets they can offer as collateral. Financial innovation enhances the ability of agents to "collateralize," but also introduces risk because of the possibility of fluctuations in collateral requirements or loan-to-value ratios.  We take literally the definition of financial innovation to be the introduction of a truly new financial regime. This forces us to deviate from the standard assumption that agents formulate rational expectations with full information about the stochastic process driving fluctuations in credit conditions. In particular, we assume that agents learn (in Bayesian fashion) about the transition probabilities of financial regimes only as they observe regimes with high and low ability to borrow over time. In the long run, and in the absence of new waves of financial innovation, they learn the true transition probabilities and form standard rational expectations, but in the short run agents' beliefs display waves of optimism and pessimism depending on their initial priors and on the market conditions they observe. These changing beliefs influence agents' borrowing decisions and equilibrium asset prices, and together with the collateral constraint they form a financial amplification feedback mechanism: optimistic (pessimistic) expectations lead to over-borrowing (under-borrowing) and increased (reduced) asset prices, and as asset prices change the ability to borrow changes as well.

Our analysis focuses in particular on a learning scenario in which the arrival of financial innovation starts an "optimistic phase," in which a few observations of enhanced borrowing ability lead agents to believe that the financial environment is stable and risky assets are not "very risky." Hence, they borrow more and bid up the price of risky assets more than in a full-information ra- tional expectations equilibrium. The higher value of assets in turn relaxes the credit constraint.  Thus, the initial increase in debt due to optimism is amplified by the interaction with the collateral constraint via optimistic asset prices. Conversely, when the first realization of the low-borrowing- ability regime is observed, a "pessimistic phase" starts in which agents overstate the probability of continuing in poor financial regimes and overstate the riskiness of assets. This results in lower debt levels and lower asset prices, and the collateral constraint amplifies this downturn.

Macro-prudential policy action is desirable in this environment because the collateral constraint introduces a pecuniary externality in credit markets that leads to more debt and financial crises that are more severe and frequent than in the absence of this externality. The externality exists because individual agents fail to internalize the effect of their borrowing decisions on asset prices, particularly future asset prices in states of financial distress (in which the feedback loop via the collateral constraint triggers a financial crash).

There are several studies in the growing literature on macro-prudential regulation that have examined the implications of this externality, but typically under the assumption that agents form rational expectations with full information (e.g. Lorenzoni (2008), Stein (2011), Bianchi (2011), Bianchi and Mendoza (2010), Korinek (2010), Jeanne and Korinek (2010), Benigno, Chen, Otrok, Rebucci, and Young (2010)). In contrast, the novel contribution of this paper is in that we study the effects of macro-prudential policy in an environment in which the pecuniary externality is influenced by the interaction of the credit constraint with learning about the riskiness of a new financial regime. The analysis of Boz and Mendoza (2010) suggest that taking this interaction into account can be important, because they found that the credit constraint in a learning setup produces significantly larger effects on debt and asset prices than in a full-information environment with the same credit constraint. Their study, however, focused only on quantifying the properties of the decentralized competitive equilibrium and abstracted from normative issues and policy analysis. The policy analysis of this paper considers a social planner under two different informational assumptions. First, an uninformed planner who has to learn about the true riskiness of the new financial environment, and faces the set of feasible credit positions supported by the collateral values of the competitive equilibrium with learning. We start with a baseline scenario in which private agents and the planner have the same initial priors and thus form the same sequence of beliefs, and study later on scenarios in which private agents and the uninformed planner form different beliefs. Second, an informed planner with full information, who therefore knows the true transition probabilities across financial regimes, and faces a set of feasible credit positions consistent with the collateral values of the full-information, rational expectations competitive equilibrium.

We compute the decentralized competitive equilibrium of the model with learning (DEL) and contrast this case with the above social planner equilibria. We then compare the main features of these equilibria, in terms of the behavior of macroeconomic aggregates and asset pricing indicators, and examine the characteristics of macro-prudential policies that support the allocations of the planning problems as competitive equilibria. This analysis emphasizes the potential limitations of macro-prudential policy in the presence of significant financial innovation, and highlights the relevance of taking into account informational frictions in evaluating the effectiveness of macro-prudential policy.

The quantitative analysis indicates that the interaction of the collateral constraint with optimistic beliefs in the DEL equilibrium can strengthen the case for introducing macro-prudential regulation compared with the decentralized equilibrium under full information (DEF). This is because, as Boz and Mendoza (2010) showed, the interaction of these elements produces larger amplification both of the credit boom in the optimistic phase and of the financial crash when the economy switches to the bad financial regime. The results also show, however, that the effectiveness of macro-prudential policy varies widely with the assumptions about the information set and collateral pricing function used by the social planner. Moreover, for the uninformed planner, the effectiveness of macro-prudential policy also depends on the tightness of the borrowing constraint and the pace at which optimism builds in the early stages of financial innovation.

Consider first the uninformed planner. For this planner, the undervaluation of risk weakens the incentives to build precautionary savings against states of nature with low-borrowing-ability regimes over the long run, because this planner underestimates the probability of landing on and remaining in those states. In contrast, the informed planner assesses the correct probabilities of landing and remaining in states with good and bad credit regimes, so its incentives to build precautionary savings are stronger. In fact, the informed planner's optimal macro-prudential policy features a precautionary component that lowers borrowing levels at given asset prices, and a component that influences portfolio choice of debt v. assets to address the effect of the agents' mispricing of risk on collateral prices.

It is important to note that even the uninformed planner has the incentive to use macro-prudential policy to tackle the pecuniary externality and alter debt and asset pricing dynamics. In our baseline calibration, however, the borrowing constraint becomes tightly binding in the early stages of financial innovation as optimism builds quickly, and as a result macro-prudential policy is not very effective (i.e. debt positions and asset prices differ little between the DEL and the uninformed planner). Intuitively, since a binding credit constraint implies that debt equals the high-credit-regime fraction of the value of collateral, debt levels for the uninformed social planner and the decentralized equilibrium are similar once the constraint becomes binding for the planner. But this is not a general result.2 Variations in the information structure in which optimism builds more gradually produce outcomes in which macro-prudential policy is effective even when the
planner has access to the same information set. On the other hand, it is generally true that the uninformed planner allows larger debt positions than the informed planner because of the lower precautionary savings incentives.

We also analyze the welfare losses that arise from the pecuniary externality and the optimism embedded in agents' subjective beliefs. The losses arising due to their combined e®ect are large, reaching up to 7 percent in terms of a compensating variation in permanent consumption that equalizes the welfare of the informed planner with that of the DEL economy. The welfare losses attributable to the pecuniary externality alone are relatively small, in line with the findings reported by Bianchi (2011) and Bianchi and Mendoza (2010), and they fall significantly at the peak of optimism.

Our model follows a long and old tradition of models of financial crises in which credit frictions and imperfect information interact. This notion dates back to the classic work of Fisher (1933), in which he described his debt-deflation financial amplification mechanism as the result of a feedbackloop between agents' beliefs and credit frictions (particularly those that force fires sales of assets and goods by distressed borrowers). Minsky (1992) is along a similar vein. More recently, macroeconomic models of financial accelerators (e.g. Bernanke, Gertler, and Gilchrist (1999), Kiyotaki and Moore (1997), Aiyagari and Gertler (1999)) have focused on modeling financial amplification but typically under rational expectations with full information about the stochastic processes of exogenous shocks.

The particular specification of imperfect information and learning that we use follows closely that of Boz and Mendoza (2010) and Cogley and Sargent (2008a), in which agents observe regime realizations of a Markov-switching process without noise but need to learn its transition probability matrix. The imperfect information assumption is based on the premise that the U.S. financial system went through significant changes beginning in the mid-90s as a result of financial innovation and deregulation that took place at a rapid pace. As in Boz and Mendoza (2010), agents go through a learning process in order to "discover" the true riskiness of the new financial environment as they observe realizations of regimes with high or low borrowing ability.

Our quantitative analysis is related to Bianchi and Mendoza (2010)'s quantitative study of macro-prudential policy. They examined an asset pricing model with a similar collateral constraint and used comparisons of the competitive equilibria vis-a-vis a social planner to show that optimal macro-prudential policy curbs credit growth in good times and reduces the frequency and severity of financial crises. The government can accomplish this by using Pigouvian taxes on debt and dividends to induce agents to internalize the model's pecuniary externality. Bianchi and Mendoza's framework does not capture, however, the role of informational frictions interacting with frictions in financial markets, and thus is silent about the implications of di®erences in the information sets of policy-makers and private agents.

