Selected Reference and Reading Materials compiled by Dan Villanueva


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Record ID

326     [ Page 36 of 68, No. 1 ]

Date

2013-01

Author

Xisong Jin and Francisco Nadal De Simone

Affiliation

Luxembourg School of Finance and Banque centrale du Luxembourg

Title

Banking Systemic Vulnerabilities: A Tail-risk Dynamic CIMDO Approach

Summary /
Abstract

This study proposes a novel framework which combines marginal probabilities of default estimated from a structural credit risk model with the consistent information multivariate density optimization (CIMDO) methodology of Segoviano, and the generalized dynamic factor model (GDFM) supplemented by a dynamic t-copula. The framework models banks' default dependence explicitly and captures the time-varying non-linearities and feedback effects typical of financial markets. It measures banking systemic credit risk in three forms: (1) credit risk common to all banks; (2) credit risk in the banking system conditional on distress on a specific bank or combinations of banks and; (3) the buildup of banking system vulnerabilities over time which may unravel disorderly. In addition, the estimates of the common components of the banking sector short-term and conditional forward default measures contain early warning features, and the identification of their drivers is useful for macroprudential policy. Finally, the framework produces robust out-of-sample forecasts of the banking systemic credit risk measures. This paper advances the agenda of making macroprudential policy operational.

Keywords

Financial stability; procyclicality, macroprudential policy; credit risk; early warning indicators; default probability, non-linearities, generalized dynamic factor model; dynamic copulas; GARCH

URL

http://www.bcl.lu/fr/publications/cahiers_etudes/82/BCLWP082.pdf



Record ID

325     [ Page 36 of 68, No. 2 ]

Date

2013-04

Author

Money and Capital Markets Department

Affiliation

IMF

Title

A NEW LOOK AT THE ROLE OF SOVEREIGN CREDIT DEFAULT SWAPS (Ch. 2, Global Financial Stability Report, April 2013)

Summary /
Abstract

Credit default swaps on government debt are effective tools for investors to hedge risks, and can enhance financial stability, according to a new analysis from the International Monetary Fund.

Credit default swaps are financial instruments investors can use for hedging. In the case of government debt, investors use the swaps to express an opinion about the creditworthiness of a government, and to protect themselves in the event a country defaults or undertakes a debt restructuring.

The growing use of sovereign credit default swaps in advanced economy debt has raised questions about whether their speculative use could have destabilizing effects on the financial system, and how policymakers should respond. The European Union has recently banned the purchase of protection using these contracts if the buyer isn’t hedging, called naked selling of sovereign credit default swaps contracts.

In new research from the Global Financial Stability Report, the IMF said policymakers could improve the market for sovereign credit default swaps in other ways: by requiring more data disclosure, and by implementing the Group of Twenty regulatory reforms that aim to enhance the robustness and functioning of over-the-counter derivatives markets.

“Our study showed that sovereign credit default swaps are receiving a bad rap—they are no more or less effective at representing the credit risk of governments than are the government’s own bonds,” said Laura Kodres chief of the global stability analysis division in the IMF’s Monetary and Capital Markets Department and the head of the team that produced the analysis.

Not just for emerging economies anymore

Financial markets developed credit default swaps on government debt as flexible instruments to hedge and trade sovereign credit risks. Before to the global crisis, the market consisted largely of contracts on emerging market government debt because investors consider their credit risk as higher and more variable.

Although credit default swaps on government debt are only a fraction of countries’ outstanding debt market, their importance has been growing rapidly since 2008, especially in advanced economies where the creditworthiness of some of these countries have come under pressure. With the intensified attention, their usage has come under more scrutiny.

Debunking myths about credit default swaps

The IMF said credit default swap spreads provide indications of sovereign credit risk that reflect the same economic fundamentals and market conditions as the underlying government bonds. There is little indication that they raise sovereign funding costs—in other words, not much evidence that “the tail wags the dog.”

The IMF’s empirical analysis finds that both credit default swaps and government bond spreads exhibit similar and significant dependence on key economic fundamentals, such as government debt-to-GDP ratios and GDP growth prospects. Also, investor appetite for risk and market liquidity similarly influence both swap and bond spreads.

