The role of capital, liquidity and credit growth in financial crises in Latin America and East Asia

We construct a dataset of bank capital adequacy and liquidity to test their relationships to crises in Asia and Latin America. Event studies, logit and ROC estimations suggest these variables are valuable leading indicators of crises. They can be used to improve Early Warning System design although there are trade-offs between model simplicity, which implies less monitoring costs and complexity which may improve accuracy. There are significant differences between the regions so pooling assumptions are unsound. AUCs show that capital and/or liquidity can be used in a parsimonious model without substantial loss in crisis predictive accuracy. We find no direct role for credit growth in either region. Our results have implications for Asian and Latin American financial regulators concerned with the impacts of Basel III on their banking systems.This work is funded under ESRC Grant No. PTA – 053 – 27 – 0002, entitled “An Investigation into the Causes of Banking Crises and Early Warning System Design”

Equity prices and the real economy - A vector error-correction approach

We assess the impact of equity prices on the level of output in the Europe Union economies and the US using Vector Error Correction (VECM) time series techniques. The distinction between impacts in bank based and equity market based economies is shown to be important, with equity prices having a greater impact on output in market-based economies. Share prices are shown to be largely autonomous in variance decompositions, whilst equity price do have a strong impact on output in the UK and US in their variance decompositions. An analysis of impulse responses suggests that large market based economies have more effective fiscal and monetary policy instruments

The evolution of the financial crisis of 2007–8

The financial crisis that started in August 2008 reached a climax in the autumn of 2008 with a wave of bank nationalisations across North America and Europe. Although banking crises are not uncommon, this is the largest since 1929–33. This paper discusses the build-up to the crisis, looking at the role of low real interest rates in stimulating an asset price bubble. That bubble was stocked by financial innovation and increases in lending. New financial products were not stress tested and have failed in the downturn. After discussing the bubbles we look at the collapse of the complex asset structure, and then put the crisis in the context of the literature. The paper concludes with a discussion of policy implications of the crisis, and advocates a significant improvement in the regulatory structure

Shocks and shock absorbers: The International Propagation Of Equity Market Shocks and the design of appropriate policy responses

Equity prices are major sources of shocks to the world economy and channels for propagation of these shocks. We seek to calibrate macroeconomic effects of falls in share prices and assess appropriate policy responses, using the National Institute Global Econometric Model NiGEM. Based on estimated relationships, falls in US equity prices have significant impacts on global activity; potential for liquidity traps suggest a need for complementary monetary and fiscal policy easing. However, fiscal easing boosts long-term real interest rates and hence moderates one of the automatic shock absorbers provided by the market mechanism

Accounting for the determinants of banks’ credit ratings

The contribution of the banking industry to the recent financial crisis 2007/8 has raised public concerns about the excessive involvement of banks in risky activities. In addition there have been public concerns about the ability of credit rating agencies to evaluate these risks in advance. In this context, this study uses an ordered logit analysis to examine the determinants of banks’ credit ratings using a sample of US and UK banks’ accounting data from 1994 to 2009. Our intention is to examine to what extent banks’ ratings reflect banks’ risks. Our analysis shows that a small number of accounting variables, namely: bank size, liquidity, efficiency and profitability are able to correctly assign credit rating for approximately 74% to 78% the sample banks. Surprisingly, the association between banks’ credit ratings and each of leverage asset quality and capital is not robust, suggesting that the rating agency’s models did not pick them up despite their importance in the crisis. In addition, the relationship between banks’ credit ratings and liquidity is the reverse of that which an adequate early warning system would require. As banks benefit from higher credit ratings they will have addressed their determinants rather than taking care of systemic factors that affect underlying risk. Policy makers therefore need to intervene to address this market failure.This study was financially supported by the Institute of Chartered Accountants of Scotland (ICAS)

Financial liberalization and capital adequacy in models of financial crises

We characterize the effects of financial liberalization indices on OECD banking crises, controlling for the standard macro prudential variables that prevail in the current literature. We use the Fraser Institute’s Economic Freedom of the World database. This yields a variable that captures credit market regulations which broadly measures the restrictions under which banks operate. We then test for the direct impacts of some of its components, deposit interest rate regulations and private sector credit controls, on crisis probabilities and their indirect effects via capital adequacy. Over the period 1980 – 2012, we find that less regulated markets are associated with a lower crisis frequency, and it appears that the channel comes through strengthening the defence that capital provides. Deposit interest rate liberalisation adds to the strength of capital in protecting against crises. However, private sector credit liberalisation, appears to increase the probability of having a crisis, albeit not significantly. If policy makers are concerned about the costs of low risk events, they may wish to control private sector credit even if it has a probability of affecting significantly crises of between 10 and 20 per cent

Consumer confidence indeces and short-term forecasting of consumption

Recently there has been growing interest in examining the potential shortterm link between survey-based confidence indicators and real economic activity, notably for macroeconomic policy making. This paper builds on previous studies to establish whether there is a short-term predictive relationship between measures of consumer confidence and actual consumption, that could be used for forecasting, in a range of major industrial countries. It then extends such previous analyses by assessing whether this relation has changed over time, and whether we can attribute any time-varying relation to structural developments in the economy, such as financial deepening and the increasing role of house prices in determination of consumption

Consumer confidence indices and short-term forecasting of consumption

Recently there has been growing interest in examining the potential shortterm link between survey-based confidence indicators and real economic activity, notably for macroeconomic policy making. This paper builds on previous studies to establish whether there is a short-term predictive relationship between measures of consumer confidence and actual consumption, that could be used for forecasting, in a range of major industrial countries. It then extends such previous analyses by assessing whether this relation has changed over time, and whether we can attribute any time-varying relation to structural developments in the economy, such as financial deepening and the increasing role of house prices in determination of consumption

Off-balance sheet exposures and banking crises in OECD countries

Against the background of the acknowledged importance of off-balance-sheet exposures in the sub prime crisis, we seek to investigate whether this was a new phenomenon or common to earlier crises. Using a logit approach to predicting banking crises in 14 OECD countries we find a significant impact of a proxy for the ratio of banks‟ off-balance-sheet activity to total (off and on balance sheet) activity, as well as capital and liquidity ratios, the current account balance and GDP growth. These results are robust to the exclusion of the most crisis prone countries in our model. For early warning purposes we show that real house price growth is a good proxy for off balance sheet activity prior to the sub-prime episode. Variables capturing off-balance sheet activity have been neglected in most early warning models to date. We consider it essential that regulators take into account the results for crisis prediction in regulating banks and their off-balance sheet exposures, and thus controlling their contribution to systemic risk

Bank regulation, property prices and early warning systems for banking crises in OECD countries

Early warning systems (EWS) for banking crises generally omit bank capital, bank liquidity and property prices. Most work on EWS has been for global samples dominated by emerging market crises where time series data on bank capital adequacy and property prices are typically absent. We estimate logit crisis models for OECD countries, finding strong effects from capital adequacy and liquidity ratios as well as property prices, and can exclude traditional variables. Higher capital adequacy and liquidity ratios have a marked effect on the crisis probabilities, implying long run benefits to offset some of the costs that such regulations may impose