Regulating the Doom Loop
with Spyros Alogoskoufis (2020)
International Journal of Central Banking, 16(4): 251-292
(also ECB Working Paper 2313 and ESRB Working Paper 74)
ONLINE APPENDIX
SUMMARY: VoxEU (also published in Pisani-Ferry and Zettelmeyer (eds), Chapter 5, "Risk Sharing Plus Market Discipline")
PRESENTATION: Slides
CONFERENCES: CEPR Research and Policy Network on European Economic Architecture at the College de France (April 2019); EBA Research Workshop (November 2018)
MEDIA: Financial Times; Central Banking
CITED BY: ECB Vice-President Vítor Constâncio; Banco de España Governor Pablo Hernández de Cos; MEP Luis Garicano
ABSTRACT: Euro area governments have committed to break the doom loop between banks and sovereigns. But policymakers disagree on how to treat sovereign exposures in bank regulation. Our contribution is to model endogenous sovereign portfolio reallocation by banks in response to regulatory reform. Simulations highlight a tension between concentration and credit risk in portfolio reallocation. Resolving this tension requires regulatory reform to be complemented by an expansion in the portfolio opportunity set to include an area-wide low-risk asset. By reinvesting into such an asset, banks would reduce both their concentration and credit risk exposure.
with Spyros Alogoskoufis (2020)
International Journal of Central Banking, 16(4): 251-292
(also ECB Working Paper 2313 and ESRB Working Paper 74)
ONLINE APPENDIX
SUMMARY: VoxEU (also published in Pisani-Ferry and Zettelmeyer (eds), Chapter 5, "Risk Sharing Plus Market Discipline")
PRESENTATION: Slides
CONFERENCES: CEPR Research and Policy Network on European Economic Architecture at the College de France (April 2019); EBA Research Workshop (November 2018)
MEDIA: Financial Times; Central Banking
CITED BY: ECB Vice-President Vítor Constâncio; Banco de España Governor Pablo Hernández de Cos; MEP Luis Garicano
ABSTRACT: Euro area governments have committed to break the doom loop between banks and sovereigns. But policymakers disagree on how to treat sovereign exposures in bank regulation. Our contribution is to model endogenous sovereign portfolio reallocation by banks in response to regulatory reform. Simulations highlight a tension between concentration and credit risk in portfolio reallocation. Resolving this tension requires regulatory reform to be complemented by an expansion in the portfolio opportunity set to include an area-wide low-risk asset. By reinvesting into such an asset, banks would reduce both their concentration and credit risk exposure.
Discriminatory Pricing of Over-the-Counter Derivatives
with Harald Hau, Peter Hoffmann and Yannick Timmer (2020)
Management Science, forthcoming
IMF Working Paper 19/100, CEPR Discussion Paper 12525 and ESRB Working Paper 61
CONFERENCES: European Economic Association (August 2018); European Finance Association (August 2018); Annual Meeting of the Central Bank Research Association (August 2018); SAFE Market Microstructure Conference (August 2018); Annual Conference in International Finance at the BI Norwegian Business School (June 2018); Western Finance Association (June 2018); Financial Intermediation Research Society (June 2018); Spring Meeting of the European Association of Young Economists (May 2018); SFS Cavalcade North America (May 2018); Annual Central Bank Conference on the Microstructure of Financial Markets (October 2017); Annual Conference of the European Systemic Risk Board (September 2016)
MEDIA: Financial Times; Bloomberg
CITED BY: Central Bank of Ireland Governor Philip Lane; Bank of England Executive Director for Markets Andrew Hauser
ABSTRACT: New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.
