financial stability

ARHOLIADAU ATODAL AWST 2013

SUPPLEMENTARY EXAMINATIONS AUGUST 2013

CYFRIFEG A CHYLLID ACCOUNTING AND FINANCE

BANCIO A CHYLLID BANKING AND FINANCE

ECONOMEG ECONOMICS

RHEOLAETH MANAGEMENT

BUSNES A MARCHNATA BUSINESS AND MARKETING

AMSER A GANIATEIR: 2 AWR

TIME ALLOWED: 2 HOURS

ASB 4850 Financial Stability

NI CHANIATEIR CYFRIFIANELLAU Y GELLER EU RHAGLENNU

NO PROGRAMMABLE CALCULATORS ARE PERMITTED

YOU MUST ANSWER PART A AND ANY ONE QUESTION IN PART B!

All Questions Carry Equal Marks

Part A: (Compulsory)

Are low monetary policy rates good or bad for financial stability? Discuss in detail and support your answer with reference to empirical research by Jiminez et al. (2013) and Maddaloni and Peydro-Alcalde (2011) in this area.

Solution:

Low monetary policy rates are being blamed by observers for the build up of the recent financial crisis.

Expansive monetary policy (effect of low interest rates) results in:

· Softening standards by banks.

· Taking excessive risks.

· Higher volume of credit.

· Changes in composition of credit (composition pool of borrowers).

· Agency problem (i.e., low levels of capital due to increased writes-offs, reductions in investment).

· Improve banks’ liquidity and net worth.

· Riskless assets less attractive and may lead to a search-for-yield .

· Securitization enhances bank lending capacity and attractive returns.

· Monetary illusion to boost profits- inducing higher risk-taking to credit risk (i.e., loans with a higher probability of default).

· Increasing the yield curve slope (maturity mismatch) softens lending standards and exposure to liquidity risk.

· Reduce adverse selection problems in credit markets and decrease screening by banks.

· Foster bubbles in asset prices and credit.

· Increase opportunity cost to hold cash - risky investment more attractive.

· Reduce the banks’ net worth or charter value (i.e., “Gambling for resurrection” strategy more attractive).

Important! Market participants craved for low interest rates to alleviate their financial predicaments!

Jiménez et.al., (Econometrica 2013) study empirically the impact of short-term interest rates on the composition of the supply of credit (risk taking; i.e., impact on loan granting). They disentangle supply from demand of credit while accounting for short and long term interest rates using data from the Spanish credit register, bank-firm level data covering period 1984 to 2009.

Key findings:

· Key variable: interaction of bank capital, firm credit risk, and short-term interest rate changes.

· Positive coefficient on triple interaction implies more risk taking by lowly capitalized banks when interest rates decline (i.e., expanding and prolonging credit to riskier firms).

· Long term interest rates insignificant.

· Large banks loosen their lending standards for risky firms less than small banks.

· Process of extending credit driven by supply (banks) rather than demand (borrowers).

· Amplification of risk taking could be caused by financial innovation.

Maddaloni and Peydro-Alcalde (RFS 2011) ask whether low levels of short and long-term interest rates soften bank lending standards? Using data for the Euro area and the U.S. lending standards covering 1991 to 2008, they analyse the impact of both short- and long-term rates on lending standards directly and through the interaction with too low for too long monetary policy rates, securitization and banking supervision. They also investigate the relation between short-term rates and lending standards prior to the financial crisis and the economic, banking, and fiscal performance afterwards.

Key findings:

· One-standard-deviation decrease of Taylor rule residuals five time stronger than increase in softening due to increase of GDP (−13.68 per cent and −2.61 per cent, respectively).

· Monetary policy rates have an impact on lending standards almost double the impact of GDP growth (−11.48 per cent and −6.10 per cent, respectively).

· GDP growth not significant for consumer credit.

· Low short-term rates soften standards for all types of loans.

· Softening of lending standards amplified by too low for too long monetary policy rates.

· Softening of lending standards already due to low monetary policy amplified by securitization activity.

· Higher long-term rates soften lending standards for firms.

· Impact of low monetary rates on the softening of standards (due to bank balance-sheet constraints) for mortgage loans is amplified when supervision standards for bank capital are weak. Low levels of monetary policy rates increase bank loan risk-taking especially when banking supervision is weak.

· Countries with low monetary interest rates before the crisis, excessive financial innovation and weak supervision:

· Experienced worse economic performance after the crisis (measured by real fiscal and banking variables).

· Incurred higher costs towards recovery.

· Monetary policy rates affect financial stability.

Part B: (Answer ONLY ONE of the following three questions

Question B.1

Why is financial stability important? In your answer, describe in detail how central banks write about financial stability and what the benefits and drawbacks are of publishing financial stability reports.

