Research articles for the 2019-02-15
'Leaning Against the Wind', Macroprudential Policy and the Financial Cycle
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Should monetary policy lean against financial stability risks? This has been a subject of fierce debate over the last decades. We contribute to the debate about "leaning against the wind" (LAW) along three lines. First, we evaluate the cost and benefits of LAW using the Svensson (2017) framework for the euro area and find that the costs outweigh the benefits. Second, we extend the framework to address a critique that Svensson does not consider the lower frequency financial cycle. Third, we use this extended framework to assess the costs and benefits of monetary and macroprudential policy. We find that macroprudential policy has net marginal benefits in addressing risks to financial stability in the euro area, whereas monetary policy has net marginal costs. This would suggest that an active use of macroprudential policies targeting financial stability risks would alleviate the burden on monetary policy to "lean against the wind".
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Should monetary policy lean against financial stability risks? This has been a subject of fierce debate over the last decades. We contribute to the debate about "leaning against the wind" (LAW) along three lines. First, we evaluate the cost and benefits of LAW using the Svensson (2017) framework for the euro area and find that the costs outweigh the benefits. Second, we extend the framework to address a critique that Svensson does not consider the lower frequency financial cycle. Third, we use this extended framework to assess the costs and benefits of monetary and macroprudential policy. We find that macroprudential policy has net marginal benefits in addressing risks to financial stability in the euro area, whereas monetary policy has net marginal costs. This would suggest that an active use of macroprudential policies targeting financial stability risks would alleviate the burden on monetary policy to "lean against the wind".
Anticipating the Bust: A New Cyclical Systemic Risk Indicator to Assess the Likelihood and Severity of Financial Crises
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This paper presents a tractable, transparent and broad-based domestic cyclical systemic risk indicator (d-SRI) that captures risks stemming from domestic credit, real estate markets, asset prices, and external imbalances. The d-SRI increases on average several years before the onset of systemic financial crises, and its early warning properties for euro area countries are superior to those of the total credit-to-GDP gap. In addition, the level of the d-SRI around the start of financial crises is highly correlated with measures of subsequent crisis severity, such as GDP declines. Model estimates suggest that the d-SRI has significant predictive power for large declines in real GDP growth three to four years down the line, as it precedes shifts in the entire distribution of future real GDP growth and especially of its left tail. The d-SRI therefore provides useful information about both the probability and the likely cost of systemic financial crises many years in advance. Given its timely signals, the d-SRI is a useful analytical tool for macroprudential policymakers.
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This paper presents a tractable, transparent and broad-based domestic cyclical systemic risk indicator (d-SRI) that captures risks stemming from domestic credit, real estate markets, asset prices, and external imbalances. The d-SRI increases on average several years before the onset of systemic financial crises, and its early warning properties for euro area countries are superior to those of the total credit-to-GDP gap. In addition, the level of the d-SRI around the start of financial crises is highly correlated with measures of subsequent crisis severity, such as GDP declines. Model estimates suggest that the d-SRI has significant predictive power for large declines in real GDP growth three to four years down the line, as it precedes shifts in the entire distribution of future real GDP growth and especially of its left tail. The d-SRI therefore provides useful information about both the probability and the likely cost of systemic financial crises many years in advance. Given its timely signals, the d-SRI is a useful analytical tool for macroprudential policymakers.
Breaking the Shackles: Zombie Firms, Weak Banks and Depressed Restructuring in Europe
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This paper explores the connection between â€zombie†firms (firms that would typically exit in a competitive market) and bank health and the consequences for aggregate productivity in 11 European countries. Controlling for cyclical effects, the results show that zombie firms are more likely to be connected to weak banks, suggesting that the zombie firm problem in Europe may at least partly stem from bank forbearance. The increasing survival of zombie firms congests markets and constrains the growth of more productive firms, to the detriment of aggregate productivity growth. Our results suggest that around one-third of the impact of zombie congestion on capital misallocation can be directly attributed to bank health and additional analysis suggests that this may partly be due to reduced availability of credit to healthy firms. Finally, improvements in bank health are more likely to be associated with a reduction in the prevalence of zombie firms in countries where insolvency regimes do not unduly inhibit corporate restructuring. Thus, leveraging the important complementarities between bank strengthening efforts and insolvency regime reform would contribute to breaking the shackles on potential growth in Europe.
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This paper explores the connection between â€zombie†firms (firms that would typically exit in a competitive market) and bank health and the consequences for aggregate productivity in 11 European countries. Controlling for cyclical effects, the results show that zombie firms are more likely to be connected to weak banks, suggesting that the zombie firm problem in Europe may at least partly stem from bank forbearance. The increasing survival of zombie firms congests markets and constrains the growth of more productive firms, to the detriment of aggregate productivity growth. Our results suggest that around one-third of the impact of zombie congestion on capital misallocation can be directly attributed to bank health and additional analysis suggests that this may partly be due to reduced availability of credit to healthy firms. Finally, improvements in bank health are more likely to be associated with a reduction in the prevalence of zombie firms in countries where insolvency regimes do not unduly inhibit corporate restructuring. Thus, leveraging the important complementarities between bank strengthening efforts and insolvency regime reform would contribute to breaking the shackles on potential growth in Europe.