with Harald Hau, Peter Hoffmann and Yannick Timmer (2020)
Management Science, forthcoming
IMF Working Paper 19/100, CEPR Discussion Paper 12525 and ESRB Working Paper 61
CONFERENCES: European Economic Association (August 2018); European Finance Association (August 2018); Annual Meeting of the Central Bank Research Association (August 2018); SAFE Market Microstructure Conference (August 2018); Annual Conference in International Finance at the BI Norwegian Business School (June 2018); Western Finance Association (June 2018); Financial Intermediation Research Society (June 2018); Spring Meeting of the European Association of Young Economists (May 2018); SFS Cavalcade North America (May 2018); Annual Central Bank Conference on the Microstructure of Financial Markets (October 2017); Annual Conference of the European Systemic Risk Board (September 2016)
MEDIA: Financial Times; Bloomberg
CITED BY: Central Bank of Ireland Governor Philip Lane; Bank of England Executive Director for Markets Andrew Hauser
ABSTRACT: New regulatory data reveal extensive discriminatory pricing in the foreign exchange derivatives market, in which dealer-banks and their non-financial clients trade over-the-counter. After controlling for contract characteristics, dealer fixed effects, and market conditions, we find that the client at the 75th percentile of the spread distribution pays an average of 30 pips over the market mid-price, compared to competitive spreads of less than 2.5 pips paid by the bottom 25% of clients. Higher spreads are paid by less sophisticated clients. However, trades on multi-dealer request-for-quote platforms exhibit competitive spreads regardless of client sophistication, thereby eliminating discriminatory pricing.
Systemic Illiquidity in the Interbank Network
with Gerardo Ferrara, Zijun Liu and Tomohiro Ota (2019)
Quantitative Finance, 19(11): 1779-1795
(also Bank of England Working Paper 586 and ESRB Working Paper 86)
SUMMARY: VoxEU and Bank Underground
CONFERENCES: 1st international conference on payments and settlement at the Deutsche Bundesbank (September 2015); 13th payment and settlement simulator seminar at the Bank of Finland (August 2015); 2nd conference of the Society for Economic Measurement at the OECD (July 2015); Cambridge University (Isaac Newton Institute) workshop on “monitoring systemic risk” (September 2014)
ABSTRACT: We study systemic illiquidity using a unique dataset on UK banks’ daily cash flows, short-term interbank funding and liquid asset buffers. Failure to roll-over short-term funding or repay obligations when they fall due generates an externality in the form of systemic illiquidity. We simulate a model in which systemic illiquidity propagates in the interbank funding network over multiple days. In this setting, we show that systemic illiquidity is minimised by a macroprudential policy that skews the distribution of liquid assets towards banks that are important in the network.
with Gerardo Ferrara, Zijun Liu and Tomohiro Ota (2019)
Quantitative Finance, 19(11): 1779-1795
(also Bank of England Working Paper 586 and ESRB Working Paper 86)
SUMMARY: VoxEU and Bank Underground
CONFERENCES: 1st international conference on payments and settlement at the Deutsche Bundesbank (September 2015); 13th payment and settlement simulator seminar at the Bank of Finland (August 2015); 2nd conference of the Society for Economic Measurement at the OECD (July 2015); Cambridge University (Isaac Newton Institute) workshop on “monitoring systemic risk” (September 2014)
ABSTRACT: We study systemic illiquidity using a unique dataset on UK banks’ daily cash flows, short-term interbank funding and liquid asset buffers. Failure to roll-over short-term funding or repay obligations when they fall due generates an externality in the form of systemic illiquidity. We simulate a model in which systemic illiquidity propagates in the interbank funding network over multiple days. In this setting, we show that systemic illiquidity is minimised by a macroprudential policy that skews the distribution of liquid assets towards banks that are important in the network.
Who Bears Interest Rate Risk?
with Peter Hoffmann, Federico Pierobon and Guillaume Vuillemey (2019)
Review of Financial Studies, 32(8): 2921-2954
(also ECB Working Paper 2176)
SUMMARY: ECB Financial Stability Review
PRESENTATION: Slides
CONFERENCES: EBA Research Workshop (November 2018); Financial Intermediation Research Society (June 2018); SFS Cavalcade North America (May 2018); XII Annual Seminar on Risk, Financial Stability and Banking at the Banco Central do Brasil (August 2017)
MEDIA: CFA Digest
CITED BY: Central Bank of Ireland Governor Philip Lane
ABSTRACT: We study the allocation of interest rate risk within the European banking sector using novel data. Banks' exposure to interest rate risk is small on aggregate, but heterogeneous in the cross-section. In contrast to conventional wisdom, net worth is increasing in interest rates for approximately half of the institutions in our sample. Cross-sectional variation in banks' exposures is driven by cross-country differences in loan rate fixation conventions for mortgages. Banks use derivatives to share interest rate risk and partially hedge on-balance sheet exposures. Residual exposures imply that changes in interest rates have redistributive effects within the banking sector.