Our paper is also related to Gennaioli, Shleifer, and Vishny (2010), who study financial innovation in an environment in which "local thinking" leads agents to neglect low probability adverse events (see also Gennaioli and Shleifer (2010)). As in our model, the informational friction distorts decision rules and asset prices, but the informational frictions in the two setups differ.3 Moreover, the welfare analysis of Gennaioli, Shleifer, and Vishny (2010) focuses on the effect of financial innovation under local thinking, while we emphasize the interaction between a fire-sale externality and informational frictions.

Finally, our work is also related to the argument developed by Stein (2011) to favor a cap and trade system to address a pecuniary externality that leads banks to issue excessive short-term debt in the presence of private information. Our analysis differs in that we study the implications of a form of model uncertainty (i.e. uncertainty about the transition probabilities across financial regimes) for macro-prudential regulation, instead of private information, and we focus on Pigouvian taxes as a policy instrument to address the pecuniary externality.

The (Other) Deleveraging. By Manmohan Singh

The (Other) Deleveraging. By Manmohan Singh
IMF Working Paper No. 12/179
July 2012
http://www.imfbookstore.org/IMFORG/WPIEA2012179

Summary: Deleveraging has two components--shrinking of balance sheets due to increased haircuts/shedding of assets, and the reduction in the interconnectedness of the financial system. We focus on the second aspect and show that post-Lehman there has been a significant decline in the interconnectedness in the pledged collateral market between banks and nonbanks. We find that both the collateral and its associated velocity are not rebounding as of end-2011 and still about $4-5 trillion lower than the peak of $10 trillion as of end-2007. This paper updates Singh (2011) and we use this data to compare with the monetary aggregates (largely due to QE efforts in US, Euro area and UK), and discuss the overall financial lubrication that likely impacts the conduct of global monetary policy.


Excerpts:

Deleveraging from shrinking of bank balance sheets is not (yet) taking place; however, we still find the financial system imploding.

The reduction in debt (or deleveraging) has two components. The first (and more familiar) involves the shrinking of balance sheets. The other is a reduction in the interconnectedness of the financial system (Figure 1). Most recent researchers have focused on the impact of smaller balance sheets, overlooking this ‘other’ deleveraging resulting from reduced interconnectedness. Yet, as the current crisis unfolds, key actors in the global financial system seem to be “ring fencing” themselves owing to heightened counterparty risk. While “rational” from an individual perspective, this behavior may have unintended consequences for the financial markets.

The interconnections nexus has become considerably more complex over the past two decades.  The interconnectedness of the financial system aspect may be viewed from the lens of collateral chains. Typically, collateral from hedge funds, pension, insurers, central banks etc., is intermediated by the large global banks. For example, a Hong Kong hedge fund may get financing from UBS secured by its collateral. This collateral may include, say, Indonesian bonds which will be pledged to UBS, (U.K.) for re-use. There may be demand for such bonds from, for instance, a pension fund in Chile who may have Santander as its global bank.  However, due to heightened counterparty risk, UBS may not want to onward pledge to Santander, despite demand for the collateral with UBS. Fewer trusted counterparties in the market owing to elevated counterparty risk leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging. In volume terms, over the past decade this collateral use has become on par with monetary aggregates like M2.

The balance sheet shrinking due to ‘price decline’ (i.e., increased haircuts) has been studied extensively [...]. But the balance sheet shrinkage is being postponed—Euro area bank balance sheets may have increased up to €500bn since the end of November, 2011 helped by the liquidity injection from ECB’s 3-year Long Term Repo Operations or LTROs (net of reduced Monthly Repurchase Operations, MROs).

However, de-leveraging of the financial system due to the shortening of ‘re-pledging chains’ has not (yet) received attention. This deleveraging is taking place despite the recent official sector support. This second component of deleveraging is contributing towards the higher credit cost to the real economy. In fact, relative to 2006, the primary indices that measure aggregate borrowing cost are well over 2.5 times in the U.S. and 4 times in the Eurozone (see Figure 2). This is after adjusting for the central bank rate cuts which have lowered the total cost of borrowing for similar corporates (e.g., in the U.S., from about 6% in 2006 to about 4% at present). Figure 3 shows that for the past three decades, the cost of borrowing for financials has been below non-financials; however this has changed post-Lehman. Since much of the real economy resorts to banks to borrow (aside from the large industrials), the higher borrowing cost for banks is then passed on the real economy.

As the “other” deleveraging continues, the financial system remains short of high-grade collateral that can be re-pledged. Recent official sector efforts such as ECB’s “flexibility” (and the ELA programs of national central banks in the Eurozone) in accepting “bad” collateral attempts to keep the good/bad collateral ratio in the market higher than otherwise. ECB’s acceptance of good and bad collateral at non market price brings Gresham's law into play. But, if such moves become part of the central banker’s standard toolkit, the fiscal aspects and risks associated with such policies cannot be ignored. By so doing, the central banks have interposed themselves as risk-taking intermediaries with the potential to bring significant unintended consequences.

Paths to Eurobonds

Paths to Eurobonds. By Stijn Claessens, Ashoka Mody, and Shahin Vallée
July, 2012
IMF Working Paper No. 12/172
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012172

Summary: This paper discusses proposals for common euro area sovereign securities. Such instruments can potentially serve two functions: in the short-term, stabilize financial markets and banks and, in the medium-term, help improve the euro area economic governance framework through enhanced fiscal discipline and risk-sharing. Many questions remain on whether financial instruments can ever accomplish such goals without bold institutional and political decisions, and, whether, in the absence of such decisions, they can create new distortions. The proposals discussed are also not necessarily competing substitutes; rather, they can be complements to be sequenced along alternative paths that possibly culminate in a fully-fledged Eurobond. The specific path chosen by policymakers should allow for learning and secure the necessary evolution of institutional infrastructures and political safeguards.

Excerpts:

The European Monetary Union was purposefully designed as a monetary union without a fiscal union. History has not been kind to such arrangements, as Bordo et al. (2011) argue and as several critics had warned before the eurozone came into being (for a review of that earlier literature, see Bornhorst, Mody, and Ohnsorge, forthcoming). The ongoing crisis appears to have validated these concerns. The absence of formal pooling of resources has required the construction of additional arrangements for inter-governmental fiscal support to respond to countries in crisis. These arrangements include the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM). And as the crisis has evolved, the European Central Bank (the ECB) has needed to play an important role in supporting banks and, indirectly, sovereigns in need.

In this context, the common issuance of debt in the euro area has been increasingly evoked— including most recently by the European Parliament and the European Council—both as an immediate response to the financial crisis and as a structural feature of the monetary union.

This paper is a review of various proposals for common debt issuance. Clearly, common instruments are not the only or necessarily the primary way to reduce financial instability or improve economic, financial and fiscal governance in the euro area. Indeed, common debt issuance is inextricably linked to the shape and form of a future fiscal union. Because a fiscal (and banking) union is likely a longer-term project, a discussion of common instruments today can help sharpen the discussion of the choices underlying a fiscal union and possibly initiate more limited forms of risk-sharing and pooling that create a valuable learning process.

In undertaking this review, we are motivated by the following questions:

* How does the proposal change incentives of governments (debtors) and creditors?  Does it offer clarity on how average and marginal costs of borrowing would be affected, and how default would be treated?

* What is the nature of the insurance that is being offered? Would the new instrument help reduce risk and improve liquidity? Who will want to hold those instruments?

* Would the (currently perverse) sovereign-bank linkages be reduced? What are effects on current financial markets (ill)functioning?

* What are the phasing-in, transitional, legal, and institutional issues?

* And, are there paths along which the different proposed instruments may be combined?

Conclusions

Common debt could bring reprieve from current financial instability. Specifically, the creation of a large safe asset can reduce flight to safety from one sovereign to another and weaken the links between banks and their respective sovereigns that are currently destabilizing. Common debt issuance could also be a structural stabilizing feature of the euro area by helping to create deeper and more liquid financial markets allowing the monetary union to capture the liquidity gains of a broader sovereign debt market. Importantly, these initiatives can serve to focus attention on the need for fiscal federalism including macroeconomic stabilization and risk-sharing mechanisms but also fiscal discipline.

