Regulating Complexity in Financial Markets

As the financial crisis has tragically illustrated, the complexities of modern financial markets and investment securities can trigger systemic market failures. Addressing these complexities, this Article maintains, is perhaps the greatest financial-market challenge of the future. The Article first examines and explains the nature of these complexities. It then analyzes the regulatory and other steps that should be considered to reduce the potential for failure. Because complex financial markets resemble complex engineering systems, and failures in those markets have characteristics of failures in those systems, the Article‟s analysis draws on chaos theory and other approaches used to analyze complex engineering systems

Asset Sales and Debt Capacity

In this paper, we explore the link between asset sales end debt capacity. Asset sales are a common way far firms to raise cash, and so present an alternative to security issues for firms near financial distress. We argue that liquid assets -- those that can be resold at attractive terms -- are good candidates for debt finance because financial distress for firms with such assets is relatively inexpensive. We apply this logic to explain variation in debt capacity across industries and over the business cycle, as well as to the rise in U.S. corporate leverage in the 1980s.

Illiquidity and All Its Friends

The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macroprudential policies.

Illiquidity and All Its Friends.

The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macroprudential policies.

Inter-firm trade finance in times of crisis

The paper discusses the main features that distinguish inter-firm international trade finance from alternative sources of financing. On the one hand, inter-firm trade finance could help overcome informational problems associated with other lending relationships; on the other, it may contribute to propagate shocks due to the interconnection among firms along credit chains. The paper evaluates the potential effects of a financial crisis on the use of trade credit for firms operating in developing countries. It argues that while the advantages of trade credit might remain largely unexploited due to poor legal institutions, the disadvantages might be exacerbated because of these firms’ greater exposure to a default chain. Based on these arguments, a menu of choices is identified for what policymakers can do to boost firms’ access to inter-firm trade finance in times of crisis.Debt Markets,Access to Finance,Bankruptcy and Resolution of Financial Distress,Economic Theory&Research,Emerging Markets

Contract risks and credit spread determinants in the international project bond market

International bond markets have become an increasingly important source of long-term capital for infrastructure projects in emerging market economies over the past decade. The Ras Laffan Liquified Natural Gas (Ras Gas) project represents a milestone in this respect: its $1.2 billion bond offering, completed in December 1996, has been the largest for any international project. The Ras Gas project has the right to extract, process, and sell liquefied natural gas (LNG) from a field off the shore of Qatar. The principal off-taker is the Korea Gas Corporation (Kogas), which resells most of the LNG to the Korea Electric Power Corporation (Kepco) for electricity generation. In this clinical study the authors analyze the determinants of credit spreads for the Ras Gas project in terms of its contractual structure, with a view to better understanding the role of contract design in facilitating access to the global project bond market. Market risk perceptions have long been recognized to be a function of firm-specific variables, particularly asset value as embodied in contracts. The authors therefore study the impact of three interlocking contracts on the credit spreads of the project's actively traded global bonds: the 25-year output sales and purchase agreement with Kogas-Kepco, the international bond covenant, and an output price-contingent debt service guarantee by Mobil to debt holders. Using a sample of daily data from January 1997 to March 2000, the authors find that the quality of the off-taker's credit-and, more important, the market's assessment of the off-taker's economic prospects-drive project bond credit spreads and pricing. In addition, seemingly unrelated events in emerging debt markets spill over to project bond markets and affect risk perceptions and prices in this segment. Judicious use of an output price-contingent debt service guarantee by shareholders can significantly reduce project risks, and markets reward issuers through tighter credit spreads. Bondholders and shareholders share residual risks over time, despite covenants meant to preempt risk shifting. This type of risk shifting originates from incomplete contracts and the nonrecourse nature of project finance. It does not necessarily result from a deliberate attempt by management to increase shareholder value at the expense of debt holders by pursuing high-risk, low-value activities, although project managers and shareholders could still exploit their informational advantages by leaving output supply contracts incomplete in ways beneficial to their private interests. The results hold important lessons for global project finance. Projects incorporating certain design features can reap significant financial gains through lower borrowing costs and longer debt maturities: Judicious guarantees by parents that enjoy a particular hedging advantage enhance a project's appeal, as reflected in favorable pricing. Pledging receivables rather than physical assets as collateral and administering investor cash flows through an off-shore account offers additional security to debt holders. Projects should use their liability structure to create an implicit option on future private debt financing that matches the real option of a project expansion. The finding that bondholders bear residual risks means that shareholders can reduce their risks arising from bilateral monopolies and buy insurance against unforeseen and unforeseeable events.Payment Systems&Infrastructure,Economic Theory&Research,Banks&Banking Reform,Financial Intermediation,Environmental Economics&Policies,Banks&Banking Reform,Financial Intermediation,Economic Theory&Research,Environmental Economics&Policies,Housing Finance

Illiquidity and all its Friends

The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies.Liquidity, Contagion, Bailouts, Regulation

The Evolving Market for Catastrophic Event Risk

This paper discusses the recent changes in the market for catastrophe risk. These risks have traditionally been distributed through the insurance and reinsurance systems. However, because insurance companies tend to share relatively small amounts of their cat exposures and because insurance companies' capital is threatened by large event, these risks are now being shared partly through the capital markets. In looking to likely future developments, the paper enumerates five key ingredients that successfully structured cat instruments are likely to share: retentions should be substantial; layers of protection should not be too high; dollar amounts of risk transfer should not be too small; loss triggers should be beyond cendent control; and loss triggers should be symmetrically transparent.