Solution:

Importance is due to:

· High costs and frequency of financial crises

· Increasingly growing number of financial transactions

· Financial innovation and new and more complex instruments

Ensuring financial stability becomes one of primary objectives of central banks.

A financial stability report (FSR) “…FSR is a regular, self-contained publication that focuses on

risks and exposures in the financial system” (Cihak 2006; pp.5).

FSRs:

· Independent publications with the analytical content.

· Published on an annual or semi-annual basis.

· Cover issues such as risks and exposures of financial institutions.

· Comprehensive report of soundness of the entire system.

Reasons to publish an FSR:

· Contribute towards financial stability (educate about risks to financial institutions, inform different parties on their collective impact on the system, put an agreement between market participants to achieve financial coherence).

· Show commitment (of the central bank) in maintaining financially stable system.

· Through FSRs banks communicate their findings to the public (build trust).

· Promotes transparency and disclosure of the risks associated with a business or entity (market discipline).

· Give indication of objectives, targets contributing to more stable system.

· Present tools which are used to measure soundness of the financial system.

· Apply tools which measure the progress of the actions taken.

Reasons against publishing an FSR:

· Issues discussed are too sensitive for a public knowledge (publication at the time of financial instability might precipitate shocks or crisis that the central bank was trying to avoid, by inducing liquidity problems).

· However, if banks are certain about their contingency arrangements, publication can actually help.

· Influence of the central bank is limited, the outcomes cannot be guaranteed, final effect depends from other parties such as other agencies and market players.

· Requires resources (regular publications).

Question B.2

Define the term “systemic risk” and describe in detail the measure developed by Acharya, Pedersen, Philippon, and Richardson (2011).

Solution:

Systemic Risk: “When we see it” phenomenon which is difficult to define and quantify.

· “Systemic financial risk is an event which triggers a loss of economic value or confidence in a substantial portion of the financial system that is serious to have significant adverse effects on the real economy. These events can be sudden and unexpected, or their occurrence can build up through time in the absence of appropriate policy responses. The adverse real economic effects from systemic problems are generally seen as arising from disruptions to the payment system, to credit flows, and from the destruction of asset values.”

Systemic expected shortfall (SES) is a measure used to show how financial institutions (each bank) contribute to systemic risk (crisis). It is related to financial firm's marginal expected shortfall, (MES) and to it’s leverage.

· Estimation of SES: 3 components

1. Excess ex ante leverage;

2. Measured marginal expected shortfall (MES) using pre-crisis data;

3. An adjustment term;

· How does it work?

SES increases with

· Institution's leverage and

· With its expected loss in the tail of the system's loss distribution

What is MES?

Financial firm's marginal expected shortfall measures how group i 's risk taking adds to

the bank's overall risk. MES can be measured by estimating group i 's losses when the

firm as a whole is doing poorly. It is the average return of each firm during the 5%

worst days for the market.  

What is it being used for?

Used to predict emerging risks during the financial crisis of 2007-2009.

Compared against realized systemic risk measures:

A. The capital shortfalls at large financial institutions as assessed in the regulator's stress tests during the Spring of 2009;

B. The drop in equity values of large financial firms during the crisis;

C. The increase in credit risk estimated from credit default swaps (CDS) of large financial firms during the crisis;

Features:

MES is simple to compute and therefore easy for regulators to consider.

MES and leverage predict each firm's contribution to a crisis (Acharya et al., 2010).

High explanatory power in comparison with standard firm-level risk measures such as VAR, expected loss, volatility.

Question B.3

Compare and contrast shadow banking activities with traditional banking activities. Discuss how the shadow banking system is connected with the regulated banking system.

Solution:

Shadow banking vs. traditional banking:

· Similarly to traditional banking, shadow banking system conducts credit intermediation (transforming long-term risky loans onto seemingly risk-free short-term, money-like instruments).

· In contrast to traditional banks, shadow banks lack of access to public sources of liquidity such as the central banks’ (e.g., the Federal Reserve’s) discount window, or public sources of insurance such as deposit insurance (e.g., the Federal Deposit Insurance Corporation’s insurance system).

· Unlike traditional banking credit intermediation is performed through a daisy-chain of non-bank financial intermediaries in a multi step process. This entails “vertical slicing” of traditional banks’ credit intermediation.

Interconnectedness:

· Interconnectedness between non-bank unregulated (shadow banking) and regulated banking has increased significantly over the recent years leading to risk of contagion through shocks across institutions.

· European banking depends more heavily on finance from the financial sector than in the past, in particular from other financial intermediaries (OFIs) . OFIs cover shadow banking entities, including securitisation vehicles.

· Shadow banking is more prone to runs and liquidity dry-up because of its short-term nature.

· This finding confirms that macro-prudential authorities and supervisors should carefully monitor the growing interlinkages between the regulated banking sector and the shadow banking system.

Diwedd/End