Fund Management and Systemic Risk - Lessons from the Global Financial Crisis

Fund managers play an important role in increasing efficiency and stability in financial markets. But research also indicates that fund management in certain circumstances may contribute to the buildup of systemic risk and severity of financial crises. The global financial crisis provided a number of new experiences on the contribution of fund managers to systemic risk. In this article, we focus on these lessons from the crisis. We distinguish between three sources of systemic risk in the financial system that may arise from fund management: insufficient credit risk transfer to fund managers; runs on funds that cause sudden reductions in funding to banks and other financial entities; and contagion through business ties between fund managers and their sponsors. Our discussion relates to the current intense debate on the role the so-called shadow banking system played in the global financial crisis. Several regulatory initiatives have been launched or suggested to reduce the systemic risk arising from non-bank financial entities, and we briefly discuss the likely impact of these on the sources of systemic risk outlined in the article

Corporate governance and correlation in corporate defaults

Manuscript Type Empirical Research Question/Issue This study examines the effect of weak corporate governance in terms of concentrated ownership, low board effectiveness, low financial transparency and higher shareholder rights on default correlation when firms have different credit qualities. Research Findings/Insights Using historical default data in the United States from 2000 to 2015, we find that the degree of default correlation increases disproportionately for firms with concentrated ownership, low board effectiveness, low financial transparency and disclosures, and higher shareholder rights. More importantly, the effect of weak corporate governance on default correlation is high during a financial crisis. Theoretical/Academic Implications This is one of the first studies testing the impact of corporate governance on the correlation in corporate defaults. It indicates new avenues of research for both corporate governance and credit risk management in relation to why joint default probabilities vary among firms. Practitioner/Policy Implications Our results imply that good corporate governance is essential for credit risk management because poor corporate governance may increase individual default risk and create the domino effect of credit defaults. Practitioners and policy makers should enhance control over poor governance practices to reduce the probabilities of default. Moreover, the impact of corporate governance on correlation in corporate defaults is more pronounced in financial crises and warrants consideration from policy makers to take steps toward cushioning its effects

Rating the United Kingdom: the British government’s sovereign credit ratings, 1976-1978

The UK received its first sovereign credit ratings in 1978. Despite having required financial assistance from the International Monetary Fund only 18 months earlier, the British government managed to secure ‘triple-A’ ratings from both Standard and Poor's and Moody's. Both assessments of creditworthiness reflected improving economic conditions but also British efforts to influence the sovereign ratings process. The Bank of England and the Treasury sought guidance from American investment banks to prepare for the ratings process and then controlled the flow of information available to the rating agencies accordingly, stressing the strengths of the national economy and downplaying the weaknesses. The British government subsequently launched its first bond issue in the New York market to high levels of investor demand. Consideration of these achievements complements the historiography concerning Britain's economic fortunes in the late 1970s. Scrutiny of events also offers a rare glimpse into the confidential sovereign ratings process. Both agencies relied on a combination of quantitative and qualitative evaluations of the UK. In addition, this article highlights the existence of a unique period in the history of sovereign credit ratings. From 1974 to 1985, the ratings industry enjoyed a cautious revival focused principally on ‘triple-A’ borrowers

What drives credit rating changes?:a return decomposition approach

This paper examines the relative importance of a shock to expected cash flows (i.e., cash-flow news) and a shock to expected discount rates (i.e., discount-rate news) in credit rating changes. Specifically, we use a Vector Autoregressive model to implement the return decomposition of Campbell and Shiller (Review of Financial Studies, 1, 1988, 195) and Vuolteenaho (Journal of Finance, 57, 2002, 233) to extract cash-flow news and discount-rate news from stock returns at the firm-level. We find that credit rating changes are, on average, more strongly associated with cash-flow news than with discount-rate news, consistent with cash-flow news being more permanent than discount-rate news. We further find that both cash-flow news and discount-rate news are more strongly related to credit rating changes when they convey negative information about firm value. This asymmetric association is consistent with the non-linear nature of default risk and with the fact that rating agencies incorporate bad news sooner than good news into their rating revisions. This paper contributes to the literature by providing evidence on the relative importance of cash-flow news and discount-rate news in the credit rating process