Knowledge that Transforms

We analyze the international transmission of financial stress and its effects on global economic activity. Our analysis is based on country-specific monthly financial stress indices (FSIs) over the sample period 1970–2012 for 20 major economies. First, we show that co-movement between the FSIs increases during major financial crises and towards the end of our sample period. Second, we show that the risk of large financial stress spillovers to an economy increases with its level of economic openness. Third, we show – using a global VAR (GVAR) model – that (i) a financial stress shock in the US quickly transmits internationally, (ii) financial stress shocks have lagged but persistent negative effects on economic activity, and (iii) that a negative US demand shock induces only limited financial stress on a global scale. Finally, we show that spillovers of financial stress run mainly from advanced to emerging economies and not in the opposite direction.

Using supervisory data for U.S. banks, we evaluate the alignment of Basel II/III AIRB (advanced internal ratings based) risk estimates with portfolio risk. We use loan performance as a direct measure of portfolio risk as well as less direct market-based measures. Our results document that AIRB risk weights are highly correlated with loan performance and that, in contrast, Basel I risk weights are not. We find that capital requirements under the AIRB approach are higher than those under Basel I especially for portfolios recently under stress such as mortgages and some sovereign exposures. The alignment of Basel risk estimates with market-based risk indicators is less robust, although the association is nevertheless stronger under the AIRB approach. Our results support the view that internally generated risk weights are determined mostly by portfolio risk and, as a result, are substantially more risk sensitive than the fixed asset class based risk weights of Basel I.

This paper uses Eurobarometer survey data from 26 EU countries to evaluate whether the general public cares about financial stability and imbalances over and above their effects on macroeconomic variables such as unemployment and inflation. I confirm previous results in the literature that life satisfaction – a widely used measure of household welfare – negatively depends on the unemployment rate. In addition to previous results in the literature, I establish a strong empirical link between life satisfaction and consumer confidence as measured by the European Commission consumer survey. The main result of the paper is that life satisfaction generally does not systematically depend on a number of measures of financial imbalance based on credit and asset prices once the other macroeconomic controls are included.

With unique daily short sale data of Borsa Istanbul (stock exchange of Turkey), we investigate the dynamic relationship between short selling activity and volatility, liquidity and market return from January 2005 to December 2012 using a VAR(p)-cDCC-FIEGARCH(1,d,1) approach. Our findings suggest that short sellers are contrarian traders and contribute to efficient stock market in Turkey. We also show that increased short selling activity is associated with higher liquidity and decreased volatility. However this relation weakens during the financial turmoil of 2008. Our results indicate that any ban on short sales may be detrimental for financial stability and market quality in Turkey.

In the aftermath of the 2007–2009 crisis, banks claiming positive diversification benefits are being met with skepticism. Nevertheless, diversification might be important and sizable for some large internationally active banking groups. We use a universally applicable correlation matrix approach to calculate international diversification effects, in which bank subsidiaries are treated as individual assets of the banking group portfolio. We apply the framework to 49 of the world's largest banking groups with significant foreign business units over the 1992–2009 period. Focusing on the most important risk in banking, credit risk, we find that allowing for geographical diversification could reduce banks’ credit risk by 1.1% on average, with risk reduction ranging from negligible up to 8%.

This paper analyzes the channels through which financial liberalization affects bank risk-taking in an international sample of 4333 banks in 83 countries. Our results indicate that financial liberalization increases bank risk-taking in both developed and developing countries but through different channels. Financial liberalization promotes stronger bank competition that increases risk-taking incentives in developed countries, whereas in developing countries it increases bank risk by expanding opportunities to take risk. Capital requirements help reduce the negative impact of financial liberalization on financial stability in both developed and developing countries. However, official supervision and financial transparency are only effective in developing countries.

Extensive regulatory changes and technological advances have transformed banking systems to a great extent. Banks have reacted to the challenges posed by the new operating environment by creating new products and expanding their activities to some uncharted business areas. In this paper, we study how modern banking which gave birth to the off-balance-sheet leverage activities affected the risk profile of U.S. banks as well as the level of systemic risk before and after the onset of the late 2000s financial crisis. Towards this, we separate on- from off-balance-sheet leverage and capture the latter with different, yet complementary, measures which do not exist in the current literature. Special attention is paid on the deleveraging process that occurred in the banking market after the crisis erupted, which is an additional innovative feature of this study. Our findings reveal that leverage, both explicit and hidden off-the-balance-sheet, increases the individual risk of banking firms making them vulnerable to financial shocks. Reverse leverage, on the other hand, is beneficial for individual banks’ health, but is found to be harmful for financial stability. We also demonstrate that the banks which concentrate on traditional lines of business typically carry less risk compared to those involved with modern financial instruments.

Interest in too big to fail (TBTF) resolutions of insolvent large complex financial firms has intensified in recent years. TBTF resolutions protect some in-the-money counterparties of a targeted insolvent firm from losses that they would suffer if the usual bankruptcy resolution regimes used in resolving other firms in the industry were applied. Although special TBTF resolution regimes may reduce the collateral spill-over costs of the failure, the combined direct and indirect costs from such “bailouts” may be large and often financed in part or in total by taxpayers. Thus, TBTF has become a major public policy issue that has not been resolved in part because of disagreements about definitions and thereby the estimates of the benefits and costs. This paper explores these differences and develops a framework for standardizing the definitions and evaluating the desirability of TBTF resolutions more accurately.

The impact of collateral diversification by non-financial firms on systemic risk is studied in a general equilibrium model with standard production functions and mixed debt-equity financing. Systemic risk comes about as soon as firms diversify their collateral by holding claims on a big wholesale (merchant) bank whose asset side includes claims on the same producer set. The merchant bank sector proves to be fragile (has a short distance to default) regardless of competition. In this setting, the policy response, consisting in official guarantees for the merchant bank's liabilities, entails considerable government loss risk. An alternative without the need for public sector involvement is to encourage systemically important merchant banks to introduce a simple bail-in mechanism by restricting their liabilities to contingent convertible bonds. This line of regulatory policy is particularly relevant to the containment of systemic events in globally leveraged economies serviced by big international banks outside host country regulatory control.

This paper establishes baseline valuations for housing assets using rent cash flows in 22 regions of the U.S. in a Lucas (1978) framework. The model matches the unconditional averages of the price–rent ratios from 1978 to 2012 quite well; however, the model valuations after 2002 are well below the market price–rent ratios. We explore three mechanisms to understand these housing overvaluations in the post-2002 period relative to the consumption-based model: (1) using cross-sectional subprime consumer and commercial lending characteristics; (2) transaction costs; and (3) turning off the pro-cyclicality of the rent growth in the data. We find that all three factors explain some fraction of the bubble in valuations, but none alone is enough to understand the full extent of post-2002 valuations.