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Default and Lost Opportunities: A Message from Argentina for Euro-Zone Countries

Persistent euro-zone turmoil has kept the world economy on edge. Doubts about the ability of many countries in the single-currency region to service their sovereign debt are rising along with the interest rates the affected nations must pay to roll over maturing obligations.

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Transmission of distress in a bank credit

The European sovereign debt crisis has impaired many European banks. The distress on the European banks may transmit worldwide, and result in a large-scale knock-on default of financial institutions. This study presents a computer simulation model to analyze the risk of insolvency of banks and defaults in a bank credit network. Simulation experiments reproduce the knock-on default, and quantify the impact which is imposed on the number of bank defaults by heterogeneity of the bank credit network, the equity capital ratio of banks, and the capital surcharge on big banks.

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Shadow banking and repo

1 Executive summary

1.1 “Shadow banking” is an imprecise term that has attracted various definitions. The current working definition is “non-banks performing bank-like functions”, although the Financial Stability Board (FSB) has narrowed this down to “non-banks performing credit intermediation” (by which they mean the recycling of savings into loans).

1.2 In fact, shadow banking is an alternative term for market finance. It is market-based because  it decomposes the process of credit intermediation into an articulated sequence or  chain of discrete operations typically performed by separate specialist non-bank entities which interact across the wholesale financial market. Shadow banking also relies on active secondary markets in order to be able to price assets and relies on the wholesale financial market for funding. The  wholesale financial market includes repo.

1.3 The shadow banking system provides credit both directly as well as indirectly through various processes of financial transformation (redistribution of risk): credit, maturity and liquidity transformation. Together with leverage, these are the risk factors on which the FSB is focusing.

1.4 Official concern about shadow banking stems from the fear that it poses greater systemic risk than traditional banking. A range of issues have been highlighted: the scale of shadow banking; regulatory gaps; regulatory arbitrage;  agency problems in securitisation; the interconnectedness of shadow banks  with each other,  and  the interconnectedness of the shadow and traditional banking systems; the complexity of the shadow banking system; the resulting lack of transparency; the mispricing of risk in wholesale market funding;  and  the tendency of collateralised financing to  generate excessive leverage and to amplify pro-cyclicality.

1.5 While some shadow banking may be the product of regulatory gaps and arbitrage, it is widely recognised that much of this activity is driven by efficiency gains from specialisation and comparative advantage over traditional banks, and is therefore desirable.

1.6 Part of the concern about shadow banking is about the possible instability of the wholesale funding on which the shadow banking system is seen to rely. While wholesale liabilities such as repo are like the deposits issued by traditional banks, they are judged to be riskier for a number of reasons: the greater dependency of shadow banks on such funding; less regulation; lack of any official safety net; and the fickleness of such institutional cash balances.

1.7 The FSB has set up a number of “workstreams” to look at the key risk factors in credit intermediation by shadow banks, one of which is focused on repo and securities lending.  The repo (and securities lending) workstream is considering the possible introduction of macro-prudential requirements such as minimum margin or haircuts to mitigate pro-cyclicality, and improving the  infrastructure  of the secured funding markets. This paper is intended to inform this work.

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An Intertemporal CAPM with Stochastic Volatility

Abstract: 
This paper extends the approximate closed-form intertemporal capital asset pricing model of Campbell (1993) to allow for stochastic volatility. The return on the aggregate stock market is modeled as one element of a vector autoregressive (VAR) system, and the volatility of all shocks to the VAR is another element of the system. The paper presents evidence that growth stocks underperform value stocks because they hedge two types of deterioration in investment opportunities: declining expected stock returns, and increasing volatility.

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The Link between Eurozone Sovereign  Debt and CDS Prices

Abstract

We perform a theoretical and empirical analysis of the relationship between the price of Eurozone sovereign-linked credit default swaps (CDS) and the same sovereign bond markets during the Eurozone debt crisis of 2009-2011. We first present a simple model which establishes the no-arbitrage relationship between CDS and bond yield spreads. We then test this relationship empirically and explain why the market may deviate from it. Reasons include the different currencies of denomination of market-standard CDS and their reference obligations. We also examine whether CDS spread cause changes in bond spreads, and vice-versa, in a Granger sense. We find evidence for a Granger causal relationship with a one day lag from CDS to bonds for Greece and Spain, the reverse relationship for France and Italy and a feedback relationship for Ireland and Portugal.

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Systemic Risks in Global Banking: What Can Available Data Tell Us and What More Data Are Needed?

Abstract

The recent financial crisis has shown how interconnected the financial world has become. Shocks in one location or asset class can have a sizable impact on the stability of institutions and markets around the world. But systemic risk analysis is severely hampered by the lack of consistent data that capture the international dimensions of finance. While currently available data can be used more effectively, supervisors and other agencies need more and better data to construct even rudimentary measures of risks in the international financial system.

Similarly, market participants need better information on aggregate positions and linkages to appropriately monitor and price risks. Ongoing initiatives that will help close data gaps include the G20 Data Gaps Initiative, which recommends the collection of consistent bank level data for joint analyses and enhancements to existing sets of aggregate statistics, and enhancements to the BIS international banking statistics.

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