But there clearly are risks associated with such common instruments. In terms of fiscal discipline, the pricing approaches, where countries’ own debt is lower ranked and hence pays a higher price, are intriguing. But the tranching creates new challenges, not least if the junior tranches replicate the instability that we are currently witnessing. Similarly, to the extent that funds are earmarked to repay the common debt, greater pro-cyclicality may ensue as earmarked resources are less available to deal with adverse shocks.

Ideally then, common debt should follow from a fundamental discussion of the long-term shape of a fiscal, financial and monetary union. The absence of a debate on fiscal union reflects in part historical concerns that one group of countries may become dependent on another group on a permanent basis. But short of addressing these fundamental issues completely, common debt issuance can initiate a political process towards this goal. If, for the moment, there is only appetite for limited and bounded fiscal risk-sharing, then the Eurobills can start a learning process. These could be scaled up if proven successful and evolve towards more ambitious structures. If the assessment is that a key task today is to bring debt-to-GDP ratios down before further progress can be made, then the Redemption Pact is the right first step. But this would take 20-25 years and delay the creation of a permanent mechanism to complete the monetary union.

Thus, addressing both the current debt overhang problem and insuring against loss of market access likely requires combining several proposals. And while a gradual phase-in provides some advantages, in particular as it can foster a political discussion about fiscal risk-sharing and transfers, the current financial crisis might call for more rapid introduction. Regardless, steps towards common debt issuance require an open political discussion given the importance of accountability and legitimacy dimensions associated with the embryonic creation of a fiscal union. Federations are not static political constructs and common debt issuance can both contribute to effective economic management and act as a catalyst for political change. In that sense, the proposals put forward are a constructive feature of the ongoing discussion, forcing a critical and focused rethinking of the EMU architecture.

Monitoring Systemic Risk Based on Dynamic Thresholds

Monitoring Systemic Risk Based on Dynamic Thresholds. By Kasper Lund-Jensen
IMF Working Paper No. 12/159
June 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012159

Summary: Successful implementation of macroprudential policy is contingent on the ability to identify and estimate systemic risk in real time. In this paper, systemic risk is defined as the conditional probability of a systemic banking crisis and this conditional probability is modeled in a fixed effect binary response model framework. The model structure is dynamic and is designed for monitoring as the systemic risk forecasts only depend on data that are available in real time. Several risk factors are identified and it is hereby shown that the level of systemic risk contains a predictable component which varies through time. Furthermore, it is shown how the systemic risk forecasts map into crisis signals and how policy thresholds are derived in this framework. Finally, in an out-of-sample exercise, it is shown that the systemic risk estimates provided reliable early warning signals ahead of the recent financial crisis for several economies.

Excerpts:

Introduction

The financial crisis in 2007–09, and the following global economic recession, has highlighted the importance of a macroprudential policy framework which seeks to limit systemic financial risk.  While there is still no consensus on how to implement macroprudential policy it is clear that successful implementation is contingent on establishing robust methods for monitoring systemic risk.3 This current paper makes a step towards achieving this goal. Systemic risk assessment in real time is a challenging task due to the intrinsically unpredictable nature of systemic financial risk. However, this study shows, in a fixed effect binary response model framework, that systemic risk does contain a component which varies in a predictable way through time and that modeling this component can potentially improve policy decisions.

In this paper, systemic risk is defined as the conditional probability of a systemic banking crisis and I am interested in modeling and forecasting this (potentially) time varying probability. If different systemic banking crises differ completely in terms of underlying causes, triggers, and economic impact the conditional crisis probability will be unpredictable. However, as illustrated in section IV, systemic banking crises appear to share many commonalities. For example, banking crises are often preceded by prolonged periods of high credit growth and tend to occur when the banking sector is highly leveraged.

Systemic risk can be characterized by both cross-sectional and time-related dimensions (e.g.  Hartmann, de Bandt, and Alcalde, 2009). The cross-sectional dimension concerns how risks are correlated across financial institutions at a given point in time due to direct and indirect linkages across institutions and prevailing default conditions. The time series dimension concerns the evolution of systemic risk over time due to changes in the macroeconomic environment. This includes changes in the default cycle, changes in financial market conditions, and the potential build-up of financial imbalances such as asset and credit market bubbles. The focus in this paper is on the time dimension of systemic risk although the empirical analysis includes a variable that proxies for the strength of interconnectedness between financial institutions.

This paper makes the following contributions to the literature on systemic risk assessment: Firstly, it employs a dynamic binary response model, based on a large panel of 68 advanced and emerging economies, to identify leading indicators of systemic risk. While Demirgüç-Kunt and Detragiache (1998a) study the determinants of banking crises the purpose of this paper is to evaluate whether systemic risk can be monitored in real time. Consequently, it employs a purely dynamic model structure such that the systemic risk forecasts are based solely on information available in real time. Furthermore, the estimation strategy employed in this paper is consistent under more general conditions than a random effect estimator used in other studies (e.g.  Demirgüç-Kunt and Detragiache (1998a) and Wong, Wong and Leung (2010)). Secondly, this paper shows how to derive risk factor thresholds in the binary response model framework. The threshold of a single risk factor is dynamic in the sense that it depends on the value of the other risk factors and it is argued that this approach has some advantages relative to static thresholds based on the signal extraction approach.4 Finally, I perform a pseudo out-of-sample analysis for the period 2001–2010 in order to assess whether the risk factors provided early-warning signals ahead of the recent financial crisis.

Based on the empirical analysis, I reach the following main conclusions:

1. Systemic risk, as defined here, does appear to be predictable in real time. In particular, the following risk factors are identified: banking sector leverage, equity price growth, the credit-to-GDP gap, real effective exchange rate appreciation, changes in the banks’ lending premium and the degree of banks interconnectedness as measured by the ratio of non-core to core bank liabilities. There is also some evidence which suggests that house price growth increases systemic risk but the effect is not statistically significant at conventional significance levels.

2. There exists a significant contagion effect between economies. When an economy with a large financial sector is experiencing a systemic banking crisis, the systemic risk forecasts in other economies increases significantly.

3. Rapid credit growth in a country is often associated with a higher level of systemic risk.  However, as highlighted in a recent IMF report (2011), a boom in credit can also reflect a healthy market response to expected future productivity gains as a result of new technology, new resources or institutional improvements. Indeed, many episodes of credit booms were not followed by a systemic banking crisis or any other material instability. It is critical that a policymaker is able to distinguish between these two scenarios when implementing economic policy. I find empirical evidence which suggests that credit growth increases systemic risk considerably more when accompanied by high equity price growth. Therefore, I argue that the evolution in equity prices can be useful for identifying a healthy credit expansion.

4. In a crisis signaling exercise, I find that the binary response model approach outperforms the popular signal extracting approach in terms of type I and type II errors.

5. Based on a model specification with credit-to-GDP growth, banking sector leverage and equity price growth I carefully evaluate the optimal credit-to-GDP growth threshold.  Contrary to the signal extraction approach the optimal threshold is not static but depends on the value of the other risk factors. For example, the threshold is around 10 percent if equity prices have decreased by 10 percent and banking sector leverage is around 130 percent but only around 0 percent if equity prices have grown by 20 percent and banking sector leverage is 160 percent. In comparison, the signal extraction method leads to a (static) credit-to-GDP growth threshold of 4.9 percent based on the same data sample.

6. In the out-of-sample analysis, I find that the systemic risk factors generally provided informative signals in many countries. Based on an in-sample calibration, around 50– 80 percent of the crises were correctly identified in real time without constructing too many false signals. In particular, a monitoring model based on credit-to-GDP growth and banking sector leverage signaled early warning signals ahead of the U.S. subprime crisis in 2007.

Systemic Risk and Asymmetric Responses in the Financial Industry

Systemic Risk and Asymmetric Responses in the Financial Industry. By López-Espinosa, Germán; Moreno, Antonio; Rubia, Antonio; and Valderrama, Laura
IMF Working Paper No. 12/152
June, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25991.0

Summary: To date, an operational measure of systemic risk capturing non-linear tail comovement between system-wide and individual bank returns has not yet been developed. This paper proposes an extension of the so-called CoVaR measure that captures the asymmetric response of the banking system to positive and negative shocks to the market-valued balance sheets of individual banks. For the median of our sample of U.S. banks, the relative impact on the system of a fall in individual market value is sevenfold that of an increase. Moreover, the downward bias in systemic risk from ignoring this asymmetric pattern increases with bank size. The conditional tail comovement between the banking system and a top decile bank which is losing market value is 5.4 larger than the unconditional tail comovement versus only 2.2 for banks in the bottom decile. The asymmetric model also produces much better estimates and fitting, and thus improves the capacity to monitor systemic risk. Our results suggest that ignoring asymmetries in tail interdependence may lead to a severe underestimation of systemic risk in a downward market.