The analysis also shows that credit default swap markets incorporate new information faster than sovereign bond markets during periods of stress, despite wide differences across countries in normal times. Generally, the more liquid the credit default swaps market, the more rapidly it incorporates information relative to bond markets.

By contrast, whether credit default swap markets are more likely to propagate shocks than other markets is unclear. This is because risks embedded in credit default swaps cannot be readily isolated from risks generally found in the financial system, such as those associated with financial firms.

“We found little evidence to support many of the negative perceptions and alleged destabilizing roles of credit default swaps, although there is some evidence of that swap spreads overshoot their predicted level for some euro area countries during periods of stress,” said Kodres.

Don’t shoot the messenger

Initiatives by policymakers, such as the European Union ban on naked selling of credit default swaps, could eventually harm the hedging role of markets as market liquidity and depth deteriorate and result in higher spillovers to other markets.

This could add to financial instability and contagious transmission channels as hedgers migrate their hedges to the next best markets, potentially adding unintended stress and volatility to these markets. In the longer term, such actions could increase sovereign funding costs, to the contrary of the intentions of policymakers.

The IMF said policymakers can improve how the market for sovereign credit default swaps works by focusing their attention on implementing existing measures:

• Require counterparties to post initial margin on bilateral trades or move them to a central counterparty clearing house to lessen counterparty risks and reduce the potential for spillovers from sovereign credit events

• Mandate better data disclosure to mitigate uncertainty about exposures and interconnections of the market participants

• Implement temporary restrictions rather than imposing permanent ones only if necessary due to stress in financial markets, although previous research has found temporary trading bans to be of only limited use.

Keywords

Sovereign credit default swaps, government debt, hedging risks, financial stability

URL

http://www.imf.org/external/pubs/ft/gfsr/2013/01/pdf/c2.pdf



Record ID

324     [ Page 36 of 68, No. 3 ]

Date

2013-04

Author

Money and Capital Markets Department

Affiliation

IMF

Title

Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability? (Ch. 3, Global Financial Stability Report, April 2013)

Summary /
Abstract

Several years of exceptionally low interest rates and bond buying by some advanced economy central banks have improved some indicators of banks’ health while supporting the economy and financial stability, according to new research from the International Monetary Fund.

In its latest Global Financial Stability Report, the IMF analyzes the effects of central bank policies on banks and financial stability since the global crisis. Central banks have taken bold policy actions that have reduced banking sector vulnerabilities and stabilized some markets, such as the interbank and mortgage securities markets. But the policies may have undesirable side-effects that could put financial stability at risk the longer they are in place.

The IMF said so far these risks are not showing up much in banks, but could be shifting to other parts of the financial sector, such as to so-called “shadow banks.” There is also some concern that the prolonged period of low interest rates is encouraging banks to roll over nonperforming loans rather than repairing their balance sheets.

“So far, so good, but if the time that central banks have provided through their unconventional policies is not used productively by financial institutions and their regulators, at some point we can expect another round of financial distress,” said Laura Kodres, chief of global stability analysis in the IMF’s Monetary and Capital Markets Department and the head of the team that produced the analysis.

Potential risks

Despite the positive short-run effects for banks, there are financial risks associated with these central bank policies, which are likely to increase the longer they are maintained, according to the IMF.

The analysis found some aspects of this unprecedented monetary policy may be delaying balance sheet repair in banks and could raise credit risk over the medium term. This would explain the increase in market perceptions of bank default risk in response to central bank policy announcements, the IMF said.

Risks may also be shifting to other parts of the financial system not examined in the report, such as shadow banks, pension funds and insurance companies—or to other countries. Monitoring these risks requires improved data collection by those responsible for monitoring system-wide risks on nonbank financial institutions, as well as intrusive oversight by financial supervisors.

The report cautions that some risks may materialize when central banks end the measures taken in the wake of the global crisis.

Uncertainty about asset sales by central banks could lead to shifts in market sentiment and rapid price changes that could result in losses for bond holders—especially banks and central banks. The degree to which long-term yields may rise from their currently compressed levels, which would make bond prices drop, heightens this concern.

Losses could hurt weakly capitalized banks in the short run, although the IMF said the net effect of interest rate increases may be positive for banks over the medium term as their lending picks up.