with Peter Hoffmann, Federico Pierobon and Guillaume Vuillemey (2019)
Review of Financial Studies, 32(8): 2921-2954
(also ECB Working Paper 2176)
SUMMARY: ECB Financial Stability Review
PRESENTATION: Slides
CONFERENCES: EBA Research Workshop (November 2018); Financial Intermediation Research Society (June 2018); SFS Cavalcade North America (May 2018); XII Annual Seminar on Risk, Financial Stability and Banking at the Banco Central do Brasil (August 2017)
MEDIA: CFA Digest
CITED BY: Central Bank of Ireland Governor Philip Lane
ABSTRACT: We study the allocation of interest rate risk within the European banking sector using novel data. Banks' exposure to interest rate risk is small on aggregate, but heterogeneous in the cross-section. In contrast to conventional wisdom, net worth is increasing in interest rates for approximately half of the institutions in our sample. Cross-sectional variation in banks' exposures is driven by cross-country differences in loan rate fixation conventions for mortgages. Banks use derivatives to share interest rate risk and partially hedge on-balance sheet exposures. Residual exposures imply that changes in interest rates have redistributive effects within the banking sector.
ESBies: Safety in the Tranches
with Markus Brunnermeier, Marco Pagano, Ricardo Reis, Stijn Van Nieuwerburgh and Dimitri Vayanos (2017)
Economic Policy, 32(90): 175-219
(also ESRB Working Paper 21)
ONLINE APPENDIX
SUMMARY: VoxEU
CONFERENCES: 64th Economic Policy panel meeting (October 2016); 1st ESRB annual conference (September 2016); FRIC 2016 conference on financial frictions at Copenhagen Business School (August 2016); 2016 annual conference in international finance at the City University of Hong Kong (June 2016)
MEDIA: Financial Times (here, here and here); The Economist; Bloomberg; Risk.net
CITED BY: The European Commission in its regulatory proposal for sovereign bond-backed securities; ECB President Mario Draghi; ECB Vice-President Vítor Constâncio (here and here); ECB Executive Board member Benoît Cœuré; ECB Executive Board member Yves Mersch (here and here); Banque de France Governor François Villeroy de Galhau; Banco de España Governor Pablo Hernández de Cos
ABSTRACT: The euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to-safety capital flows. European Safe Bonds (ESBies), a euro area-wide safe asset without joint liability, would help to resolve these problems. We make three contributions. First, numerical simulations show that ESBies with a subordination level of 30% would be as safe as German bunds and would increase safe asset supply. Second, a model shows how, when and why the two features of ESBies—diversification and seniority—can weaken the diabolic loop and its diffusion across countries. Third, we propose how to create ESBies, starting with limited issuance by public or private-sector entities.
with Markus Brunnermeier, Marco Pagano, Ricardo Reis, Stijn Van Nieuwerburgh and Dimitri Vayanos (2017)
Economic Policy, 32(90): 175-219
(also ESRB Working Paper 21)
ONLINE APPENDIX
SUMMARY: VoxEU
CONFERENCES: 64th Economic Policy panel meeting (October 2016); 1st ESRB annual conference (September 2016); FRIC 2016 conference on financial frictions at Copenhagen Business School (August 2016); 2016 annual conference in international finance at the City University of Hong Kong (June 2016)
MEDIA: Financial Times (here, here and here); The Economist; Bloomberg; Risk.net
CITED BY: The European Commission in its regulatory proposal for sovereign bond-backed securities; ECB President Mario Draghi; ECB Vice-President Vítor Constâncio (here and here); ECB Executive Board member Benoît Cœuré; ECB Executive Board member Yves Mersch (here and here); Banque de France Governor François Villeroy de Galhau; Banco de España Governor Pablo Hernández de Cos
ABSTRACT: The euro crisis was fueled by the diabolic loop between sovereign risk and bank risk, coupled with cross-border flight-to-safety capital flows. European Safe Bonds (ESBies), a euro area-wide safe asset without joint liability, would help to resolve these problems. We make three contributions. First, numerical simulations show that ESBies with a subordination level of 30% would be as safe as German bunds and would increase safe asset supply. Second, a model shows how, when and why the two features of ESBies—diversification and seniority—can weaken the diabolic loop and its diffusion across countries. Third, we propose how to create ESBies, starting with limited issuance by public or private-sector entities.