Excerpts:

In this paper, we discuss the suitability of the general modeling strategy implemented in Adrian and Brunnermeier (2011) and propose a direct extension which accounts for nonlinear tail comovements between individual bank returns and financial system returns. Like most VaR models, the CoVaR approach builds on semi-parametric assumptions that characterize the dynamics of the time series of returns. Among others, the procedure requires the specification of the functional form that relates the conditional quantile of the whole financial system to the returns of the individual firm. The model proposed by Adrian and Brunnermeier (2011) assumes that system returns depend linearly on individual returns, so changes in the latter would feed proportionally into the former. This assumption is simple, convenient, and to a large extent facilitates the estimation of the parameters involved and the generation of downside-risk comovement estimates. On the other hand, this structure imposes certain limitations, as it neglects nonlinear patterns in the propagation of volatility shocks and of perturbations to the risk factors affecting banks' exposures. Both patterns feature distinctively in downside-risk dynamics.

There are strong economic arguments that suggest that the financial system may respond nonlinearly to shocks initiated in a single institution. A sizeable, positive shock in an individual bank is unlikely to generate the same characteristic response (i.e., comovement with the system) in absolute terms than a massive negative shock of the same magnitude, particularly if dealing with large-scale financial institutions.2 The disruption to the banking system caused by the failure of a financial institution may occur through direct exposures to the failing institution, through the contraction of financial services provided by the weakening institution (clearing, settlement, custodial or collateral management services), or from a shock to investor confidence that spreads out to sound institutions under adverse selection imperfections (Nier, 2011). Indeed, an extreme idiosyncratic shock in the banking industry, will not only reduce the market value of the stocks a¤ected, but may also spread uncertainty in the system rushing depositors and lending counterparties to withdraw their holdings from performing institutions and across unrelated asset classes, precipitating widespread insolvency. Historical experience suggests that a confidence loss in the soundness of the banking sector takes time to dissipate and may generate devastating e¤ects on the real economy. Bernanke (1983) comes to the conclusion that bank runs were largely responsible of the systemic collapse of the financial industry and the subsequent contagion to the real sectors during the Great Depression. Another channel of contagion in a downward market is through the fire-sales of assets initiated by the stricken institution to restore its capital adequacy, causing valuation losses in firms holding equivalent securities. This mechanism, induced by the generalized collateral lending practices that are prevalent in the wholesale interbank market, can exacerbate price volatility in a crisis situation, as discussed by Brunnermeier and Pedersen (2009).  The increased complexity and connectedness of financial institutions can generate "Black Swan" effects, morphing small perturbations in one part of the financial system into large negative shocks on seemingly unrelated parts of the system. These arguments suggest that the financial system is more sensitive to downside losses than upside gains. In such a case, the linear assumption involved in Adrian and Brunnermeier (2011) would neglect a key aspect of downside risk modeling and lead to underestimate the extent of systemic risk contribution of an individual bank.

We propose a simple extension of this procedure that encompasses the linear functional form as a special case and which, more generally, allows us to capture asymmetric patterns in systemic spillovers. We shall refer to this specification as asymmetric CoVaR in the sequel. This approach retains the tractability of the linear model, which ensures that parameters can readily be identified by appropriate techniques, and produces CoVaR estimates which are expected to be more accurate. Furthermore, given the resultant estimates, the existence of nonlinear patterns that motivate the asymmetric model can be addressed formally through a standard Wald test statistic. In this paper, we analyze the suitability of the asymmetric CoVaR in a comprehensive sample of U.S. banks over the period 1990-2010. We find strong statistical evidence suggesting the existence of asymmetric patterns in the marginal contribution of these banks to the systemic risk. Neglecting these nonlinearities gives rise to estimates that systematically underestimate the marginal contribution to systemic risk. Remarkably, the magnitude of the bias is tied to the size of the firm, so that the bigger the company, the greater the underestimation bias. This result is consistent with the too-big-to-fail hypothesis which stresses the need to maintain continuity of the vital economic functions of a large financial institution whose disorderly failure would cause significant disruption to the wider financial system.3 Ignoring the existence of asymmetries would thus lead to conservative estimates of risk contributions, more so in large firms which are more likely to be systemic. Accounting for asymmetries in a simple extension of the model would remove that bias.

 Concluding Remarks

In this paper, we have discussed the suitability of the CoVaR procedure recently proposed by Adrian and Brunnermeier (2011). This valuable approach helps understand the drivers of systemic risk in the banking industry. Implementing this procedure in practice requires specifying the unobservable functional form that relates the dynamics of the conditional tail of system's returns to the returns of an individual bank. Adrian and Brunnermeier (2011) build on a model that assumes a simple linear representation, such that returns are proportional.

We show that this approach may provide a reasonable approximation for small-sized banks.  However, in more general terms, and particularly for large-scale banks, the linear assumption leads to a severe underestimation of the conditional comovement in a downward market and, hence, their systemic importance may be perceived to be lower than their actual contribution to systemic risk. Yet, how to measure and buttress e¤ectively the resilience of the financial system to losses crystallizing in a stress scenario is the main concern of policy makers, regulatory authorities, and financial markets alike. Witness the rally on U.S. equities and dollar on March 14, 2012 after the regulator announced favorable bank stress test results for the largest nineteen U.S. bank holding companies.

The reason is that the symmetric model implicitly assumes that positive and negative individual returns are equally strong to capture downside risk comovement. Our empirical results however, provide robust evidence that negative shocks to individual returns generate a much larger impact on the financial system than positive disturbances. For a median-sized bank, the relative impact ratio is sevenfold. We contend that this non-linear pattern should be acknowledged in the econometric modeling of systemic risk to avoid a serious misappraisal of risk. Moreover, our analysis suggests that the symmetric specification introduces systematic biases in risk assessment as a function of bank size. Specifically, the distortion caused by a linear model misspecification is more pronounced for larger banks, which are also more systemic on average. Our results show that tail interdependence between the financial system and a bottom-size decile bank which is contracting its balance sheet is 2.2 times larger than its average comovement. More strikingly, this ratio reaches 5.4 for the top-size decile bank. This result is in line with the too-big-to-fail hypothesis and lends support to recent recommendations put forth by the Financial Stability Board to require higher loss absorbency capacity on large banks. Likewise, it is consistent with the resolution plan required by the Dodd-Frank Act for bank holding companies and non-bank financial institutions with $50 billion or more in total assets. Submitting periodically a plan for rapid and orderly resolution in the event of financial distress or failure will enable the FDIC to evaluate potential loss severity and minimize the disruption that a failure may have in the rest of the system, thus performing its resolution functions more e¢ ciently. This measure will also help alleviate moral hazard concerns associated with systemic institutions and strengthen the stability of the overall financial system.

To capture the asymmetric pattern on tail comovement, we propose a simple yet e¤ective extension of the original CoVaR model. This extension preserves the tractability of the original model and its suitability can formally be tested formally through a simple Wald-type test, given the estimates of the model. We show that this simple extension is robust to more general specifications capturing non-linear patterns in returns, though at the expense of losing tractability.

The refinement of the CoVaR statistical measure presented in the paper aims at quantifying asymmetric spillover e¤ects when strains in banks' balance sheets are elevated, and thus contributes a step towards strengthening systemic risk monitoring in stress scenarios.  Furthermore, its focus on tail comovement originated from negative perturbations in the growth rate of market-valued banks' balance sheets, may yield insights into the impact on the financial system from large-scale deleveraging by banks seeking to rebuild their capital cushions. This particular concern has been recently rekindled by the continued spikes in volatility in euro area financial markets. It has been estimated that, following pressures on the European banking system as banks cope with sovereign stress, European banks may shrink their combined balance sheet significantly with the potential of unleashing shockwaves to emerging economies hurting their financial stability (IMF, 2012). The estimation of the impact on the real economy from aggregate weakness of the financial sector, and the design of optimal macroprudential policies to arrest systemic risk when tail interdependencies feed non-linearly into the financial system, are left for future research.

Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies. By Carlo Cottarelli & Laura Jaramillo

Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies. By Carlo Cottarelli & Laura Jaramillo
May 01, 2012
IMF Working Paper No. 12/137

Summary: Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalize longterm growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt, and financing costs. Revenue and expenditure policies are also critical in affecting productivity and employment growth. This paper discusses the complex relationships between fiscal policy and growth both in the short and in the long run.

Order a print copy: http://www.imfbookstore.org/IMFORG/WPIEA2012137

Appendix. Short-run Determinants of CDS Spreads in Advanced Economies

Introduction

Since the global financial crisis and ensuing sovereign crisis in Europe, financial markets’ assessment of credit risk for advanced economies has changed significantly. Before the crisis, the valuation of advanced economy sovereign debt treated default as a very low probability event, and therefore liquidity risk rather than default risk was seen as the dominant driver of financing costs in advanced economies. However, as the recent crisis in Europe unfolded, assessment of credit risk came to the forefront, taking into account country-specific fundamentals. In response, several countries have made progress in adopting fiscal consolidation plans, although this has not always been met with a reduction in sovereign spreads. The current crisis has shown that while markets are concerned with large debt and fiscal deficits, they also worry about low growth and its effect on debt dynamics, as wells as the feasibility of fiscal adjustment in an environment of very weak economic activity.

While a few studies have looked at sovereign spreads in advanced economies since the onset of the global crisis, we focus here on credit default swap (CDS) spreads in advanced economies during 2011, the height of the euro area crisis. Under the assumption that underlying global factors (such as global risk aversion) are behind general co-movements of CDS spreads, our analysis seeks to identify the set of country specific factors that explain the divergence of spreads across countries during the most recent phase of the global crisis. The results highlight the current short-termism of markets, which makes fiscal policy management more difficult.14 In particular, it shows that lower debt and deficit to GDP ratios lead to lower CDS spreads, but so too does faster short-term growth. There is further evidence of a nonlinear relationship between growth and sovereign bond spreads: spreads are more likely to increase if growth declines from an already low rate and the fiscal tightening is large. If growth deteriorates enough as a result of a fiscal tightening, spreads could actually rise even as the deficit falls.


Background

As fiscal fundamentals have become a growing concern of financial markets, the sovereign CDS market for advanced economies has become increasingly large.15 Several European advanced economies are now among the ten largest single name CDS exposures by net notional position (Figure A1), and since September 2009 investors can trade index products on a basket of Western European sovereign CDS.[For further information on Markit iTraxx SovX Western European Index see http://www.markit.com/assets/en/docs/commentary/credit-wrap/SovX.pdf.] With rising size and liquidity, sovereign CDS spreads now provide more reliable signaling of sovereign credit risk.

The literature on the determinants of CDS spreads in advanced economies since the onset of the financial crisis— typically focusing on a narrow set of countries and using data only through 2010—has highlighted the importance of global factors with an increasingly prominent role of country-specific factors as the crisis progressed.  Longstaff et al. (2011) show that sovereign credit risk can be linked to global factors, based on a dataset of 28 advanced and emerging economies over the period October 2000-January 2010.  Similarly, Fontana and Scheicher (2010) find that the recent repricing of sovereign credit risk in the CDS market is mostly due to common factors. Dieckmann and Plank (2011) find—for a group of 18 advanced economies between January 2007 and April 2010—that the state of the world financial system as well as a country’s domestic financial system has strong explanatory power for the behavior of CDS spreads, with euro area countries especially sensitive. Forni et al. (2012) find that domestic financial and global factors explain movements in CDS spreads, using a panel dataset of 21 advanced economies over the period January 2008-October 2010.

As the crisis has progressed, differentiation across sovereign CDS spreads has increased significantly (Figure A2), underscoring that markets are reassessing the effect of country specific-factors on default risk. This implies that looking at historical correlations can overshadow some of the important relationships that have emerged as the crisis has evolved.  In this context, this appendix attempts to shed light on the particular state of the markets in 2011, at the height of the euro area crisis. 

Empirical Model Estimation

Sovereign CDS spreads in several European countries reached historical highs during 2011.  High deficits and debt to GDP ratios have typically been a precondition for such a surge, as countries that saw their overall deficit to GDP ratio rise into the double digits or a sizeable increase in their stock of debt faced increasing market pressure (mostly in the euro area).  However, there are several indications that other elements beyond fiscal fundamentals were at play. First, countries that announced sizeable fiscal adjustment plans in 2011 were not necessarily greeted with a reduction in spreads (Figure A3). Second, countries with weak fiscal accounts (such as Japan, the United Kingdom, and the United States) did not pay high spreads in 2011, which could in part be attributed to the effects of quantitative easing strategies by central banks in these countries (Figure A4).

With this in mind, this appendix assesses in a more consistent way why 5-year CDS spreads differ across a sample of 31 advanced economies,18 by looking at a set of macroeconomic and fiscal fundamentals, based on a simple OLS cross-section regression. A cross-section analysis is preferred to a panel regression given the desired focus on market behavior in the latest phase of the crisis. In particular, a cross-section allows for a larger number of countries to be included, which adds greater variation to the dataset than does the time dimension (as this analysis covers only one crisis episode).19 CDS spreads (average for 2011) are drawn from Markit20 and transformed into logs in line with Edwards (1984). Fiscal variables used as regressors are drawn from the September 2011 Fiscal Monitor (IMF 2011a), while macroeconomic variables are drawn from the September 2011 World Economic Outlook (IMF 2011b). Regressors include:

• Macroeconomic variables: real GDP growth rate and growth squared; projected real GDP in 2014; projected potential real GDP growth, averaged over 2011-16; inflation rate for 2011.
• Near-term fiscal variables: General government primary balance and general government debt as a ratio to GDP. For Australia, Canada, and Japan, net debt to GDP is used, in view of the sizeable amount of their assets.
• Long-term fiscal variables: Net present value of the increase in public pension spending during 2010-50 as a ratio to GDP (from IMF, 2010c); net present value of the increase in public health care spending during 2010-50 as a ratio to GDP (from IMF, 2010d); projected primary balance to GDP in 2014; projected debt to GDP in 2014.
• Investor base: General government debt of the country in question held by its national central bank (from the IMF International Financial Statistics) and, in the case of Japan, the U.K. and the U.S., by foreign central banks, based on the latest available data.

Estimation Results

Table A1 provides the results of the model. Column 1 reports a general specification in which all variables are included. The following columns illustrate the specification search, with insignificant variables dropped one by one. Column 5, the preferred specification, provides a relatively good fit with an adjusted R-squared of 0.76. The results illustrate the current short-termism of markets:

• Fiscal variables are important, with markets focusing primarily on short-term developments (the projected primary deficit and debt in 2011). The primary balance is only significant for euro area countries. The coefficients on deficits and debt are broadly in line with what has been found by previous econometric work, though at the lower end of the range.22 For a country with CDS spreads of 200 basis points, a 1 percentage point increase in the debt ratio raises the spread by about 3 basis points and a 1 percentage point increase in the deficit raises the spread by 35 basis points.  Given the log-linear specification, the larger the initial level of the CDS spread, the larger the impact on spreads, in basis points, of an increase in deficit and debt ratios; consistently, a weakening of fiscal variables has a more negative impact in countries with higher initial deficit and debt ratios.

• Long-term fiscal variables are not found to be significant. The coefficients on future debt and deficits and on public pension and health spending were not found to be significant. This suggests that reforms to entitlement spending or measures that would only have a long term impact would not necessarily be rewarded by markets in the short run. This result underscores the difficulty of providing credible information to markets in this area and the need for more effective communication of the effect of such reforms on the soundness of public finances.

• Short-term growth is important (higher growth leading to lower spreads), while potential growth and future growth are not significant. This relationship is found to be nonlinear—with a positive coefficient on the squared growth term—as spreads are more likely to increase when growth is already low and fiscal tightening is larger.23 Based on these results, if the fiscal multiplier is sufficiently large (higher than 0.7 based on the estimated coefficients), the improvement in spreads from a lower deficit could be offset by the negative impact of adjustment on short-term growth, which also acts through the short-term rise in the debt to GDP ratio (see Figure 5 in the main text).