Policymakers should be vigilant and flexible

The report says that central bank policies should continue to support the economy and financial stability until the recovery is well established.

The IMF said policymakers need to be vigilant and assess the emergence of potential and emerging financial stability threats. They also should use targeted policies designed to foster bank balance-sheet repair and reduce their vulnerability to market disruptions. By reducing the risks in the financial sector, micro- and macroprudential policies will allow greater leeway for monetary policy to support the economy.

The report identifies specific measures that could prove helpful to contain credit risk and funding challenges for banks, such as robust capital requirements, improved liquidity requirements, and well-designed dynamic forward-looking provisioning. Because the experience with some macroprudential tools is still relatively limited, the IMF recommends that policymakers closely monitor the effectiveness of their policies and stand ready to adjust them as needed. Coordination with other economic policies, such as monetary and fiscal policy, will also help reduce the reliance on macroprudential tools.

To minimize adverse effects on market sentiment, the IMF points out that it is important that central banks communicate clearly about their strategies to exit from their extraordinary policy measures, ahead of their implementation.

Keywords

Global financial stability, potential risks of long periods of low interest rates and bond-buying

URL

http://www.imf.org/external/pubs/ft/gfsr/2013/01/pdf/c3.pdf



Record ID

323     [ Page 36 of 68, No. 4 ]

Date

2013-04

Author

Chan-Lau, Jorge

Affiliation

Money and Capital Markets Department, IMF

Title

Market-Based Structural Top-Down Stress Tests of the Banking System

Summary /
Abstract

Despite increased need for top-down stress tests of financial institutions, performing them is challenging owing to the absence of granular information on banks’ trading and loan portfolios. To deal with these data shortcomings, this paper presents a market-based structural top-down stress testing methodology that relies in market-based measures of a bank's probability of default and structural models of default risk to infer the capital losses they could experience in stress scenarios. As an illustration, the methodology is applied to a set of banks in an advanced emerging market economy.

Keywords

Stress tests, banks, default risk, syst emic risk, structural models, market prices

URL

http://www.imf.org/external/pubs/ft/wp/2013/wp1388.pdf



Record ID

322     [ Page 36 of 68, No. 5 ]

Date

2013-04

Author

Ioan Carabenciov, Charles Freedman, Roberto Garcia-Saltos, Douglas Laxton, Ondra Kamenik, and Petar Manchev

Affiliation

Research Department, IMF

Title

The Global Projection Model with 6 Regions

Summary /
Abstract

This is the sixth of a series of papers that are being written as part of a project to estimate a small quarterly Global Projection Model (GPM). The GPM project is designed to improve the toolkit to which economists have access for studying both own-country and cross-country linkages. In this paper, we add three more regions and make a number of other changes to a previously estimated small quarterly projection model of the US, euro area, and Japanese economies. The model is estimated with Bayesian techniques, which provide a very efficient way of imposing restrictions to produce both plausible dynamics and sensible forecasting properties.

Keywords

Macroeconomic Modeling, Bayesian Estimation, Monetary Policy

URL

http://www.imf.org/external/pubs/ft/wp/2013/wp1387.pdf



Record ID

321     [ Page 36 of 68, No. 6 ]

Date

2013-02

Author

Sewon Hur and Illenin O. Kondo

Affiliation

University of Pittsburgh and Federal Reserve Board

Title

A theory of rollover risk, sudden stops, and foreign reserves

Summary /
Abstract

Emerging economies, unlike advanced economies, have accumulated large foreign reserve holdings. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in reducing debt rollover crises ("sudden stops"), akin to the role of bank reserves in preventing bank runs. We find that a small, unexpected, and permanent increase in rollover risk accounts for the outburst of sudden stops in the late 1990s, the subsequent increase in foreign reserves holdings, and the salient resilience of emerging economies to sudden stops ever since. Finally, we show that a policy of pooling reserves can substantially reduce the reserves needed by emerging economies.