ECB Spillovers and Domestic Monetary Policy Effectiveness in Small Open Economies
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In this paper we study financial spillovers from the European Central Bank's (ECB) monetary policy and communication, and whether they have consequences for the effectiveness of domestic monetary policy of small open economies. Recent work suggests that the "trilemma" in international economics as we used to know it, is actually a dilemma: small open economies with floating exchange rate regimes can only have independent monetary policies when the capital account is managed. Our findings show that domestic monetary policy is still effective, but that spillover effects, particularly from the ECB's communication, reduce domestic control over the longer end of the yield curve.
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In this paper we study financial spillovers from the European Central Bank's (ECB) monetary policy and communication, and whether they have consequences for the effectiveness of domestic monetary policy of small open economies. Recent work suggests that the "trilemma" in international economics as we used to know it, is actually a dilemma: small open economies with floating exchange rate regimes can only have independent monetary policies when the capital account is managed. Our findings show that domestic monetary policy is still effective, but that spillover effects, particularly from the ECB's communication, reduce domestic control over the longer end of the yield curve.
Forbearance Patterns in the Post-Crisis Period
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Using supervisory loan-level data on corporate loans, we show that banks facing high levels of non-performing loans relative to their capital and provisions were more likely to grant forbearance measures to the riskiest group of borrowers. More specifically, we find that risky borrowers are more likely to get an increase in the overall limit or the maturity of a loan product from a distressed lender. As a second step, we analyse the effectiveness of this practice in reducing the probability of default. We show that the most common measure of forbearance is effective in the short run but no forbearance measure significantly reduces the probability of default in the long run. Our evidence also suggests that forbearance and new lending are substitutes for banks, as high shares of forbearance are negatively correlated with new lending to the same group of borrowers.
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Using supervisory loan-level data on corporate loans, we show that banks facing high levels of non-performing loans relative to their capital and provisions were more likely to grant forbearance measures to the riskiest group of borrowers. More specifically, we find that risky borrowers are more likely to get an increase in the overall limit or the maturity of a loan product from a distressed lender. As a second step, we analyse the effectiveness of this practice in reducing the probability of default. We show that the most common measure of forbearance is effective in the short run but no forbearance measure significantly reduces the probability of default in the long run. Our evidence also suggests that forbearance and new lending are substitutes for banks, as high shares of forbearance are negatively correlated with new lending to the same group of borrowers.
Identification of Interbank Loans and Interest Rates from Interbank Payments - A Reliability Assessment
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We investigate the reliability of the 'Furfine filter' often used to identify interbank loans and interest rates from interbank payments settled at central banks. To this end, we have been granted access to records of all unsecured overnight interbank loans during a month from the banks that participated in Norges Bank's real-time gross settlement system. The filter applied was able to identify each of these loans and correctly derive the associated interest rates. The filter's reliability is also supported by additional evidence based on the Norwegian Overnight Weighted Average (NOWA) interest rates beyond the survey month. Sensitivity analyses suggest the share of false or overlooked loans may remain small if the filter design largely incorporates interbank market conventions regarding loan size requests and interests rate quotes.
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We investigate the reliability of the 'Furfine filter' often used to identify interbank loans and interest rates from interbank payments settled at central banks. To this end, we have been granted access to records of all unsecured overnight interbank loans during a month from the banks that participated in Norges Bank's real-time gross settlement system. The filter applied was able to identify each of these loans and correctly derive the associated interest rates. The filter's reliability is also supported by additional evidence based on the Norwegian Overnight Weighted Average (NOWA) interest rates beyond the survey month. Sensitivity analyses suggest the share of false or overlooked loans may remain small if the filter design largely incorporates interbank market conventions regarding loan size requests and interests rate quotes.
Intrinsic Bubbles in Stock Prices Under Persistent Dividend Growth Rates
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We extend the constant discount factor model with intrinsic bubbles developed in Froot and Obstfeld (1991) to account for serial correlation in dividend growth rates. We derive an exact analytical expression for both the present value stock price and an intrinsic bubble component when dividend growth rates evolve as a Gaussian first-order autoregressive process. We estimate the model with two sets of annual U.S. stock prices and dividends data, namely the DJIA and the S&P 500 series, over the last century. Hypotheses tests reject an AR(0) process for dividend growth rates in favor of an AR(1) process for both data series. Likelihood ratio tests also favor the AR(1)-based model developed here for price-dividends ratios to the AR(0)-based model considered in Froot and Obstfeld (1991). Hypotheses tests also reject the absence of a bubble component in both series. This inference is robust to whether or not the parameters governing the intrinsic bubbles process are restricted to values implied by our model or freely estimated. Incorporating the bubble component into our model provides a significant improvement in fit to observed P/D ratios and stock prices as compared to the present value stock prices alone.