Financial Structure
with Marco Pagano (2016)
Palgrave Handbook of European Banking (chapter 2)
ABSTRACT: The financial structure of an economy is the set of institutions that channel resources from its savers to its investors, allocate them across alternative uses, and enable investors to share risks and diversify their portfolios. These functions can be performed by capital markets or by financial intermediaries that match savers and borrowers independently of markets. In Europe, banks dominate financial intermediation, and their dominance has increased over the 1990s and early 2000s, particularly in comparison with other developed economies such as the United States and Japan. This chapter attributes Europe’s increasingly bank-based financial structure to misguided policy choices. Evidence from an emerging literature indicates that these choices have worsened Europe’s long-term economic growth prospects and rendered it more susceptible to financial crises.
with Marco Pagano (2016)
Palgrave Handbook of European Banking (chapter 2)
ABSTRACT: The financial structure of an economy is the set of institutions that channel resources from its savers to its investors, allocate them across alternative uses, and enable investors to share risks and diversify their portfolios. These functions can be performed by capital markets or by financial intermediaries that match savers and borrowers independently of markets. In Europe, banks dominate financial intermediation, and their dominance has increased over the 1990s and early 2000s, particularly in comparison with other developed economies such as the United States and Japan. This chapter attributes Europe’s increasingly bank-based financial structure to misguided policy choices. Evidence from an emerging literature indicates that these choices have worsened Europe’s long-term economic growth prospects and rendered it more susceptible to financial crises.
Shedding Light on Dark Markets: First Insights From the New EU-wide OTC Derivatives Dataset
with Jorge Abad, Iñaki Aldasoro, Christoph Aymanns, Marco D’Errico, Linda Fache Rousová, Peter Hoffmann, Martin Neychev and Tarik Roukny (2016)
ESRB Occasional Paper 11
MEDIA: Central Banking
CITED BY: ECB President Mario Draghi (here and here); ECB Vice-President Vítor Constâncio (here and here); Central Bank of Ireland Governor Philip Lane; Bank of England Chief Economist Andy Haldane
ABSTRACT: We present a first analysis of the EU-wide transactions-level derivatives dataset collected under the European Markets Infrastructure Regulation. We describe the structure of the dataset, drawing comparisons with existing survey-based evidence on derivatives markets, and zoom in on three markets: interest rate, credit and foreign exchange derivatives. New insights from each of these three markets provide the basis for further research.
with Jorge Abad, Iñaki Aldasoro, Christoph Aymanns, Marco D’Errico, Linda Fache Rousová, Peter Hoffmann, Martin Neychev and Tarik Roukny (2016)
ESRB Occasional Paper 11
MEDIA: Central Banking
CITED BY: ECB President Mario Draghi (here and here); ECB Vice-President Vítor Constâncio (here and here); Central Bank of Ireland Governor Philip Lane; Bank of England Chief Economist Andy Haldane
ABSTRACT: We present a first analysis of the EU-wide transactions-level derivatives dataset collected under the European Markets Infrastructure Regulation. We describe the structure of the dataset, drawing comparisons with existing survey-based evidence on derivatives markets, and zoom in on three markets: interest rate, credit and foreign exchange derivatives. New insights from each of these three markets provide the basis for further research.
