A Market Based Measure of Credit Quality and Banks' Performance During the Subprime Crisis

We propose a new method for measuring the quality of banks credit portfolios. This method makes use of information impounded in bank share prices by exploiting differences in their sensitivity to credit default swap spreads of borrowers of varying quality. The method allows us to derive a credit risk indicator (CRI), which is the perceived share of high risk exposures in a bank's portfolio. We estimate CRIs for the 150 largest U.S. bank holding companies and find that they have strong predictive power for the BHCs' performance during the subprime crisis, even after controlling for a variety of traditional asset quality proxies. Interestingly, we also find that the BHCs' aggregate CRI did not deteriorate since the beginning of the subprime crisis. This suggests that the market was aware of their (average) exposure to high risk credit.credit risk;asset quality;banks;subprime crisis

Privatized Returns and Socialized Risks: CEO Incentives, Securitization Accounting and the Financial Crisis

The paper investigates the role of CEO’s equity and risk incentives in boosting securitization in the financial industry and in motivating executives to reduce the perceived risk while betting on it. Using a sample of US financial institutions over the period 2003-2009 we document that CEOs with high equity incentives have systematically engaged in securitization transactions to a larger extent than CEOs with low incentives. We also show that CEOs with high equity and risk-related incentives have engaged in the securitization of risky loans and have used securitization for transferring risks to outside investors. Finally, we show that executives incentivized on risk have provided outside investors with low quality disclosure about losses recorded on securitized loans thus contributing to increase the opacity of securitization transactions undertaken. Overall, we interpret our results as evidence that CEOs have foreseen in securitizations under US GAAP an opportunity for hiding risks while bearing them and generating profits and cash flows because of the risks. Our results are robust to several model specifications as well as to endogeneity concerns

Can banks circumvent minimum capital requirements? The case of mortgage portfolios under Basel II

The recent mortgage crisis has resulted in several bank failures as the number of mortgage defaults increased. The current Basel I capital framework does not require banks to hold sufficient amounts of capital to support their mortgage lending activities. The new Basel II capital rules are intended to correct this problem. However, Basel II models could become too complex and too costly to implement, often resulting in a trade-off between complexity and model accuracy. In addition, the variation of the model, particularly how mortgage portfolios are segmented, could have a significant impact on the default and loss estimated and, thus, could affect the amount of capital that banks are required to hold. This paper finds that the calculated Basel II capital varies considerably across the default prediction model and segmentation schemes, thus providing banks with an incentive to choose an approach that results in the least required capital for them. The authors also find that a more granular segmentation model produces smaller required capital, regardless of the economic environment. In addition, while borrowers' credit risk factors are consistently superior, economic factors have also played a role in mortgage default during the financial crisis.Capital ; Banks and banking ; Basel capital accord

Public credit registries as a tool for bank regulation and supervision

This paper is about the importance of the information in Public Credit Registries (PCRs) for supporting and improving banking sector regulation and supervision, particularly in the light of the new approach embodied in Basel III. Against the backdrop of the financial crisis and the existence of information data gaps, the importance of complete, accurate and timely credit information in the financial system is evident. Both in normal times and during crises, authorities need a device that allows them to look at the universe of credits in a detailed and readily way. And more importantly, they need to develop tools that exploit as much as possible the information therein contained. PCR databases contain individual credit information on borrowers and their credits which makes it possible to implement advanced techniques that measure banks'credit risk exposure. It allows optimizing the prudential regulation ensuring that provisioning and capital requirements are properly calibrated to cover expected and unexpected losses respectively. It also permits validating banks'internal rating systems, performing stress tests and informing macroprudential surveillance. In this respect, it is envisioned that the existence of a PCR will be a key factor to enhance the supervision and regulation of the financial system. Furthermore, the extent, accuracy and availability of the information collected by the authorities will determine the usefulness of the PCR as part of their toolkit to monitor the potential vulnerabilities not only on a microprudential level, but also on a macroprudential one.Banks&Banking Reform,Access to Finance,Financial Intermediation,Debt Markets,Bankruptcy and Resolution of Financial Distress