• Central bank financing (either from national central banks or from foreign central banks) is important in lowering spreads, as long as it is not inflationary. This coefficient is higher than the one on the debt ratio, implying that the effect of purchases by national central banks (and by foreign central banks for reserve currencies) goes beyond the effect of reducing the overall supply of government bonds sold to the public. This probably reflects confidence effects provided by the presence of the central bank in the market. Note, however, that the central bank holdings variable does not include purchases by the ECB through the Securities Market Program.24 The coefficient for inflation is highly significant, and thus implies that central bank purchases are effective in moderating spreads only if they are not inflationary. Given the large accumulation of excess reserves by banks, inflation pressures currently remain at bay in most countries. The respite in sovereign bond markets, following the long-term refinancing operations (LTRO) of the European Central Bank (ECB) are a further example of the confidence effects of central bank intervention. These results suggest that the availability of financing from an entity with sufficiently large resources could help reduce spreads in the current environment.

Conclusions

The cross-section estimates point to the current short-term vision of markets, with special concern for near-term growth prospects. This could possibly reflect strong risk aversion after four years of market turmoil. These results imply that tighter fiscal policy could actually lead to wider, rather than narrower, spreads in the short term. It is important to note, however, that the euro area crisis is still not fully resolved and financial markets remain unsettled, therefore these results may reflect the particular state of markets in 2011 rather than more permanent features, something that a cross section cannot shed light on. Moreover, it would be important to assess the direct effect on spreads of other variables beyond fiscal fundamentals, such as exposure to contingent liabilities from the banking sector. Potential simultaneity issues (e.g., between spreads and growth) also deserve additional attention.

Money and Collaterall, by Manmohan Singh & Peter Stella

Money and Collateral, by Manmohan Singh & Peter Stella
IMF Working Paper No. 12/95
Apr 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25851.0

Summary: Between 1980 and before the recent crisis, the ratio of financial market debt to liquid assets rose exponentially in the U.S. (and in other financial markets), reflecting in part the greater use of securitized assets to collateralize borrowing. The subsequent crisis has reduced the pool of assets considered acceptable as collateral, resulting in a liquidity shortage. When trying to address this, policy makers will need to consider concepts of liquidity besides the traditional metric of excess bank reserves and do more than merely substitute central bank money for collateral that currently remains highly liquid.

Excerpts:

Introduction

In the traditional view of a banking system, credit and money are largely counterparts to each other on different sides of the balance sheet. In the process of maturity transformation, banks are able to create liquid claims on themselves, namely money, which is the counterpart to the less liquid loans or credit.2 Owing to the law of large numbers, banks have—for centuries— been able to safely conduct this business with relatively little liquid reserves, as long as basic confidence in the soundness of the bank portfolio is maintained.

In recent decades, with the advent of securitization and electronic means of trading and settlement, it became possible to greatly expand the scope of assets that could be transformed directly, through their use as collateral, into highly liquid or money-like assets. The expansion in the scope of the assets that could be securitized was in part facilitated by the growth of the shadow financial system, which was largely unregulated, and the ability to borrow from non-deposit sources. This meant deposits no longer equaled credit (Schularick and Taylor, 2008). The justification for light touch or no regulation of this new market was that collateralization was sufficient (and of high quality) and that market forces would ensure appropriate risk taking and dispersion among those educated investors best able to take those risks which were often tailor made to their demands. Where regulation fell short was in failing to recognize the growing interconnectedness of the shadow and regulated sectors, and the growing tail risk that sizable leverage entailed (Gennaioli, Shleifer and Vishny, 2011).

Post-Lehman, there has been a disintermediation process leading to a fall in the money multiplier. This is related to the shortage of collateral (Singh 2011). This is having a real impact—in fact deleveraging is more pronounced due to less collateral. Section II of the paper focuses on money as a legal tender, the money multiplier; then we introduce the adjusted money multiplier. Section III discusses collateral, including tail-risk collateral.  Section IV tries to bridge the money and collateral aspects from a “safe assets” angle. Section V introduces collateral chains and describes the economics behind the private pledged collateral market. Section VI brings the monetary and collateral issues together under an overall financial lubrication framework. In our conclusion (section VII) we offer a useful basis for understanding monetary policy in the current environment.



Conclusion

“Monetary” policy is currently being undertaken in uncharted territory and may change some fundamental assumptions that link monetary and macro-financial policies. Central banks are considering whether and how to augment the apparently ‘failed’ transmission mechanism and in so doing will need to consider the role that collateral plays as financial lubrication (see also Debelle, 2012). Swaps of “good” for “bad” collateral may become part of the standard toolkit.31 If so, the fiscal aspects and risks associated with such policies—which are virtually nil in conventional QE swaps of central bank money for treasuries—are important and cannot be ignored. Furthermore, the issue of institutional accountability and authority to engage in such operations touches at the heart of central bank independence in a democratic society.

These fundamental questions concerning new policy tools and institutional design have arisen at the same time as developed countries have issued massive amounts of new debt.  Although the traditional bogeyman of pure seigniorage financing, that is, massive monetary purchases of government debt may have disappeared from the dark corners of central banks, this does not imply that inflation has been forever arrested. Thus a central bank may “stand firm” yet witness rises in the price level that occur to “align the market value of government debt to the value of its expected real backing.” Hence current concerns as to the potential limitations fiscal policy places on monetary policy are well founded and indeed are novel only to those unfamiliar with similar concerns raised for decades in emerging and developing countries as well as in the “mature” markets before World War II.

Economic crisis: Views from Greece

I asked some Greek professionals about the crisis in their country on behalf of Hanna Intelligence's CEO, Mr. Jose Navio:

dear sir, I got some questions for you, if you have the time:

1  could you please make mention of effects in the citizenry like more children abandoned in hospices because the family cannot maintain them?
2  do you know of lack of food/medicines or lower quality of them?
3  is it better in your opinion to get out of the Euro and use again the old drachma (or any other new currency)?
4  is it better in your opinion to default and to reject the troika bail-outs?

thank you very much in advance,

xxx

The answer of one of those professionals:

Date: 2/27/2012
Subject: RE: Greece and the economic crisis

Dear Mr xxx,

thank you for asking about my country's present; my comment should focus on two issues:

The first one refers to the huge "brain drain" that is in progress during this period in Greece, even to a greater extent than the period after the WWII, which was the greatest immigration period in Greek history. People of all ages and professions are migrating in foreign countries around the world seeking for a job and better living conditions, in all financial, communal and governance/ infrastructural terms.

The second one refers to the sharp rise of homeless people and unable to sustain their families' every day living, dignity and income, due to the unprecedented percentages of unemployment, wages' cuttings and increase of the prices of almost all commodities. In cooperation with the church and under the coordination of various entities and NGOs, citizens are gathering food and clothing to assist all those who suffer the "human insecurity" that prevails nowadays in Greece.

I can't say what could have been better for Greece in economic terms, since it's out of my area of expertise, and I don't want to follow the paradigm of all those who suddenly became experts in economic strategies, options, terms and conspiracy theories. I can confirm though that this situation is the result of bad Greek governance for the last thirty years and that although Greece didn't loose sovereignty through wars in it's modern history, it did through economic procedures and EU norms; in any case Greeks are experiencing a very hard austerity policy, humiliation from various (mostly) European governments and states, and most important, instead of facing a hopeful future and prospect, they see things getting worst every day, even after all this inhuman behaviors.

I don't know what the plan or EU's "Grand Strategy" might be for Greece, but definately the proud and cultural Greeks don't deserve what they experience during these years, not even what is yet to come. The civil society is a "boiling pot" due to the downgrade of the every day living standards, unpunished and "untouchable" politicians responsible for this situation,explicit inequalities and non-existing options for the future generations. Let's hope at least that we'll not experience also a bloodshed or Egypt-like uprisings..

I hope I gave you a brief and indicative picture of contemporary Greece, and been of some help to your questions.

Best regards,

xxx

Intra-group support measures in times of stress or unexpected loss by financial groups in the banking, insurance and securities sectors

The Joint Forum: Report on intra-group support measures
Feb 2012
http://www.bis.org/publ/joint28.htm

The Joint Forum (BIS, IOSCO, IAIS) just published a report to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors. The report provides an important overview of intra-group support measures used in practice at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress.

The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to the banking, securities and insurance sectors, including the regulation of financial conglomerates.