Bank Bias in Europe: Effects on Systemic Risk and Growth
with Marco Pagano (2016)
Economic Policy, 31(85): 51-106
(also ECB Working Paper 1797)
SUMMARY: VoxEU; World Economic Forum
DATA: zip file with data and code
CONFERENCES: Banco de Portugal Conference on Financial Intermediation (July 2015); Federal Reserve Bank of New York and NYU Stern Conference on Financial Intermediation (April 2015); 61st Panel Meeting of Economic Policy (April 2015); Research Workshop in Financial Economics at Mainz (March 2015); American Economic Association Annual Meeting (January 2015); ECB Conference on "The Optimal Size of the Financial Sector" (September 2014)
MEDIA: Financial Times (here, here and here); Die Presse; Het Financieele Dagblad; Central Banking
CITED BY: ECB President Mario Draghi; ECB Executive Board member Benoît Cœuré (here, here and here); Bank of Spain Governor Pablo Hernández de Cos; Bank of Finland Governor Erkki Liikanen; Oesterreichische Nationalbank Governor Ewald Nowotny; Banca d'Italia Senior Deputy Governor Salvatore Rossi; Royal Bank of Scotland Chairman Howard Davies; EU Commission in support of the capital markets union policy agenda; CEPS' European Capital Markets Expert Group
ABSTRACT: Europe’s financial structure has become strongly bank-based – far more so than in other economies. We document that an increase in the size of the banking system relative to equity and private bond markets is associated with more systemic risk and lower economic growth, particularly during housing market crises. We argue that these two phenomena arise owing to an amplification mechanism, by which banks overextend and misallocate credit when asset prices rise, and ration it when they drop. The paper concludes by discussing policy solutions to Europe’s “bank bias”, which include reducing regulatory favouritism towards banks, while simultaneously supporting the development of securities markets.
with Marco Pagano (2016)
Economic Policy, 31(85): 51-106
(also ECB Working Paper 1797)
SUMMARY: VoxEU; World Economic Forum
DATA: zip file with data and code
CONFERENCES: Banco de Portugal Conference on Financial Intermediation (July 2015); Federal Reserve Bank of New York and NYU Stern Conference on Financial Intermediation (April 2015); 61st Panel Meeting of Economic Policy (April 2015); Research Workshop in Financial Economics at Mainz (March 2015); American Economic Association Annual Meeting (January 2015); ECB Conference on "The Optimal Size of the Financial Sector" (September 2014)
MEDIA: Financial Times (here, here and here); Die Presse; Het Financieele Dagblad; Central Banking
CITED BY: ECB President Mario Draghi; ECB Executive Board member Benoît Cœuré (here, here and here); Bank of Spain Governor Pablo Hernández de Cos; Bank of Finland Governor Erkki Liikanen; Oesterreichische Nationalbank Governor Ewald Nowotny; Banca d'Italia Senior Deputy Governor Salvatore Rossi; Royal Bank of Scotland Chairman Howard Davies; EU Commission in support of the capital markets union policy agenda; CEPS' European Capital Markets Expert Group
ABSTRACT: Europe’s financial structure has become strongly bank-based – far more so than in other economies. We document that an increase in the size of the banking system relative to equity and private bond markets is associated with more systemic risk and lower economic growth, particularly during housing market crises. We argue that these two phenomena arise owing to an amplification mechanism, by which banks overextend and misallocate credit when asset prices rise, and ration it when they drop. The paper concludes by discussing policy solutions to Europe’s “bank bias”, which include reducing regulatory favouritism towards banks, while simultaneously supporting the development of securities markets.
Interbank Exposure Networks
with Kimmo Soramäki (2016)
Computational Economics, 47(1): 3-17
ABSTRACT: Financial institutions are highly interconnected. Consequently, they form complex systems which are inherently unstable. This paper reviews empirical research on the instability of complex interbank systems. Three network approaches are distinguished: descriptions of interbank exposure networks; simulation and modelling; and the development of new metrics to describe network topology and individual banks’ relative importance. The paper concludes by inferring policy implications and priorities for future research.
with Kimmo Soramäki (2016)
Computational Economics, 47(1): 3-17
ABSTRACT: Financial institutions are highly interconnected. Consequently, they form complex systems which are inherently unstable. This paper reviews empirical research on the instability of complex interbank systems. Three network approaches are distinguished: descriptions of interbank exposure networks; simulation and modelling; and the development of new metrics to describe network topology and individual banks’ relative importance. The paper concludes by inferring policy implications and priorities for future research.
