767 research outputs found
A Transparency Standard for Derivatives
Derivatives exposures across large financial institutions often contribute to â if not necessarily create â systemic risk. Current reporting standards for derivatives exposures are nevertheless inadequate for assessing these systemic risk contributions. In this paper, I explain how a transparency standard, in contrast to the current standard, would facilitate such risk analysis. I also demonstrate that such a standard is implementable by providing examples of existing disclosures from large dealer firms in their quarterly filings. These disclosures often contain useful firm-level data on derivatives, but due to a lack of standardization, they cannot be aggregated to assess the risk to the system. I highlight the important contribution that reporting the âmargin coverage ratioâ (MCR), namely the ratio of a derivatives dealerâs cash (or liquidity, more broadly) to its contingent collateral or margin calls in case of a significant downgrade of its credit quality, could make toward assessing systemic risk contributions.
Are banks passive liquidity backstops? deposit rates and flows during the 2007-2009 crisis
Can banks maintain their advantage as liquidity providers when they are heavily exposed to a financial crisis? The standard argument - that banks can - hinges on deposit inflows that are seeking a safe haven and provide banks with a natural hedge to fund drawn credit lines and other commitments. We shed new light on this issue by studying the behavior of bank deposit rates and inflows during the 2007-09 crisis. Our results indicate that the role of the banking system as a stabilizing liquidity insurer is not one of the passive recipient, but of an active seeker, of deposits. We find that banks facing a funding squeeze sought to attract deposits by offering higher rates. Banks offering higher rates were also those most exposed to liquidity demand shocks (as measured by their unused commitments, wholesale funding dependence, and limited liquid assets), as well as with fundamentally weak balance-sheets (as measured by their non-performing loans or by subsequent failure). Such rate increases have a competitive effect in that they lead other banks to offer higher rates as well. Overall, the results present a nuanced view of deposit rates and flows to banks in a crisis, one that reflects banks not just as safety havens but also as stressed entities scrambling for deposits.
Asset Pricing with Liquidity Risk
This paper solves explicitly an equilibrium asset pricing model with liquidity risk -- the risk arising from unpredictable changes in liquidity over time. In our liquidity-adjusted capital asset pricing model, a security's required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with market return and market liquidity. In addition, the model shows how a negative shock to a security's liquidity, if it is persistent, results in low contemporaneous returns and high predicted future returns. The model provides a simple, unified framework for understanding the various channels through which liquidity risk may affect asset prices. Our empirical results shed light on the total and relative economic significance of these channels.
A Theory of Income Smoothing When Insiders Know More Than Outsiders
We consider a setting in which insiders have information about income that outside shareholders do not, but property rights ensure that outside shareholders can enforce a fair payout. To avoid intervention, insiders report income consistent with outsiders' expectations based on publicly available information rather than true income, resulting in an observed income and payout process that adjust partially and over time towards a target. Insiders under-invest in production and effort so as not to unduly raise outsiders' expectations about future income, a problem that is more severe the smaller is the inside ownership and results in an "outside equity Laffer curve". A disclosure environment with adequate quality of independent auditing mitigates the problem, implying that accounting quality can enhance investments, size of public stock markets and economic growth.
Leverage, Moral Hazard and Liquidity
We consider a moral hazard setup wherein leveraged firms have incentives
to take on excessive risks and are thus rationed when they attempt to
roll over debt. Firms can sell assets to alleviate rationing. Liquidated
assets are purchased by non-rationed firms but their borrowing capacity
is also limited by the risk-taking moral hazard. The market-clearing
price exhibits cash-in-the-market pricing and depends on the entire
distribution of leverage (debt to be rolled over) in the economy. This
distribution of leverage, and its form as roll-over debt, are derived as
endogenous outcomes with eachfirm's choice of leverage affecting the
difficulty of otherfirms in rolling over debt in future. The model
provides an agency-theoretic linkage between market liquidity and
funding liquidity and formalizes the de-leveraging offinancial
institutions observed during crises. It also explains the role played by
system-wide leverage in generating deep discounts in prices when adverse
asset-quality shocks materialize in good times
Is Cash Negative Debt? A Hedging Perspective on Corporate Financial Policies
We model the interplay between cash and debt policies in the presence of financial constraints. While saving cash allows financially constrained firms to hedge against future income shortfalls, reducing debt - "saving borrowing capacity" - is a more effective way of securing future investment in high cash flow states. This trade-off implies that constrained firms will allocate excess cash flows into cash holdings if their hedging needs are high (i.e., if the correlation between operating cash flows and investment opportunities is low). However, constrained firms will use excess cash flows to reduce current debt if their hedging needs are low. The empirical examination of cash and debt policies of a large sample of constrained and unconstrained firms reveals evidence that is consistent with our theory. In particular, our evidence shows that financially constrained firms with high hedging needs have a strong propensity to save cash out of cash flows, while showing no propensity to reduce outstanding debt. In contrast, constrained firms with low hedging needs systematically channel free cash flows towards debt reduction, as opposed to cash savings. Our analysis points to an important hedging motive behind standard financial policies such as cash and debt management. It suggests that cash should not be viewed as negative debt.
Monetary easing and financial instability
We study optimal monetary policy in the presence of financial stability concerns. We build a model in which monetary easing can lower the cost of capital for firms and restore the natural level of investment, but does also subsidize inefficient maturity transformation by financial intermediaries in the form of âcarry trades" that borrow cheap at the short-term against illiquid long-term assets. Carry trades not only lead to financial instability in the form of rollover risk, but also crowd out real investment since intermediaries equate the marginal return on lending to firms to that on carry trades. Optimal monetary policy trades off any stimulative gains against these costs of carry trades. The model provides a framework to understand the puzzling phenomenon that the unprecedented post-2008 monetary easing has been associated with below-trend real investment, even while returns to real and financial capital have been historically high
The Seeds of a Crisis: A Theory of Bank Liquidity and Risk-Taking over the Business Cycle
We examine how the banking sector may ignite the formation of asset
price bubbles when there is access to abundant liquidity. Inside banks,
given lack of observability of effort, loan officers (or risk takers)
are compensated based on the volume of loans but are penalized if banks
suffer a high enough liquidity shortfall. Outside banks, when there is
heightened macroeconomic risk, investors reduce direct investment and
hold more bank deposits. This ‘flight to quality’ leaves
banks flush with liquidity, lowering the sensitivity of bankers’
payoffs to downside risks of loans and inducing excessive credit volume
and asset price bubbles. The seeds of a crisis are thus sown. We show
that the optimal monetary policy involves a “leaning against
liquidity” approach: A Central Bank should adopt a contractionary
monetary policy in times of excessive bank liquidity in order to curb
risk-taking incentives at banks, and conversely, follow an expansionary
monetary policy in times of scarce liquidity so as to boost investment
Caught between Scylla and Charybdis? Regulating bank leverage when there is rent seeking and risk shifting
Banks face two moral hazard problems: asset substitution by shareholders (e.g., making risky, negative net present value loans) and managerial rent seeking (e.g., investing in inefficient âpetâ projects or simply being lazy and uninnovative). The privately-optimal level of bank leverage is neither too low nor too high: It balances effi ciently the market discipline imposed by owners of risky debt on managerial rent-seeking against the asset-substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund correlated assets. A minimum equity capital requirement can rule out asset substitution but also compromises market discipline by making bank debt too safe. The optimal capital regulation requires that a part of bank capital be unavailable to creditors upon failure, and be available to shareholders only contingent on good performance.Bank capital ; Moral hazard ; Systemic risk
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