Liquidity in global markets.

The latest episode of turbulence has been marked by an extended period of illiquidity in a large number of markets –ranging from traditionally highly liquid interbank money markets to the less-liquid structured credit markets. The event began with what was widely perceived as a credit deterioration in the US subprime mortgage market. However, this quickly raised uncertainty about the valuation of securities related to this market, thus affecting their liquidity. The rapidity with which this market illiquidity has been transmitted into funding illiquidity has been both striking and unprecedented. The event has raised questions about how market liquidity in a variety of instruments is determined in both primary and secondary markets and how mechanisms act to transmit illiquidity across markets during a period of stress. The article seeks to identify how standard concepts of liquidity can be applied to various types of markets across the globe with a view to interpreting how liquidity deteriorated so quickly. Several attributes of liquidity –types of market structures (including existence of formal intermediaries and trading venues), the construction of the instruments, and the types of investors– are used to guide the analysis. One feature that appears to be important for liquidity is the degree to which information about the risks underlying the financial instrument are well understood by both buyers and sellers. Another insight is that the expectations of market participants about liquidity and their ability to monitor it also have an impact on liquidity itself. These attributes suggest that the growth in securitization and complex structured credit products –new developments in the transfer of credit risk– may carry with them a predilection to adverse liquidity events that will require further examination. In light of the analysis, the article identifies ways of mitigating some of the problems that arose in this latest bout of illiquidity. Because liquidity is created and maintained by the market participants themselves, most of the room for improvement rests with the private sector. It is already clear that some market practices and policies will need to change and in this context some suggestions for enhancements to financial institutions’ liquidity risk management are outlined. However, given that both market and funding liquidity are intimately related to financial stability, a public good, there is also a potential role for the public sector. Hence, the tools used by central banks to maintain their role in effi cient monetary policy transmission together with financial stability will need to be reviewed.

The Impact of Default Dependency and Collateralization on Asset Pricing and Credit Risk Modeling

This article presents a comprehensive framework for valuing financial instruments subject to credit risk and collateralization. In particular, we focus on the impact of default dependence on asset pricing, as correlated default risk is one of the most pervasive threats to financial markets. Some well-known risky valuation models in the markets can be viewed as special cases of this framework. We introduce the concept of comvariance (or comrelation) into the area of credit risk modeling to capture the default relationship among three or more parties. Accounting for default correlations and comrelations becomes important, especially during the credit crisis. Moreover, we find that collateralization works well for financial instruments subject to bilateral credit risk, but fails for ones subject to multilateral credit risk

A primer on the subprime crisis.

The catalyst of the current financial turmoil has been the losses on the subprime mortgage market. However, the low quality of these partly collateralised housing loans was known for a while and the default on subprime mortgages largely expected. Therefore, how to account for the fact that an expected shock on a small segment of the US mortgage market turned into a major financial crisis, causing the near-collapse of the Commercial Paper and of the interbank lending markets, that is to say of two of the most liquid financial markets? Banks have transferred risks to special entities, the so-called “conduits”, SIV (Special Investment Vehicles) and SPV (Special Purpose Vehicles). Such a practice gave the false impression that credit risk was transferred from banks outside the financial system. This was indeed not the case. The funding needs associated in particular with backup lines of credit for off-balance sheet vehicles generated pressures on the the interbank markets and led central banks to massively intervene. The roots of the current turmoil are therefore of a deeper and structural nature. For that reason, it is necessary to assess, from a longer term perspective, what are the main consequences of the recent structural changes on financial markets in order to have a good grasp on the current financial market dynamics and clarify what is meant nowadays by liquidity.

Better capturing risks in the trading book.

The 1996 Amendment to the Basel Capital Accord, which allows, under certain conditions, the use of internal models to calculate regulatory capital requirements for market risk, has resulted in an apparently sound supervisory trading book regime for internationally active banks. Since this amendment was passed, the composition of the trading book has nevertheless changed substantially to include a more and more credit-related products such as credit derivatives and tranches of collateralised debt obligations (CDOs), as well as complex products such as hedge fund or fund of funds structured products. Furthermore, the contents of the trading book are expected to broaden due to the implementation of new international accounting and prudential standards. This development has led to an increase in credit risk in the trading book and a concomitant rise in other risks such as default risk, event risk, liquidity risk, concentration risk and correlation risk, which were not adequately captured when market risk regulations were devised. This has prompted: • banks to improve their risk assessment and control systems for trading book activities. These systems still often use Value at Risk (VaR) calculations based on a uniform 10-day holding period, which does not always appear relevant; • banking supervisors to enhance the supervision of these systems, in particular by ensuring that the measures proposed in July 2005 by the Basel Committee and the International Organisation of Securities Commissions (IOSCO), known as “Basel 2.5”, are correctly implemented. These measures aim to capture risks in the trading book in a more rigorous and comprehensive manner.