Excertps

Executive Summary

The objective of this report prepared by the Joint Forum is to assist national supervisors in gaining a better understanding of the use of intra-group support measures in times of stress or unexpected loss by financial groups across the banking, insurance and securities sectors.  The report provides an important overview of the use of intra-group support at a time when authorities are increasingly focused on ways to ensure banks and other financial entities can be wound down in an orderly manner during periods of distress. The report may also assist the thematic work contemplated by the Financial Stability Board (FSB) on deposit insurance schemes and feed into the ongoing policy development in relation to recovery and resolution plans.

The report is based on the findings of a high-level stock-take which examined the use of intra-group support measures available to banks, insurers and securities firms. The stocktake was conducted through a survey by the Joint Forum Working Group on Risk Assessment and Capital (JFRAC) that was completed by 31 financial institutions headquartered in ten jurisdictions on three continents: Europe, North America and Asia.  Participants were drawn from the banking, insurance and securities sectors and from many of the jurisdictions represented by Joint Forum members. Many participating firms were large global financial institutions.

The report provides an overview and analysis of the types and frequency of intra-group support measures used in practice. It is based only on information provided by participants in the survey. Responses were verified by supervisors only in certain instances.

The survey’s main findings are as follows:

1. Intra-group support measures can vary from institution to institution, driven by the regulatory, legal and tax environment; the management style of the particular institution; and the cross-border nature of the business. Authorities should be mindful of the complicating effect of these measures on resolution regimes and the recovery process in the event of failure.

2. The majority of respondents surveyed indicated centralised capital and liquidity management systems were in place. According to proponents, this approach promotes the efficient management of a group’s overall capital level and helps maximise liquidity while reducing the cost of funds. However, the respondents that favoured a “self-sufficiency” approach pointed out that centralised management potentially has the effect of increasing contagion risk within a group in the event of distress at any subsidiaries. The use of these systems impacts the nature and design of intra-group support measures with some firms indicating that the way they managed capital and liquidity within the group was a key driver in their decisions about the intra-group transactions and support measures they used.

3. Committed facilities, subordinated loans and guarantees were the most widely used measures. This was evident across all sectors and participating jurisdictions.

4. Internal support measures generally were provided on a one-way basis (eg downstream from a parent to a subsidiary). Loans and borrowings, however, were provided in some groups on a reciprocal basis. As groups surveyed generally operated across borders, most indicated support measures were provided both domestically and internationally. Support measures were also in place between both regulated and unregulated entities and between entities in different sectors.

5. The study found no evidence of intra-group support measures either a) being implemented on anything other than an arm’s length basis, or b) resulting in the inappropriate transfer of capital, income or assets from regulated entities or in a way which generated capital resources within a group. However, this does not necessarily mean that supervisory scrutiny of intra-group support measures is unwarranted. As this report is based on industry responses, further in-depth analysis by national supervisors may provide a more complete picture of the risks potentially posed by intra-group support measures.

6. While the existing regulatory frameworks for intra-group support measures are somewhat limited, firms do have certain internal policies and procedures to manage and restrict internal transactions. Respondents pointed out that the regulatory and legal framework can make it difficult for some forms of intra-group support to come into force while supervisors aim to ensure that both regulated entities and stakeholders are protected from risks arising from the use of support measures. For instance, upstream transfers of liquidity and capital are monitored and large exposure rules can limit the extent of intra-group interaction for risk control purposes. Jurisdictional differences in regulatory settings can also pose a challenge for firms operating across borders.

7. Based on the survey and independent of remaining concerns and information gaps, single sector supervisors should be aware of the risks that intra-group support measures may pose and should fully understand the measures used by an institution, including its motivations for using certain measures over others. In order to obtain further insight into the intra-group support measures put in place by financial institutions within their jurisdiction, national supervisors should, where appropriate, conduct further analysis in this area. A high-level model questionnaire is provided in Annex II with the aim of assisting national supervisors with ongoing work relating to intra-group support measures.

Why did the U.S. recover faster from the Panic of 1907 than from the 2008 recession and the Great Depression?

Why did the U.S. recover faster from the Panic of 1907 than from the 2008 recession and the Great Depression?
By PHIL GRAMM AND MIKE SOLON
WSJ, Feb 02, 2012
http://online.wsj.com/article/SB10001424052970204740904577193382505500756.html

Commerce Department data released last Friday show that four years after the recession began, real gross domestic product per person is down $1,112, while 5.8 million fewer Americans are working than when the recession started.

Never before in postwar America has either real per capita GDP or employment still been lower four years after a recession began. If in this "recovery" our economy had grown and generated jobs at the average rate achieved following the 10 previous postwar recessions, GDP per person would be $4,528 higher and 13.7 million more Americans would be working today.

Behind the startling statistics of lost income and jobs are the real and painful stories of American families falling further behind: record high poverty levels, record low teenage employment, record high long-term unemployment, shrinking birthrates, exploding welfare benefits, and a crippled middle class.

As the recovery faltered, President Obama first claimed the weakness of the recovery was due to the depth of the recession, saying that it was "going to take a while for us to get out of this. I think even I did not realize the magnitude . . . of the recession until fairly far into it."

But, in fact, the 1981-82 recession was deeper and unemployment was higher. Moreover, the 1982 recovery was constrained by a contractionary monetary policy that pushed interest rates above 21%, a tough but necessary step to break inflation. It was also a recovery that required a painful restructuring of American businesses to become more competitive in the increasingly globalized economy. By way of comparison, our current recovery has benefited from the most expansionary monetary policy in U.S. history and a rapid return to profitability by corporate America.

Despite the significant disadvantages the economy faced in 1982, President Ronald Reagan's policies ignited a recovery so powerful that if it were being repeated today, real per capita GDP would be $5,694 higher than it is now—an extra $22,776 for a family of four. Some 16.9 million more Americans would have jobs.

The most recent excuse for the failed recovery is that financial crises, by their very nature, result in slower, more difficult recoveries. Yet the 1981-82 recession was at least in part financially induced by inflation, record interest rates and the dislocations they generated. The high interest rates wreaked havoc on long-term lenders like S&Ls, whose net worth turned negative in mid-1982. But even if we ignore the financial roots of the 1981-82 recession, the financial crisis rationalization of the current, weak recovery does not stand up to scrutiny.

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic "A Monetary History of the United States," found "much similarity in its early phases" between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

It is certainly true that the economy languished in the Great Depression as it has over the past four years. But today's malaise is similar to that of the Depression not because of the financial events that triggered the disease but because of the virtually identical and equally absurd policy prescriptions of the doctors.

Under President Franklin Roosevelt, federal spending jumped by 3.6% of GDP from 1932 to 1936, an unprecedented spending spree, as the New Deal was implemented. Under President Obama, spending exploded by 4.6% of GDP from 2008 to 2011. The federal debt by the end of 1938 was almost 150% above the 1929 level. Publicly held debt is projected to be double the 2008 level by the end of 2012. The regulatory burden mushroomed under Roosevelt, as it has under Mr. Obama.

Tax policy then and now was equally destructive. The top individual income tax rate rose from 24% to 63% and then to 79% during the Hoover and Roosevelt administrations. Corporate rates were increased by 36%. Under Mr. Obama, capital gains taxes are set to rise by one third, the top effective tax rate on dividends will more than triple, and the highest marginal tax rate will effectively rise by 21.4%.

Moreover, the Obama administration's populist tirades against private business are hauntingly similar to the Roosevelt administration's tirades. FDR's demagoguery against "the privileged few" and "economic royalists" has evolved into Mr. Obama's "the richest 1%" and America's "millionaires and billionaires."

Yet, in his signature style, Mr. Obama now claims our weak recovery is not because a Democratic Congress said yes to his policy prescriptions in 2009-10 but because a Republican House said no in 2011. The sad truth is this president sowed his policies and America is reaping the results.

Faced with the failed results of his own governing strategy of tax, spend and control, the president will have no choice but to follow an election strategy of blame, vilify and divide. But come Nov. 6, American voters need only ask themselves the question Reagan asked in 1980: "Are you better off than you were four years ago?"

Sadly, with their income reduced by thousands, the number of U.S. jobs down by millions, and the nation trillions deeper in debt, the answer will be a resounding "No."

Mr. Gramm, a former U.S. senator from Texas, is the senior partner at U.S. Policy Metrics, where Mr. Solon, a former senior budget staffer in both houses of Congress, is also a partner.