The Future of the Government Sponsored Enterprises: The Role for Government in the U.S. Mortgage Market

This paper analyzes options for reforming the U.S. housing finance system in view of the failure of Fannie Mae and Freddie Mac as government sponsored enterprises (GSEs). The options considered include GSE reform, a range of possible new governmental mortgage guarantee plans, and greater reliance on private mortgage markets. The analysis also considers the likely consequences of adopting alternative roles for government in the U.S. housing and mortgage markets. We start by reviewing the history of the GSEs and their contributions to the operation of U.S. housing and mortgage markets, including the actions that led to their failure in conjunction with the recent mortgage market crisis. The reform options we consider include those proposed in a 2011 U.S. Treasury White Paper, plans for new government mortgage guarantees from various researchers and organizations, and the evidence from Western European countries for the efficacy of private mortgages markets.

Regulation and Banking Stability: A Survey of Empirical Studies

This paper brings together and adds structure to the empirical literature on the link between banking regulation and banking system stability. In addition to clarifying the theoretical underpinnings for studying banking regulation, it points to several directions for future empirical research, necessary to fill the gaps in our understanding of the link between banking regulation and stability. The paper starts with a review of the literature on the design of banking regulation and its link with stability, followed by an assessment of the most common methodologies used in this literature. The paper then reviews the empirical literature of various banking regulations. This is followed by a proposal on the new directions for research of the link between banking regulation and banking system stabilityBanking Stability, Banking Regulation

The future of securitization

Securitization is a financial innovation that experiences a boom-bust cycle, as many other innovations before. This paper analyzes possible reasons for the breakdown of primary and secondary securitization markets, and argues that misaligned incentives along the value chain are the primary cause of the problems. The illiquidity of asset and interbank markets, in this view, is a market failure derived from ill-designed mechanisms of coordinating financial intermediaries and investors. Thus, illiquidity is closely related to the design of the financial chains. Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements

Systemic risk measures: the simpler the better.

We compute six different sets of systemic risk measures for a sample of the 20 biggest European and 13 biggest US banks from January 2004 to November 2009. The six measures are based on i) Principal components of the bank’s Credit Default Swaps (CDSs), ii) Interbank interest rate spreads, iii) Structural credit risk models, iv) Collateralized Debt Obligations (CDOs) indexes and their tranches, v) Multivariate densities computed from CDS spreads and vi) Co-Risk measures. We then rank the measures using three different criteria: i) Causality tests, ii) Price discovery tests and iii) their correlation with an index of systemic events. For the European and US markets, the best indicators are the first Principal Component of the single-name CDSs and the LIBOR-OIS or LIBOR-TBILL spreads, respectively, whereas the least reliable indicators are the Co-Risk measures and the systemic spreads extracted from the CDO indexes and their tranches.Systemic risk; CDS; Libor spreads; CoVaR;

The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats

The intensity of recent turbulence in financial markets has surprised nearly everyone. This paper searches out the root causes of the crisis, distinguishing them from scapegoating explanations that have been used in policy circles to divert attention from the underlying breakdown of incentives. Incentive conflicts explain how securitization went wrong, why credit ratings proved so inaccurate, and why it is superficial to blame the crisis on mark-to-market accounting, an unexpected loss of liquidity or trends in globalization and deregulation in financial markets. Our analysis finds disturbing implications of the crisis for Basel II and its implementation. We argue that the principal source of financial instability lies in contradictory political and bureaucratic incentives that undermine the effectiveness of financial regulation and supervision in every country in the world. We conclude the paper by identifying reforms that would improve incentives by increasing transparency and accountability in government and industry alike.Financial crisis, Securitization, Regulation and Supervision, Safety Nets