Mapping the UK Interbank System
with Zijun Liu and Tomohiro Ota (2014)
Journal of Banking & Finance, 45: 288-303
(also Bank of England Working Paper 516)
PRESENTATION: Video
CONFERENCES: Kiel Institute workshop on ‘Network approaches for interbank markets’ (May 2013); 1st European Banking Authority research workshop (November 2012); ETH Zurich Latsis Symposium on ‘Economics on the move’ (September 2012)
MEDIA: Central Banking
CITED BY: Bank of England Chief Economist Andy Haldane
ABSTRACT: We present new evidence on the structure of interbank connections across key markets: derivatives, marketable securities, repo, unsecured lending and secured lending. Taken together, these markets comprise two networks: a network of interbank exposures and a network of interbank funding. Network structure varies across and within these two networks, for reasons related to markets’ different economic functions. Credit risk and liquidity risk therefore propagate in the interbank system through different network structures. We discuss the implications for financial stability.
with Zijun Liu and Tomohiro Ota (2014)
Journal of Banking & Finance, 45: 288-303
(also Bank of England Working Paper 516)
PRESENTATION: Video
CONFERENCES: Kiel Institute workshop on ‘Network approaches for interbank markets’ (May 2013); 1st European Banking Authority research workshop (November 2012); ETH Zurich Latsis Symposium on ‘Economics on the move’ (September 2012)
MEDIA: Central Banking
CITED BY: Bank of England Chief Economist Andy Haldane
ABSTRACT: We present new evidence on the structure of interbank connections across key markets: derivatives, marketable securities, repo, unsecured lending and secured lending. Taken together, these markets comprise two networks: a network of interbank exposures and a network of interbank funding. Network structure varies across and within these two networks, for reasons related to markets’ different economic functions. Credit risk and liquidity risk therefore propagate in the interbank system through different network structures. We discuss the implications for financial stability.
Bank Ratings: What Determines their Quality?
with Harald Hau and David Marqués (2013)
Economic Policy, 28(74): 289-333
(also ECB Working Paper 1484 and CEPR Discussion Paper 9171)
PRESENTATION: Slides
CONFERENCES: European Finance Association 40th annual conference: Cambridge, UK (August 2013); 49th annual conference on bank structure and competition at the Federal Reserve Bank of Chicago (May 2013); 12th annual Darden international finance conference (April 2013); Global research forum on 'International macroeconomics and finance' at the European Central Bank (December 2012); 1st European Banking Authority research workshop (November 2012)
MEDIA: Bloomberg; Les Echos; El Pais; Il Sore; NZZ
ABSTRACT: This paper examines the quality of credit ratings assigned to banks by the three largest rating agencies. We interpret credit ratings as relative assessments of creditworthiness, and define a new ordinal metric of rating error based on banks’ expected default frequencies. Our results suggest that on average large banks receive more positive bank ratings, particularly from the agency to which the bank provides substantial securitization business. These competitive distortions are economically significant and contribute to perpetuate the existence of ‘too-big-to-fail’ banks. We also show that, overall, differential risk weights recommended by the Basel accords for investment grade banks bear no significant relationship to empirical default probabilities.
with Harald Hau and David Marqués (2013)
Economic Policy, 28(74): 289-333
(also ECB Working Paper 1484 and CEPR Discussion Paper 9171)
PRESENTATION: Slides
CONFERENCES: European Finance Association 40th annual conference: Cambridge, UK (August 2013); 49th annual conference on bank structure and competition at the Federal Reserve Bank of Chicago (May 2013); 12th annual Darden international finance conference (April 2013); Global research forum on 'International macroeconomics and finance' at the European Central Bank (December 2012); 1st European Banking Authority research workshop (November 2012)
MEDIA: Bloomberg; Les Echos; El Pais; Il Sore; NZZ
ABSTRACT: This paper examines the quality of credit ratings assigned to banks by the three largest rating agencies. We interpret credit ratings as relative assessments of creditworthiness, and define a new ordinal metric of rating error based on banks’ expected default frequencies. Our results suggest that on average large banks receive more positive bank ratings, particularly from the agency to which the bank provides substantial securitization business. These competitive distortions are economically significant and contribute to perpetuate the existence of ‘too-big-to-fail’ banks. We also show that, overall, differential risk weights recommended by the Basel accords for investment grade banks bear no significant relationship to empirical default probabilities.
Disclaimer: this site is my own; it has nothing to do with the ECB, ESRB or Bank of England.