How Risky Are Banks’ Risk Weighted Assets? Evidence from the Financial Crisis

How Risky Are Banks’ Risk Weighted Assets? Evidence from the Financial Crisis. By Sonali Das & Amadou N. R. Sy
IMF Working Paper No. 12/36
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25687.0

Summary: We study how investors account for the riskiness of banks’ risk-weighted assets (RWA) by examining the determinants of stock returns and market measures of risk. We find that banks with higher RWA had lower stock returns over the US and European crises. This relationship is weaker in Europe where banks can use Basel II internal risk models. For large banks, investors paid less attention to RWA and rewarded instead lower wholesale funding and better asset quality. RWA do not, in general, predict market measures of risk although there is evidence of a positive relationship before the US crisis which becomes negative afterwards.

Introduction:

“The leverage ratio - a simple ratio of capital to balance sheet assets - and the more complex riskbased requirements work well together. The leverage requirement provides a baseline level of capital to protect the safety net, while the risk-based requirement can capture additional risks that are not covered by the leverage framework. The more advanced and complex the models become, the greater the need for such a baseline. The leverage ratio ensures that a capital backstop remains even if model errors or other miscalculations impair the reliability of risk-based capital. This is a crucial consideration - particularly as we work through the implementation of Basel II standard. By restraining balance sheet growth, the leverage ratio promotes stability and resilience during difficult economic periods.”– Remarks by Sheila Bair, Chairman, Federal Deposit Insurance Corporation before the Basel Committee on Banking Supervision, Merida, Mexico, October 4, 2006.

The financial crisis that began in 2007 has exposed a number of important weaknesses in banking regulation. A key challenge is how to appropriately determine the riskiness of banks’ assets. The principle that regulatory capital requirements should be tied to the risks taken by banks was accepted internationally and formalized with the Basel I accord in 1988, and the definition of capital and measurement of risks have undergone several revisions since that time.  The second Basel accord, published in 2004, recommended banks hold total regulatory capital equal to at least 8 percent of their risk-weighted assets (RWA). The recently updated Basel III guidelines emphasize higher quality forms of capital, but makes limited strides in the measurement of risks. Instead, Basel III proposes as a complementary measure, a non-riskweighted leverage ratio.

Risk weighted assets are an important element of risk-based capital ratios. Indeed, banks can increase their capital adequacy ratios in two ways: (i) by increasing the amount of regulatory capital held, which boosts the numerator of the ratio, or (ii) by decreasing risk-weighted assets, which is the denominator of the regulatory ratio. A key concern about current methods of determining risk-weighted assets is that they leave room for individual banks to “optimize” capital requirements by underestimating their risks and thus being permitted to hold lower capital. Jones (2000) discusses techniques banks can use to engage in regulatory capital arbitrage and provides evidence on the magnitude of these activities in the Unites States. Even under the Basel I system, in which particular classes of assets are assigned fixed risk-weights, the capital ratio denominator can be circumvented. Merton (1995) provides an example in which, in place of a portfolio of mortgages, a bank can hold the economic equivalent of that portfolio at a riskweight one-eighth as large. Innovations in financial products since the first Basel accord have also likely made it easier for financial institutions to manipulate their regulatory risk measure.  Acharya, Schnabl, and Suarez (2010) analyze asset-backed commercial paper and find results suggesting that banks used this form of securitization to concentrate, rather than disperse, financial risks in the banking sector while reducing bank capital requirements.

In addition to concerns about underestimating the riskiness of assets, there are differences in calculation of risk weighted assets across countries that may have unintended effects on financial stability. Lord Adair Turner, chairman of the UK Financial Services Authority, warned in June that international differences in the calculation of risk-weighted assets could undermine Basel III3 and Sheila Bair, former chairman of the US Federal Deposit Insurance Corporation, added her concern that Europe and the US may be diverging in their calculation of RWA: “The risk weightings are highly variable in Europe and have led to continuing declines in capital levels, even in the recession. There's pretty strong evidence that the RWA calculation isn't working as it's supposed to.”

In this paper, we study whether equity investors find banks’ reported risk-weighted assets to be a credible measure of risk. First, did banks with lower risk-weighted assets have higher stock returns during the recent financial crisis? And second, do measures of risk based on equity market information correspond to risk-weighted assets? Demirgüç-Kunt, Detragiache, and Merrouche (2010) and Beltratti and Stulz (2010) study banks’ stock return performance during the financial crisis as well, focusing primarily on the effect of different measures of capital and bank governance, respectively. Our paper studies whether markets price bank risk as measured by RWA, to inform the debate on how best to measure the risks embedded in banks’ portfolios.  Addressing the first question, we find that banks with higher RWA performed worse during the severe phase of the crisis, from July 2007 to September 2008, suggesting that equity investors did look at RWA as a determinant of banks’ stock returns in this period. This relationship is weaker in Europe where banks can use Basel II internal risk models. For large banks, investors paid less attention to RWA and rewarded instead lower wholesale funding and better asset quality.

We find as in Demirguc-Kunt, Detragiache, and Merrouche (2010) that markets do not respond to all measures of capital, but respond positively to higher quality measures – that is, capital with greater loss-absorbing potential. We also investigate the possibility of a capital-liquidity trade-off in the market assessment of banks. Our results indicate that there is indeed a capital-liquidity trade-off: (i) banks with more stable sources of short-term funding are not rewarded as highly for having higher capital, and (ii) banks with liquid assets are not rewarded as highly for having higher capital.

Regarding the relationship between RWA and stock market measures of bank risk, we find that RWA do not, in general, predict market measures of banks’ riskiness. There is evidence, however, of a positive relationship between RWA and market risk in the three years prior to the crisis, from 2004 to 2006, and this relationship becomes negative after the crisis. This could result from the large increase in market measures of risk, which reflect the volatility of a bank’s stock price, since the crisis, while banks have not adjusted their RWA to account for increased risk.

Conclusions

There has been a steady decline in the measure of asset-risk that banks report to regulators—riskweighted assets (RWA)—over the last decade. In light of this trend and other indications that banks can “optimize” their capital by under-reporting RWA in an attempt to minimize regulatory burdens, we study how equity market investors account for the riskiness of RWA by examining the determinants of stock returns and stock-market measures of risk of an international panel of banks.

Regarding banking stock returns, we find a negative relationship between RWA and stock returns over periods of financial crisis, suggesting that investors use RWA as an indicator of bank portfolio risk. Indeed, banks with higher risk-weighted assets performed worse during the severe phase of the crisis, from July 2007 to September 2008. We find a similar result when we focus on the ongoing crisis in the Europe.

Comparing regions with different regulatory structures, we find, however, that the relationship between stock returns and RWA is weaker in countries where banks have more discretion in the calculation of RWA. Specifically, in countries that had implemented Basel II before the onset of the recent financial crisis, allowing banks to use their own internal models to assess credit risks, investors look to other balance-sheet measures of risk exposure but not RWA. Our results also suggest that for large banks, investors paid less attention to the quality of capital and RWAs during the crisis and rewarded instead lower reliance on wholesale funding and better asset quality as measured by the relative size of customer deposit and non-performing loans, respectively.

We confirm results from previous studies that only capital with the greatest loss-absorbing potential matters for stock returns. In addition, we find a trade-off between capital and liquidity in terms of their positive effects on bank stock returns. The more stable a bank’s funding, the less positive the effect of higher capital on its stock return; the more liquid a bank’s assets, the less an increase in capital will increase its stock return.

When it comes to stock-market measures of risk, we find that RWA do not, in general, predict market measures of bank risk. There is evidence, however, of a break in the relationship between stock market measures of risk and RWA since the start of the crisis. Indeed, we find a positive relationship between RWA and market risk in the three years prior to the crisis, from 2004 to 2006, and this relationship becomes negative after the crisis. This could result from the large increase in market measures of risk, which reflect the volatility of a bank’s stock price, since the crisis, while banks have not adjusted their RWA to reflect increased risk.

In light of increasing risk-aversion in markets during times of crisis, the question of how market assessments of risk should be incorporated into banking regulation and supervision remains. Indeed, the asymmetry of information between banks, supervisors, and market participants regarding how risky RWA are can lead to increased uncertainty about the adequacy of bank capital, which during a financial crisis, can have damaging effects for financial stability.