Knowledge that Transforms

This paper develops an index of financial stress for the Canadian financial system. It is a continuous variable with a spectrum of values, where extreme values are called financial crises. An internal Bank of Canada survey is used to condition the choice of variables. The authors show that alternative measures of financial crisis suggested by the literature do not accurately reflect the Canadian experience, while several measures developed in this paper are more representative and are thus likely better suited to a developed financial system. An accurate characterization of stress is a prerequisite for any researcher attempting to forecast financial crises.

The Russian bond default in August 1998 and the long-term capital management (LTCM) recapitalization announcement in the following month represent an unusual period of volatility in international bond markets with bond spreads increasing dramatically across the globe. Using a latent factor model and a new data set spanning bond markets across Asia, Europe and the Americas, we quantify the contribution of contagion to the spread of these two crises. The maximum amount of contagion experienced by any of the countries investigated is about 17% of total volatility in bond spreads, with the main effects due to the Russian crisis. The results also show that both emerging and developed markets experienced contagion during the period.

In this paper we model the derivative strategies optimally undertaken by a manager (or head of a profit center in a hedge fund) when the detailed derivative positions taken are not contractible. We show that with commonly-used incentive features in the compensation structure, managers have incentives to implement complex derivative strategies that lead to a slight reduction in default probabilities (or a slight increase in performance measures) with a high probability at the cost of allowing for the possibility of disaster states involving large losses, although with a very small probability. Such disaster states cause systemic instability (similar to the experience of Long-Term Capital Management in September 1998). We discuss possible audit strategies, governance mechanisms and incentive structures that will ameliorate the probability of systemic instability arising from such incentives in a market with a rich enough menu of derivatives. We characterize the optimal intensity of audit effort with and without the presence of such derivative strategies. The dependence of the optimal audit intensity on the legal liability regime and different rules for apportioning the auditor's liability is derived. Our results also relate the optimal audit intensity to the cost and efficiency parameters of the audit firm.

Extant work on costs of financial instability focuses on fiscal costs and declines in aggregate GDP following banking crises. We estimate effects of banking and currency crises on consumption in 19 OECD countries, showing consumption plays an important role in the adjustment following a crisis, and effects are not captured solely by the impact of crises on standard consumption determinants, income and wealth. Additional effects, attributable to factors such as time-varying confidence, uncertainty and credit rationing, are aggravated by high and rising leverage, despite financial liberalisation easing liquidity constraints. High leverage implies that banking crises taking place now could have greater incidence than in the past.