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We extend the constant discount factor model with intrinsic bubbles developed in Froot and Obstfeld (1991) to account for serial correlation in dividend growth rates. We derive an exact analytical expression for both the present value stock price and an intrinsic bubble component when dividend growth rates evolve as a Gaussian first-order autoregressive process. We estimate the model with two sets of annual U.S. stock prices and dividends data, namely the DJIA and the S&P 500 series, over the last century. Hypotheses tests reject an AR(0) process for dividend growth rates in favor of an AR(1) process for both data series. Likelihood ratio tests also favor the AR(1)-based model developed here for price-dividends ratios to the AR(0)-based model considered in Froot and Obstfeld (1991). Hypotheses tests also reject the absence of a bubble component in both series. This inference is robust to whether or not the parameters governing the intrinsic bubbles process are restricted to values implied by our model or freely estimated. Incorporating the bubble component into our model provides a significant improvement in fit to observed P/D ratios and stock prices as compared to the present value stock prices alone.
Modifying The Carried Interest To Do What It Is Said To Do
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The carried interest received by private equity fund managers (General Partners; GPs) generates some controversies. The three most debated claims are that carried interest i) aligns incentives, ii) should be treated as a capital gain for tax purposes, and iii) should not be reported as a fee charged to investors. The existence of two key principal-agent relationships within the private equity model might be at the root of these controversies. One relationship links the GP as principal and portfolio company management team as agent. In this first contract, the three claims hold true. The other relationship links fund investors (Limited Partners; LPs) as principal with the GP as agent. I show that modifying that second contract by introducing a first-loss feature and reducing significantly the catch-up rate makes the two contracts equivalent. Hence, the benefits of the limited partnership structure can co-exist in a setting where the three claims about carried interest hold true.
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The carried interest received by private equity fund managers (General Partners; GPs) generates some controversies. The three most debated claims are that carried interest i) aligns incentives, ii) should be treated as a capital gain for tax purposes, and iii) should not be reported as a fee charged to investors. The existence of two key principal-agent relationships within the private equity model might be at the root of these controversies. One relationship links the GP as principal and portfolio company management team as agent. In this first contract, the three claims hold true. The other relationship links fund investors (Limited Partners; LPs) as principal with the GP as agent. I show that modifying that second contract by introducing a first-loss feature and reducing significantly the catch-up rate makes the two contracts equivalent. Hence, the benefits of the limited partnership structure can co-exist in a setting where the three claims about carried interest hold true.
State-aided Price Coordination in the Dutch Mortgage Market
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This paper shows how price leadership bans imposed, as part of the European Commission's State aid control, on all main mortgage providers but the largest bank shifted the Dutch mortgage market from a competitive to a collusive price leadership equilibrium. In May 2009, mortgage rates in The Netherlands suddenly rose against the decreasing funding cost trend to almost a full percentage point above the Eurozone average. We derive equilibrium best-response functions, identify the price leader, and estimate response adjustments in cointegrating equations on a large data set of daily mortgage rates 2004-2012. Consistent with the full coordination equilibrium, we find structural decreases in the leader's cost pass-through and H-statistic, suggesting monopoly power, as well as much closer following of the leader's price and strongly reduced transmission of common cost changes into price followers' mortgage rates. All the structural breaks are around the Spring of 2009, when the price leadership bans were negotiated. Predicted overcharges are 125 basis points or 26% on average.
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This paper shows how price leadership bans imposed, as part of the European Commission's State aid control, on all main mortgage providers but the largest bank shifted the Dutch mortgage market from a competitive to a collusive price leadership equilibrium. In May 2009, mortgage rates in The Netherlands suddenly rose against the decreasing funding cost trend to almost a full percentage point above the Eurozone average. We derive equilibrium best-response functions, identify the price leader, and estimate response adjustments in cointegrating equations on a large data set of daily mortgage rates 2004-2012. Consistent with the full coordination equilibrium, we find structural decreases in the leader's cost pass-through and H-statistic, suggesting monopoly power, as well as much closer following of the leader's price and strongly reduced transmission of common cost changes into price followers' mortgage rates. All the structural breaks are around the Spring of 2009, when the price leadership bans were negotiated. Predicted overcharges are 125 basis points or 26% on average.