Derivatives: Innovation in the Era of Financial Deregulation

This is the third of several papers examining the underlying viability of the assertion that regulation of the financial markets is unduly burdensome. These papers assert that the value of the financial markets is often mis-measured. The efficiency of the market in intermediating flows between capital investors and capital users (like manufacturing and service businesses, individuals, and governments) is the proper measure. Unregulated markets are found to be chronically inefficient using this standard. This costs the economy enormous amounts each year. In addition, the inefficiencies create stresses to the system that make systemic crises inevitable

Valuation and fundamentals.

The aim of this article is not to provide a comprehensive overview of the financial crisis that began a year ago. This has already been done quite extensively and in a neat way, in particular by Borio (2008), Brunnermeier (2008), Crouhy et al. (2008) and Calomiris (2008) among others, who all describe and analyse the numerous triggers and mechanisms through which the crisis unfolded and spread to the main developed financial markets. Instead, we would like to focus on what we believe is one of the core issues of this crisis and which has not been addressed yet: valuation. Valuation is at the interplay between market dynamics, economic behaviour, accounting standards and prudential rules. The multiple, and even systemic –as far as the current episode is concerned–interactions between all these elements, associated with the inability of market participants to value complex financial instruments in illiquid/stressed markets, have resulted in a fi nancial meltdown that is already considered by many observers as the worst financial crisis since the Great Depression.

AN ACCOUNTING PERSPECTIVE ON A CRISIS PERPETUATED THORUGH THE CAPITAL MARKET

Our paper analyzes the current financial crisis starting with some recent developments and reactions in the field of accounting. We find that involved parties within the financial system naturally look for a “scapegoat” instead of dealing with reality. Moreover, they try to avoid regulations that would reflect their current financial position and performance. Meanwhile, what reality reveals us is that we are dealing with a crisis of value, or better said valuation, framed by significant changes of paradigms. Starting with thoughts and reactions within trade literature and financial environment, we analyze some mechanisms of credit derivatives that propagated the crisis within the global financial system. Finally, we prove our point in defending fair value accounting and identify key aspects that allow future improvements. The need for informational transparency is emphasized through the whole paper.Financial crisis, fair value, derivatives, mortgages, informational transparency, capital markets

International accounting standardisation and financial stability.

The European Commission’s recent decision 1 to require the use of international accounting standards (IAS 2) for the preparation of the consolidated financial statements of listed companies is motivated by the very understandable and justifiable desire to improve the comparability of financial statements and achieve a level playing field. However, it raises a number of issues of principle, and some major practical difficulties. Looking beyond technical implementation issues, central bankers are faced with two crucial questions in terms of the maintenance of financial stability. – Are the standards sufficiently prudent in today’s climate of economic uncertainty and mistrust of the markets, and will they address the shortcomings that have recently been revealed? – Is there not a risk of the standards introducing artificial volatility into financial statements, impairing a proper understanding of the true position of economic agents? This article looks at the main changes proposed by the IASB in the light of these two questions, and in particular at changes which have a very significant impact on financial intermediaries, which oil the wheels of every economy. The changes in accounting for credit risk by credit institutions introduced by the revised IAS 39 3 are undoubtedly an advance in conceptual terms: by requiring the earlier recognition of risk in the accounts, they should reduce the cyclical nature (and hence the volatility) of the financial reporting of credit risk. They are also an advance in terms of regulatory convergence, in that they are closer to the prudential rules included in the new solvency ratio. As regards the determination of corporate risk exposures and the criteria for derecognition – an issue at the heart of recent accounting scandals – the IASB proposes a middle way between two contrasting approaches. On the one hand there is the view that favours form over the economic substance of risks; this has led some standard-setters to allow derecognitions that look excessive given the actual risk exposure. Other standard-setters define the concept of risk in very broad terms, prohibiting any transfer of assets and liabilities off balance sheet or any use of derecognition where the “transferor” retains the risks or rewards (i.e. profits) of a transferred asset. These two extreme positions lead to very different definitions of what should be in a balance sheet. The approach recommended by the IASB is a compromise. Although it undoubtedly needs to be made more effective, it does offer an interesting perspective. However, the concept of fair value, a key element in the IASB framework, and the proposed arrangements regarding risk management and hedging by banks, pose serious problems in terms of financial stability. Fair value accounting involves valuing as many balance and off balance sheet items as possible at market value, or where there is no market value, at a valuation calculated using modelling techniques. This appears to run counter to the principle of prudence, and to create artificial volatility in earnings and equity. Valuing all except held-to-maturity securities at market value, irrespective of liquidity or negotiability or of the intention of the owner, contravenes the principle of prudence in that some of the potential capital gains thus calculated may prove to be wholly illusory. Moreover, this approach will inevitably lead to unjustifiably high volatility in earnings and equity, which might actually aggravate the current confusion in the markets. The IASB proposals on risk hedging have similar negative effects to those on fair value accounting. The IASB requires mark-to-market valuation for all hedging instruments. The logical implication of this approach – if the principle of symmetrical treatment is to be preserved – is that the same valuation method should be used for hedged items as well. This proposal risks extending fair value accounting to intermediation banking (where the hedged item is generally accounted for), with all the attendant consequences in terms of prudence and volatility. Two other IASB proposals could also have significant consequences for the financial statements of companies in general, and not just those of banks: firstly the proposals on business combinations and the treatment of goodwill, and secondly the rules on employee benefits (pension liabilities and stock options). The effect of these two types of proposal on financial stability is not clear. If, as the IASB suggests, a purchase accounting approach is used for business combinations and goodwill is no longer amortised but subject to regular impairment reviews, this would seem to promote greater transparency and in future might even prevent some of the abuses surrounding corporate acquisitions. Similarly, the systematic recognition in the income statement of pension liabilities and of stock option grants would make corporate policies in these areas more transparent. However, a “big bang” application of these new standards would probably put many companies into a difficult position, which in turn might impair financial stability.