Keywords

Rollover risk, reserves, sudden stops

URL

http://www.federalreserve.gov/pubs/ifdp/2013/1073/ifdp1073.pdf



Record ID

320     [ Page 36 of 68, No. 7 ]

Date

2010-09

Author

Strategy, Policy, and Review Department, Monetary and Capital Markets Department, Fiscal Affairs Department, and Research Department

Affiliation

International Monetary Fund

Title

The IMF-FSB Early Warning Exercise: Design and Methodological Toolkit

Summary /
Abstract

One of the G-20's first reactions to the financial crisis that erupted by late 2008 was to task the IMF and the Financial Stability Board (FSB) with establishing a joint Early Warning Exercise (EWE). This Occasional Paper presents an overview of the IMF's contributions to the EWE. Part I sets out the process, analytical framework, outputs, and dissemination of the EWE, as well as the collaboration with the FSB. Part II describes the main analytical tools deployed in the exercise as of September 2010. As new tools are developed (or become available), they are being added to the EWE or substituted for other models. Once the global economy returns to more stable conditions, the EWE is likely to become the more forward-looking exercise it was initially meant to be, focusing primarily on low-probability, high-impact events (e.g., tail risks). Over time, as new sources of systemic risks emerge and new analytical tools become available, the EWE framework will continue to adapt.

Keywords

Early Warning Exercise, IMF, FSB

URL

http://www.imf.org/external/np/pp/eng/2010/090110.pdf



Record ID

319     [ Page 36 of 68, No. 8 ]

Date

2013-04

Author

Itai Agur and Maria Demertzis

Affiliation

IMF - Singapore Regional Training Institute

Title

"Leaning Against the Wind" and the Timing of Monetary Policy

Summary /
Abstract

If monetary policy is to aim also at financial stability, how would it change? To analyze this question, this paper develops a general-form framework. Financial stability objectives are shown to make monetary policy more aggressive: in reaction to negative shocks, cuts are deeper but shorter-lived than otherwise. By keeping cuts brief, monetary policy tightens as soon as bank risk appetite heats up. Within this shorter time span, cuts must then be deeper than otherwise to also achieve standard objectives. Finally, we analyze how robust this result is to the presence of a bank regulatory tool, and provide a parameterized example.

Keywords

Monetary policy, financial stability, bank risk, regulation

URL

http://www.imf.org/external/pubs/ft/wp/2013/wp1386.pdf



Record ID

318     [ Page 36 of 68, No. 9 ]

Date

2013-04

Author

Tobias Hagen

Affiliation

Frankfurt University of Applied Sciences, Department of Business and Law

Title

Impact of National Financial Regulation on Macroeconomic and Fiscal Performance after the 2007 Financial Shock – Econometric Analyses Based on Cross-Country Data

Summary /
Abstract

Using cross-country data, this paper estimates the impact of the 2007 financial shock on countries’ macroeconomic developments conditional on national financial regulations before the crisis. For this purpose, the “financial reform index” developed by Abiad et al. (A New Database of Financial Reforms, 2008) is used. The econometric analyses indicate that countries with more deregulated financial markets experienced deeper recessions, stronger employment losses, and larger government budget deficits. Against the background of the ongoing global crisis and the results of other studies, the usefulness of liberalized financial markets for macroeconomic stability and economic development should be rigorously reconsidered.

Keywords

Financial crisis; financial regulation, Great Recession, robust regression, semiparametric regression

URL

http://www.economics-ejournal.org/economics/discussionpapers/2013-26/count



Record ID

317     [ Page 36 of 68, No. 10 ]

Date

2013-03

Author

David Miles, Jing Yang and Gilberto Marcheggiano

Affiliation

Monetary Policy Committee, Bank of England, Bank for International Settlements, and Bank of England

Title

OPTIMAL BANK CAPITAL

Summary /
Abstract

This article reports estimates of the long-run costs and benefits of having banks fund more of their assets with loss-absorbing capital, or equity. We model how shifts in funding affect required rates of return and how costs are influenced by the tax system. We draw a clear distinction between costs to individual institutions (private costs) and overall economic (or social) costs. We find that the amount of equity capital that is likely to be desirable for banks to use is very much larger than banks have used in recent years and also higher than targets agreed under the Basel III framework.

Keywords

Bank capital, Basle III framework, private vs social costs

URL

http://onlinelibrary.wiley.com/doi/10.1111/j.1468-0297.2012.02521.x/pdf



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