Transcript Recent Financial Turmoil - What`s New by Dr Peter

Recent Financial Turmoil:
What’s New?
Peter Dunne, Queen’s University Belfast
Co-authored by Andrey Zholos
Presentation at:
The Society of Investment Analysts (Ireland)
28th Nov 2007
A Role for Financial Structure?
Traditionally ‘money’ was at the centre of macro
theory of crashes
Gertler (1988) blames the Keynesian revolution
and monetarists for redirecting attention.
Gurley and Shaw (1955) focused on Credit supply
rather than monetary aggregates.
Revisionists
Bernanke (1983) on the relative importance of monetary
versus financial factors in the Great Depression.
“The breakdown in banking affected real
activity by choking off financial flows to
certain sectors of the economy, sectors
consisting of borrowers who did not have easy
access to non-intermediated credit.”
“..worsening of balance sheets resulting from
the jump in debt service shrank borrowers’
collateral…”
Revisionists
Bernanke (1983) found that financial variables
were important determinants of output
Liabilities of failed banks and businesses and
spreads between risky and safe bond rates
added considerable explanatory power to
Barro-type output equations.
Disruption of credit markets was not simply a
response to anticipations of future output
decline.
Hamilton (1987) and many others provide
further evidence supporting this view.
Information asymmetry
Moral hazard
Akerlof's (1969) ‘market for lemons’ influenced Jaffee
& Russell (1976) and Stiglitz & Weiss (1981)
Lemons theory explains how unobserved differences in borrower quality
induces credit rationing.
Mankiw (1986) analyzes a credit market plagued by
lemons problems……a small rise in the riskless
interest rate can lead to collapse.
The increase in the loan rate reduces the average quality of borrowers.
This forces the loan rate up further to offset the lemons effect.
If the lemons problem is severe enough, the market will collapse.
Information asymmetry
Myers & Majluf (1984) and
Greenwald, Stiglitz & Weiss (1984)
Equity financing effects of information asymmetry regarding
the value of a firm's existing assets.
Bernanke and Gertler (1986)
Resurrect ‘balance sheet effects’ also known as ‘collateral
effects’, ‘financial capacity’ effects or ‘debt deflation’.
Gan(2007)
Shows such effects in the Japanese economy after the
property decline of the late 1980s.
Lessons from recent panics/crashes
Seeds of a moral hazard problem?
Japan – late 1980s……BoJ too slow!
A warning to other monetary authorities.
Crash of 1987
The beginning of the Greenspan put?
South-Asian currency and bank crises 1997&1998
Is the current turmoil just a repeat of this but with Western banks
now at the centre of the storm?
Russian debt moratorium 1998
Unobserved exposures through derivatives mkts
LTCM
Bailing out of LTCM inviting moral hazard problem
Spread of systemic risk through collapse of markets
Particularly derivatives mkts
Any difference this time?
Low interest rates, cheap money, yield chasing?
Not so different from before
Too few investment opportunities.
Was the macro environment too loose given that inflation was been
kept under control by other factors?
Inefficient credit ratings – not a new problem?
Peek and Rosengren (1998) report that throughout 1995
and 1996 Libor quotes for major Japanese banks for
eurodollar and euroyen borrowing rarely differed by
more than a few basis points, even though there were
substantial differences in their credit ratings provided
by the major rating agencies.
Any difference this time?
More concentrated and more integrated markets?
More Bank Regulation
Stronger bank balance sheets following Basel I?
More off-balance sheet activity!
More systemic reaction to crisis….all trying to beef-up
liquidity at the same time
More transparency….MiFID, NMS etc.
Increasing the risks in financial intermediation
Any difference this time?
Sovereign funds
Complications arising from politics of BRICK current account
surpluses in dollars.
Bad taste resulting from DPW sell-off of ports to AIG and some
reluctance to invest in US colateralized debt.
Slide of dollar could transmit problems to BRICK
Collateralized Debt Obligations
All the lemons problems you could wish for!
But not that new! The tail has wagged the dog before.
During LTCM crisis derivative positions threatened
other markets
US EU
Market integration - volatility
Granger causality tests (daily data for 2 years)
Variables
VIX………..S&P volatility from options
EUR10 ……iTRAXX Euro 10Y CDS prem
VOL10 ……iTRAXX High Vol 10Y CDS prem
SEN10 ……iTRAXX Sen Financial 10Y CDS prem
SUB10 ……iTRAXX Sub Financial 10Y CDS prem
Cross10 ……iTRAXX Cross 10Y CDS prem
USV2 ……UST 2year yield volatility
USV10….. UST 10year yield volatility
What causes what?