The Asset-Liability Ratio: An Innovative Risk-Adjusted Performance Measure for Life Insurers
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Established risk-adjusted financial performance measures such as the Sharpe, the Sortino or the Calmar Ratio have been developed with an exclusive focus on the mutual and hedge fund industries. Consequently, they are less suited for liability-driven investors such as life insurance companies, whose portfolio choice is materially affected by the substantial interest rate sensitivity of their long-term contractual obligations. In order to tackle this limitation, we develop the Asset-Liability Ratio, which is theoretically motivated, computable based on publicly-available data, incentive compatible and effective. Hence, it should be a valuable new tool for performance assessment in the life insurance industry.
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Established risk-adjusted financial performance measures such as the Sharpe, the Sortino or the Calmar Ratio have been developed with an exclusive focus on the mutual and hedge fund industries. Consequently, they are less suited for liability-driven investors such as life insurance companies, whose portfolio choice is materially affected by the substantial interest rate sensitivity of their long-term contractual obligations. In order to tackle this limitation, we develop the Asset-Liability Ratio, which is theoretically motivated, computable based on publicly-available data, incentive compatible and effective. Hence, it should be a valuable new tool for performance assessment in the life insurance industry.
The Long and Short of It: The Post-Crisis Corporate CDS Market
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The 2007-09 financial crisis highlighted the vulnerability of financial institutions linked by a complex web of credit default swap (CDS) contracts, sparking a wave of regulatory changes to the structure of the market. In this paper, we provide broad evidence on the evolution of the CDS market in the post-crisis period, document the properties of participants’ exposures to corporate CDS over time, and study the differential pricing of transactions between different types of counterparties.
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The 2007-09 financial crisis highlighted the vulnerability of financial institutions linked by a complex web of credit default swap (CDS) contracts, sparking a wave of regulatory changes to the structure of the market. In this paper, we provide broad evidence on the evolution of the CDS market in the post-crisis period, document the properties of participants’ exposures to corporate CDS over time, and study the differential pricing of transactions between different types of counterparties.
The Pressure to Create Cash Substitutes
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Treasuries are not money-like financial assets, but the market based credit system is the financial infrastructure that uses safe and liquid assets like Treasuries as raw material to produce money-like financial claims, i.e. shadow money. The ratio of Treasuries useable by money dealers, i.e. securities dealers or money market mutual funds, to demand for money-like financial claims by institutional investors is a statistically and economically significant determinant of spreads in both money and bond markets beyond conventional determinants. The ratio measures the pressure on the financial system to provide additional safe collateral to back money-like claims or, if that is not possible, to issue unsecured short-term liabilities. Money demand by institutional investors is an indirect source of demand for safe debt securities as collateral for shadow money, distinct from demand for safe debt securities as long term investments. The empirical findings are useful to assess financial stability.
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Treasuries are not money-like financial assets, but the market based credit system is the financial infrastructure that uses safe and liquid assets like Treasuries as raw material to produce money-like financial claims, i.e. shadow money. The ratio of Treasuries useable by money dealers, i.e. securities dealers or money market mutual funds, to demand for money-like financial claims by institutional investors is a statistically and economically significant determinant of spreads in both money and bond markets beyond conventional determinants. The ratio measures the pressure on the financial system to provide additional safe collateral to back money-like claims or, if that is not possible, to issue unsecured short-term liabilities. Money demand by institutional investors is an indirect source of demand for safe debt securities as collateral for shadow money, distinct from demand for safe debt securities as long term investments. The empirical findings are useful to assess financial stability.
The Value Relevance of Dividend Announcement: An Empirical Study of the Greek Stock Market
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Purpose: Dividend policy and its impact on share pricing, has been an issue of great concern for the academic society. Over the years, many theories evolved in an effort to explain dividend policy impact on corporate value. A widely accepted approach is the signaling effect theory. The purpose of this paper is to assess the value relevance of dividend announcement. Design/methodology/approach: Our empirical work uses Greek stock market data. We adopt the event study methodology and incorporate in our research elements that differentiate Greek stock market from other developing markets. Findings: Our empirical results tend to support the theory. Decisions on dividend policy seem to affect corporate value. Investors perceive incremented dividend payments as an indication of positive future prospect and vice versa.Research limitations/implications: Different results between large and medium capitalization shares comprise an interesting element for future research.
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Purpose: Dividend policy and its impact on share pricing, has been an issue of great concern for the academic society. Over the years, many theories evolved in an effort to explain dividend policy impact on corporate value. A widely accepted approach is the signaling effect theory. The purpose of this paper is to assess the value relevance of dividend announcement. Design/methodology/approach: Our empirical work uses Greek stock market data. We adopt the event study methodology and incorporate in our research elements that differentiate Greek stock market from other developing markets. Findings: Our empirical results tend to support the theory. Decisions on dividend policy seem to affect corporate value. Investors perceive incremented dividend payments as an indication of positive future prospect and vice versa.Research limitations/implications: Different results between large and medium capitalization shares comprise an interesting element for future research.
