Knowledge that Transforms

Using data for 48 advanced and emerging market economies during 1985–2008, this paper examines the impact of measures of financial integration and globalization on several dimensions of real activity. We find that both advances in financial integration and globalization are associated with higher growth, lower growth volatility, and lower probabilities of severe declines in real activity, with the positive impact of financial integration on macroeconomic stability enhanced by improvements in corporate governance. Thus, we find no evidence of a trade-off between advances in financial integration, globalization, and growth and macroeconomic stability.

In a model where banks play an active role in monitoring borrowers, we analyze the impact of securitization on bankers’ incentives across different macroeconomic scenarios. We show that securitization can be part of the optimal financing scheme for banks, provided banks retain an equity tranche in the sold loans to maintain proper incentives. In economic downturns however securitization should be restricted. The implementation of the optimal solvency scheme is achieved by setting appropriate capital charges through a form of capital insurance, protecting the value of bank capital in downturns, while providing additional liquidity in upturns.

The excessive increase of leverage, i.e. the abuse of debt financing, is considered one of the primary factors in the default of financial institutions since it amplifies potential investment losses. On the other side, portfolio diversification acts to mitigate these losses. Systemic risk results from correlations between individual default probabilities that cannot be considered independent. Based on the structural framework by Merton (1974), we propose a model in which these correlations arise from overlaps in banks’ portfolios. Our main result is the finding of a critical level of diversification that separates two regimes: (i) a safe regime in which a properly chosen diversification strategy offsets the higher systemic risk engendered by increased leverage and (ii) a risky regime in which an inadequate diversification strategy and/or adverse market conditions, such as market size, market volatility and time horizon, cannot compensate the same increase in leverage. Our results are of relevance for financial regulators especially because the critical level of diversification may not coincide with the one that is individually optimal.

We analyze three databases of banking crises and investigate their consistency in the identification and timing of crises. We find that there are large and statistically significant discrepancies between the datasets. We also compare the dating of banking crises according to these databases using information on the number and size of bank failures for four crises for which the timing strongly differs across these databases. We conclude that information on these variables allows determining the timing of banking crises more precisely. Our dating of the four crises corresponds closely with that of Laeven and Valencia.

We analyze the emergence of systemic risk in a network model of interconnected bank balance sheets. The model incorporates multiple sources of systemic risk, including size of financial institutions, direct exposure from interbank lendings, and asset fire sales. We suggest a new macroprudential risk management approach building on a system wide value at risk (SVaR). Under the SVaR metric, the contribution of individual banks to systemic risk is well defined and can be approximated by a Shapley value-type measure. We show that, in a SVaR regime, a fair systemic risk charge which is proportional to a bank's individual contribution to systemic risk diverges from the optimal macroprudential capitalization of the banks from a planner's perspective. The results have implications for the design of macroprudential capital surcharges.

We critically review the state of the art in macro stress testing, assessing its strengths and weaknesses. We argue that, given current technology, macro stress tests are ill-suited as early warning devices, i.e. as tools for identifying vulnerabilities during seemingly tranquil times and for triggering remedial action. By contrast, as long as properly designed, stress tests can be quite effective as crisis management and resolution tools. We also see additional side benefits, stemming largely from the way such tests can discipline thinking about financial stability. We suggest possible ways to improve their performance.

To mitigate potential contagion from future banking crises, the European Commission recently proposed a framework which would provide for the bail-in of bank creditors in the event of failure. In this study, we examine this framework retrospectively in the context of failed European banks during the global financial crisis. Empirical findings suggest that equity and subordinated bond holders would have been the main losers from the €535 billion impairment losses realized by failed European banks. Losses attributed to senior debt holders would, on aggregate, have been proportionally small, while no losses would have been imposed on depositors. Cross-country analysis, incorporating stress-tests, reveals a divergence of outcomes with subordinated debt holders wiped out in a number of countries, while senior debt holders of Greek, Austrian and Irish banks would have required bail-in.

The global financial crisis brought government guarantees to the forefront of the debate. Based on a review of frictions that hinder financial contracting, this paper concludes that the common justifications for government guarantees—i.e., principal-agent frictions or un-internalized externalities in an environment of risk neutrality—are flawed. Even where risk is purely idiosyncratic—and thus diversifiable in principle—government guarantees (typically granted via development banks/agencies) can be justified if private lenders are risk averse and because of the state's comparative advantage over markets in resolving the collective action frictions that hinder risk spreading. To exploit this advantage while keeping moral hazard in check, however, development banks/agencies have to price their guarantees fairly, crowd in the private sector, and reduce their excessive risk aversion. The latter requires overcoming agency frictions between managers and owner (the state), which would likely entail a significant reshaping of development banks’ mandates, governance, and risk management systems.

This paper presents a new view on the gold price of greenbacks during and after the American Civil War by analyzing exchange-rate volatility rather than exchange-rate levels. Our empirical investigation detects regimes of high and low volatility alternating in a way that is consistent with a theoretical exchange-rate model in which the rate is primarily driven by investors’ expectations and not by fundamentals. We interpret these findings as evidence that monetary policy makers were surprisingly able to credibly announce the resumption to gold half a year before it actually took place on January 1, 1879. Given the intense political debate about the appropriate design of the United States’ financial system, this is a remarkable result. It indicates that the policy makers’ ability to anchor investors’ expectations is relevant to achieving asset-price stability as well as effectiveness of financial market regulation. The insights from this historical episode should therefore be of interest to policy makers and regulators combating financial crises like the ongoing current debt crises worldwide.

This paper studies the impact of the subprime crisis on the ratings issued by the rating agencies in evaluating the solvency of banks. After ascertaining a significant worsening of ratings after the crisis, the paper hypothesises the possibility that this worsening is due not exclusively to a deterioration in the banks’ credit quality, but also to a change in the behaviour of the rating agencies. The study designs a methodology to separate the observed change in ratings into two multiplicative components: one associated with the deterioration of the banks’ solvency itself and another associated with the change in the agencies’ valuation criteria. The methodology is applied to the Spanish Banking System during the period 2000–2009. The results obtained show that the observed lowering of ratings (10.88%) is explained (75%) by the deterioration in the solvency of the banks, but also (25%) by the hardening of the valuation criteria adopted by the agencies. This shows the procyclical character of ratings.