Dependent variable
VIX
EUR10
VOL10
SEN10
SUB10
CROSS10
USV2
USV10
F-Signif
F-Signif
F-Signif
F-Signif
F-Signif
F-Signif
F-Signif
F-Signif
VIX
0.000
0.000
0.000
0.006
0.001
0.000
0.004
0.192
EUR10
0.311
0.000
0.304
0.000
0.012
0.516
0.264
0.474
VOL10
0.680
0.051
0.000
0.070
0.146
0.022
0.134
0.202
SEN10
0.008
0.000
0.087
0.000
0.029
0.282
0.576
0.664
SUB10
0.005
0.023
0.135
0.005
0.000
0.408
0.758
0.851
CROSS10
0.290
0.004
0.011
0.024
0.010
0.000
0.643
0.729
USV2
0.541
0.753
0.934
0.692
0.760
0.181
0.027
0.389
USV10
0.615
0.694
0.739
0.232
0.271
0.207
0.243
0.001
Shock variable
Points of interest? (1) VIX driven by iTRAXX Financials
(2) VIX feedsback to iTRAXX
Interaction of Volatility & Market Quality
Granger causality tests (daily data for 5 years)
Variables
VIX……………S&P volatility from options
USV2 ………..Volatility of UST yields
ITV2 …………Volatility of Italian yields
spra_10Y_US ……Bid-ask spread in UST mkt
spra_10Y_IT………Bid-ask spread in IT(MTS)
What causes what?
Dependent variable
VIX
USV2
ITV2
SPRA_10Y_US
SPRA_10Y_IT
F-Signif
F-Signif
F-Signif
F-Signif
F-Signif
VIX
0.000
0.000
0.612
0.116
0.742
USV2
0.228
0.000
0.254
0.036
0.548
ITV2
0.329
0.314
0.000
0.757
0.687
SPRA_10Y_US
0.839
0.069
0.189
0.000
0.002
SPRA_10Y_IT
0.992
0.051
0.002
0.146
0.000
Shock variable
Points of interest!
(1) VIX drives UST volatility
(2) US Bid-Ask drives EU Bid-Ask
Recent warnings
Giddy(1981) comment regarding the
functioning of the interbank eurocurrency
market
“Indeed, if it is true that the market places great store
on central bank support, it will continue to grant
credit without discrimination to large banks. In
effect the market will test central banks’ mettle, and
if ever the rule of central bank rescues is broken,
severe credit rationing will occur.”
Mervin King threatened such a rule break!
Recent warnings
G10 central banks report 1992
“… the heightened concern with credit risk, reflecting both a
perception of increased default risk and greater difficulties in
assessing counterparties’ strength, has led many banks to
reduce the size of interbank credit exposures that can be
authorised, to shorten the maturity of the business they are
willing to take on, and to limit dealing activities that yield low
profits but give rise to large counterparty exposures”
Yields at the short and long maturities
Long and short yield Italian Bonds
0.05
0.04
0.03
y_10_YEAR_IT
0.02
y_2_YEAR_IT
0.01
01/04/2007
01/10/2006
01/04/2006
01/10/2005
01/04/2005
01/10/2004
01/04/2004
01/10/2003
01/04/2003
0
Liquidity provision at the short and long maturities
8000000000
7000000000
6000000000
5000000000
4000000000
3000000000
2000000000
1000000000
0
Liquidity 10Year
13/05/2007
13/11/2006
13/05/2006
13/11/2005
13/05/2005
13/11/2004
13/05/2004
13/11/2003
13/05/2003
Liquidity 2Year
Recent warnings
Bernard & Bisignano (BIS, 2000)
“Interbank lending to Asia grew enormously prior to the Asian crisis, at
times with arguably little recognition of the quality of the borrowing
institution. International interbank credit also declined dramatically
after the crisis erupted, contributing to a major collapse in economic
activity.”
Short term IIBM borrowing was funding low quality sovereign debt.
Giddy (1981) and Clarke (1983) pointed to the widespread belief among
market participants that central banks would step in to support the
market if it came under stress.
Clarke reported that inquiries about counterparties’ balance sheets were
considered to be in “rather bad taste”. Particularly if the bank in
question was a very large bank – more likely to be bailed out.
Effects already
Liquidity effects
Feedback from dollar concerns
Sovereign funds worry
Higher yields on even govies in Europe
Having a futures market helped Bunds
Better functioning markets also means more
concentration in activity and therefore more
direct linkages between banking organizations
and therefore more systemic risk.
Towards solutions
What drives the assumption that central banks
will provide a safety-net?
Is it worthwhile trying to reduce moral hazard
and how can it be done?
Can bubbles be detected? …viewed as a dead
science in academia and policy circles.
Would it be possible to coordinate CB policy so
as to reduce cheap fuelling of leveraged
investments internationally?
Towards solutions
By-pass the intermediary (Sell direct to surplus
countries)
This assumes intermediaries add nothing
Can high real interest rates be good?
In very well developed economies…
Should central banks monitor the type of
investment going on.
Towards solutions
Can transparency help?
Counterparty transparency is problematic.
No incentive to reveal debt positions so lemons
problem.
If revealed it would reduce the costs of credit analysis
and counterparty risk but increase position risk
Would it reduce moral hazard risk?
Bester (1985) suggested that simultaneously offering loan
rates and collateral requirements would help.
Good borrowers would then prefer lower rates and greater
collateral given their lower probability of potential
default.
But the ‘tail can wag the dog’ unless transparency abounds.
Hold on to your hat!
Still a rough ride ahead!
We may be spared a Japanese style finish
Deflation is rather unlikely