Correlation, price discovery and co-movement of ABS and equity

Asset-backed securitization (ABS) has become a viable and increasingly attractive risk management and refinancing method either as a standalone form of structured finance or as securitized debt in Collateralized Debt Obligations (CDO). However, the absence of industry standardization has prevented rising investment demand from translating into market liquidity comparable to traditional fixed income instruments, in all but a few selected market segments. Particularly low financial transparency and complex security designs inhibits profound analysis of secondary market pricing and how it relates to established forms of external finance. This paper represents the first attempt to measure the intertemporal, bivariate causal relationship between matched price series of equity and ABS issued by the same entity. In a two-dimensional linear system of simultaneous equations we investigate the short-term dynamics and long-term consistency of daily secondary market data from the U.K. Sterling ABS/MBS market and exchange traded shares between 1998 and 2004 with and without the presence of cointegration. Our causality framework delivers compelling empirical support for a strong co-movement between matched price series of ABS-equity pairs, where ABS markets seem to contribute more to price discovery over the long run. Controlling for cointegration, risk-free interest and average market risk of corporate debt hardly alters our results. However, once we qualify the magnitude and direction of price discovery on various security characteristics, such as the ABS asset class, we find that ABS-equity pairs with large-scale CMBS/RMBS and credit card/student loan ABS reveal stronger lead-lag relationships and joint price dynamics than whole business ABS. JEL Classifications: G10, G12, G2

"A Critical Assessment of Seven Reports on Financial Reform: A Minskyan Perspective, Part III--Summary Tables"

This four-part study is a critical analysis of several reports dealing with the reform of the financial system in the United States. The study uses Minsky's framework of analysis and focuses on the implications of Ponzi finance for regulatory and supervisory policies. The main conclusion of the study is that, while all reports make some valuable suggestions, they fail to deal with the socioeconomic dynamics that emerge during long periods of economic stability. As a consequence, it is highly doubtful that the principal suggestions contained in the reports will provide any applicable means to limit the worsening of financial fragility over periods of economic stability. The study also concludes that any meaningful systemic and prudential regulatory changes should focus on the analysis of expected and actual cash flows (sources and stability) rather than capital equity, and on preventing the emergence of Ponzi processes. The latter tend to emerge over long periods of economic stability and are not necessarily engineered by crooks. On the contrary, the pursuit of economic growth may involve the extensive use of Ponzi financial processes in legal economic activities. The study argues that some Ponzi processes--more precisely, pyramid Ponzi processes--should not be allowed to proceed, no matter how severe the immediate impact on economic growth, standards of living, or competitiveness. This is so because pyramid Ponzi processes always collapse, regardless how efficient financial markets are, how well informed and well behaved individuals are, or whether there is a "bubble" or not. The longer the process is allowed to proceed, the more destructive it becomes. Pyramid Ponzi processes cannot be risk-managed or buffered against; if economic growth is to be based on a solid financial foundation, these processes cannot be allowed to continue. Finally, a supervisory and regulatory process focused on detecting Ponzi processes would be much more flexible and adaptive, since it would not be preoccupied with either functional or product limits, or with arbitrary ratios of "prudence." Rather, it would oversee all financial institutions and all products, no matter how new or marginal they might be. See also, Working Paper Nos. 574.1, 574.2, and 574.3.