Knowledge that Transforms

We provide novel evidence on regulatory and supervisory practices around the world in the context of the global financial crisis, using data from a new World Bank survey covering 143 countries. Analyzing differences between crisis and non-crisis countries, we find that crisis countries had less stringent and more complex definitions of capital but exhibited lower actual capital ratios, faced fewer restrictions on non-bank activities, were less strict in the regulatory treatment of bad loans, were less able to demand banks to adjust their equity, provisions or compensation schemes, and had greater disclosure requirements but weaker incentives for private agents to monitor banks. Comparing regulatory and supervisory practices before and after the global crisis, there is evidence of few changes. While capital ratios increased, bank governance and resolution regimes were strengthened, private sector incentives to monitor banks deteriorated.

The spectacular failure of the 150-year-old investment bank Lehman Brothers on September 15th, 2008 was a major turning point in the global financial crisis that broke out in the summer of 2007. Through the use of stock market data and credit default swap (CDS) spreads, this paper examines investors’ reaction to Lehman's collapse in an attempt to identify a spillover effect on the surviving financial institutions. The empirical analysis indicates that (i) the collateral damage was limited to the largest financial firms; (ii) the institutions most affected were the surviving “non-bank” financial services firms; and (iii) the negative effect was correlated with the financial conditions of the surviving institutions. We also detect significant abnormal jumps in CDS spreads that we interpret as evidence of sudden upward revisions in the market assessment of future default probabilities assigned to the surviving financial firms.

Drawing on the lessons from the global financial crisis and especially from its impact on the banking systems of Eastern Europe, the paper proposes a new practical approach to macroprudential stress testing. The proposed approach incorporates: (i) macroeconomic stress scenarios generated from both a country specific statistical model and historical cross-country crises experience; (ii) indirect credit risk due to foreign currency exposures of unhedged borrowers; (iii) varying underwriting practices across banks and their asset classes based on their relative aggressiveness of lending; (iv) higher correlations between the probability of default and the loss given default during stress periods; (v) a negative effect of lending concentration and residual loan maturity on unexpected losses; and (vi) the use of an economic risk weighted capital adequacy ratio as the relevant outcome indicator to measure the resilience of banks to materializing credit risk. The authors apply the proposed approach to a set of Eastern European banks and discuss the results.

This paper analyzes the interactions between government's indebtedness, sovereign default risk and the size of the informal sector. We test an underlying theory that suggests that in societies with limited tax enforcement, the presence of informality constrains the set of pledgeable fiscal policy alternatives, increases public debt and the implied probability of sovereign debt restructuring. The hypotheses that we test in our empirical analysis are: a larger size of the informal sector is associated with (1) higher public indebtedness, (2) higher interest rates paid on sovereign debt, (3) a higher level of financial instability and (4) a higher probability of sovereign default. The empirical results from cross-country panel regressions show that after controlling for previously highlighted variables in the literature that could explain the variation in financial instability, sovereign default risk and public indebtedness, the size of informality remains as a significant determinant of these variables.

We consider the provision of deposit insurance as the outcome of a non-cooperative policy game between nations. Nations compete for deposits in order to protect their banking systems from the destabilizing impact of potential capital flight. Policies are chosen to attract depositors who optimally respond to the expected return to deposits, which depends on both stability and deposit insurance levels. We identify both defensive and beggar-thy-neighbour policies. The model sheds light on the European banking crisis of 2008 in which individual nations ratcheted up their deposit insurance levels.

We model the failed bank resolution process as a repeated game between a utility-maximizing government resolution authority (RA) and a profit-maximizing banking industry. Limits to resolution technology and political/economic pressure create incentives for the RA to bail out failed complex banks; the inability of the RA to credibly commit to closing these banks creates an incentive for bank complexity. We solve the game in mixed strategies and find equilibrium conditions remarkably descriptive of government responses to actual and potential large bank insolvencies during the recent financial crisis. The central role of the technology constraint in this model highlights a crucial determinant of failed bank resolution policy that has been overlooked in the theory literature to date; without improved resolution technologies, future bank bailouts are inevitable. The effects of political pressure in this model remind us that regulatory reform (e.g., Dodd-Frank) is only as good as the regulators that implement the reform.

We examine the relevance and effectiveness of stock return correlations among financial institutions as an indicator of systemic risk. By analyzing the trends and fluctuations of daily stock return correlations and default correlations among the 22 largest bank holding companies and investment banks from 1988 to 2008, we find that daily stock return correlation is a simple, robust, forward-looking, and timely systemic risk indicator. There is an increasing trend in stock return correlation among banks, whereas there is no obvious correlation trend among non-banks. We also disaggregate the stock returns into systematic and idiosyncratic components and find that the correlation increases are largely driven by the increases in correlations between banks’ idiosyncratic risks, which give rise to increasing systemic risk. Correlation spikes tend to predict or coincide with significant economic or market events, especially during the 2007–2008 financial crisis. Furthermore, we show that stock return correlations offer a perspective on the level of systemic risk in the financial sector that is not already captured by default correlations. Stock return correlations are not subject to data limitations or model specification errors that other potential systemic risk measures may face. Therefore, we recommend that regulators and businesses monitor daily stock return correlations among those large and highly leveraged financial institutions to track the level of systemic risk.

This paper describes the changes that occurred in the conduct and instruments of monetary policy used by major central banks when the crisis hit; discusses the new tradeoffs and controversies engendered by those policy reactions; and speculates about additional likely future changes in monetary policy and institutions. Following a brief account of the evolution of monetary policymaking principles and institutions in the past, the paper deals with the controversial question of how and when to exit a period of large-scale monetary expansion. The paper documents the fact that, in spite of huge monetary injections and historically low interest rates, inflation in the US and in the Eurozone remained subdued, and reports that since the onset of the subprime crisis, there has been a dramatic deceleration in the growth of banking credit in the US. The paper also discusses the tradeoff between the lender-of-last-resort function of the central bank and moral hazard; the consequences of bailout uncertainty for central bank policy; and the particular problems faced by the ECB in the face of a major financial crisis.

Following the damaging real effects of asset price fluctuations over the recent financial crisis, the debate on the appropriate role of such prices in a monetary policy context has gained renewed attention. This paper argues that a direct monetary policy response to asset prices is not desirable under common instrumental rate rules. To illustrate this point, we build an adaptive learning model, that extends existing learning models in monetary policy, most notably, Bullard and Mitra (2002). The result remains valid in a context with heterogeneous beliefs and is robust to an optimal monetary policy rule including a weight on asset prices.