What Can Academics Contribute to the Study of Financial Stability?

There were hardly any banking crises between 1939 and 1971, so their later reemergence came as a surprise. Central bank supervisors responded practically by discovering and encouraging the adoption of current best practice in risk management by individual banks, without much theoretical input, whereas economists have mostly focused on models which abstract from default. But default is central to analysis of financial stability. Shubik pioneered introducing default into formal models, and we aim to develop this further. Meanwhile, estimating the probability of default (PD) for individual, or groups of, banks is central to the Basel II process.

The Regulatory Response to the Financial Crisis

There are, at least, seven aspects relating to financial regulation where the recent, and still current, financial turmoil has thrown up issues for discussion. These include: 1. The scale and scope of deposit insurance; 2. Bank insolvency regimes, also known as ‘prompt corrective action’; 3. Money market operations by Central Banks; 4. Commercial bank liquidity risk management; 5. Procyclicality of capital adequacy requirements (and mark-to-market), Basel II; lack of counter-cyclical instruments; 6. Boundaries of regulation, conduits, SIVs and reputational risk; 7. Crisis management:- (a) domestic, within countries, e.g. UK Tripartite Committee; (b) cross-border; how to bear the burden of cross-border defaults? This paper describes how the current crisis has exposed regulatory failings, drawing largely on recent UK experience, and suggests what remedial action might be undertaken.financial regulation, bank insolvency, deposit insurance, liquidity, Basel II, procyclicality

Distress Dependence and Financial Stability

This paper defines a set of systemic financial stability indicators which measure distress dependence among the financial institutions in a system, thereby allowing to analyze stability from three complementary perspectives: common distress in the system, distress between specific banks, and cascade effects associated with a specific bank. Our approach defines the banking system as a portfolio of banks and infers the system’s multivariate density (BSMD) from which the proposed measures are estimated. The BSMD embeds the banks’ default inter-dependence structure that captures linear and non-linear distress dependencies among the banks in the system, and its changes at different times of the economic cycle. The BSMD is recovered using the CIMDO-approach, a new approach that, in the presence of restricted data, improves density specification without explicitly imposing parametric forms that, under restricted data sets, are difficult to model. Thus, the proposed measures can be constructed from a very limited set of publicly available data and can be provided for a wide range of both developing and developed countries.

FCIs and economic activity: Some international evidence

A Monetary Conditions Index (MCI), a weighted average of the short-term real interest rate and the real exchange rate, is a commonly used indicator of aggregate demand conditions. In-sample evidence for the US, the euro area, Japan and the UK suggests that a Financial Conditions Index (FCI), also comprising property prices and share prices, would be a better indicator for economic activity than the standard MCI. Out-of sample the FCI also performs better than the MCI, but its overall performance is mixed. An FCI would have predicted the recent economic downturn in Japan and the UK, but not in the US and the euro area. --

Strategy an tactics of monetary policy: examples from Europe and the Antipodes

Monetary policy ; Banks and banking, Central ; Europe ; New Zealand ; Prices ; Foreign exchange rates ; Inflation (Finance)

The IS curve and the transmission of monetary policy: Is there a puzzle?

In this paper we assess the performance of the New Keynesian IS Curve for the G7 countries. We find that there is an IS puzzle for both the purely backwardlooking as well as for the forward-looking IS curve. The real interest rate does not have a significantly negative effect on the output gap. Based on an extended specification of the IS curve, also including asset prices and monetary aggregates, we are able to restore a significantly negative interest rate effect on aggregate demand in all countries. This finding suggests that a richer specification of the IS curve in empirical work may be necessary in order to obtain an unbiased estimate of the effect of monetary policy on aggregate demand. --

How, if at all, Should Credit Rating Agencies (CRAs) be Regulated?

The role of credit ratings agencies (CRAs) is to forecast the probability that the issuer of a debt liability will default on the due repayment (its probability of default, PD). In this respect, CRAs are one of a large set of institutions and people who seek to forecast certain aspects of the future. As a generality, the only, or at any rate the most important, requisite of a forecast is its accuracy. So long as the forecast is accurate, it is largely beside the point how the forecaster behaves otherwise, whether they lead a blameless life, or alternatively are rude to their parents, beat their children or cheat on their spouses, etc. Moreover, in the case of CRAs, (unlike the Delphic oracle), the forecast is not only relatively clear in content, (though we shall consider later how it could, and should, be made even clearer), but also the status of the event being forecast, i.e. whether the issuer defaults, or not, on due repayment, is also relatively clear – and any remaining fuzziness often becomes subject to a legal decision. So the forecasting activities of CRAs should be susceptible to ex post accountability. Compare forecast with out-turn; assess and publish the comparative accuracy of the various CRAs' and leave competition to do the rest. We shall review what extra steps need to be taken to enhance such ex post accountability, comparing forecast with outcome, and comment briefly on how, perhaps, to enhance competition