IMF Paper by Manmohan Singh and Karim Youssef
Abstract:
Probability of default (PD) measures have been widely used in estimating potential losses of, and contagion among, large financial institutions. In a period of financial stress however, the existing methods to compute PDs and generate loss estimates may vary significantly. This paper discusses three issues that should be taken into account in using PD-based methodologies for loss or contagion analyses: (i) the use of “risk-neutral probabilities” vs. “real-world probabilities;” (ii) the divergence between movements in credit and equity markets during periods of financial stress; and (iii) the assumption of stochastic vs. fixed recovery for financial institutions’ assets. All three elements have nontrivial implications for providing an accurate estimate of default probabilities and associated losses as inputs for setting policies related to large banks in distress.
FRBNY Paper by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky
Abstract:
The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.
Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.
We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.
Blog will be quiet(er) until Labor Day.
BdF Paper by Ronald Anderson (LSE)
Credit default swaps (CDSs) are derivative contracts that allow agents to shift the risk of default on an underlying credit from a credit protection buyer to a credit protection seller. Like other derivatives they are standardised relative to the underlying cash markets and in this way can help promote market liquidity. This in turn can facilitate risk shifting and price discovery. In this way they may lead to accurate pricing of credit risk and ultimately to the reduced costs of borrowing. However, like other derivatives it is possible that CDS contracts could play a part in market manipulations, especially when the underlying cash market is not transparent. This is a potential cost of CDS trading that should be weighed against potential benefits of liquidity, risk shifting and price discovery. We discuss the balance of these trade-offs in the context of singlename corporate CDSs, index CDSs, sovereign CDSs and CDSs on structured credit product tranches. We also discuss other potential costs of CDS trading including that they “make selling short too cheap” and that they may create market instability by facilitating speculative attacks.
Via Creditflux: Credit derivatives are good, on balance, says leading academic
Paper by Matthieu Bussière, Sweta C Saxena and Camilo Tovar
Abstract:
The impact of currency collapses (ie large nominal depreciations or devaluations) on real output remains unsettled in the empirical macroeconomic literature. This paper provides new empirical evidence on this relationship using a dataset for 108 emerging and developing economies for the period 1960-2006. We provide estimates of how these episodes affect growth and output trend. Our main finding is that currency collapses are associated with a permanent output loss relative to trend, which is estimated to range between 2% and 6% of GDP. However, we show that such losses tend to materialise before the drop in the value of the currency, which suggests that the costs of a currency crash largely stem from the factors leading to it. Taken on its own (ie ceteris paribus) we find that currency collapses tend to have a positive effect on output. More generally, we also find that the likelihood of a positive growth rate in the year of the collapse is over two times more likely than a contraction; and that positive growth rates in the years that follow such episodes are the norm. Finally, we show that the persistence of the crash matters, ie one-time events induce exchange rate and output dynamics that differ from consecutive episodes.
Paper by Gauti Eggertsson
Abstract:
This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.
Remarks by Joseph S. Tracy, Executive Vice President, NY Fed (also see charts link below)
I will outline the interventions that were carried out to mitigate the crisis, focusing on those conducted by the Federal Reserve. I will direct my remarks to the facilities that were created rather than to the actions taken for individual institutions since these have been discussed extensively elsewhere. The lessons learned from the crisis are important for the design of the policy response aimed at reducing the likelihood that the U.S. economy ever again experiences this degree of trauma.
Related: Charts
Lecture by Tommaso Padoa-Schioppa
The theme I have chosen for this lecture reflects the conviction that the market-government nexus lies at the heart of the crisis. It is the place where something went wrong.
In summary, I shall argue that while the crisis seems to come from the market side of the nexus, what really went wrong is on the side of the government. Firstly, government was captured by the myth that finance can regulate and correct itself spontaneously and hence retreated too much from the regulatory and supervisory role that is necessary to ensure stability. Secondly, fiscal and monetary policies fuelled imbalances and inflated bubbles. Thirdly, policy making remained almost exclusively concentrated at the level of the nation state, hence leaving unmanaged the rapid emerging reality of global finance. The crisis has only partially corrected such errors. The exit from the configuration that led to the crisis should be a government which – of course – respects economic freedom, but at the same time exerts its role forcefully, and is not prostrate before the twin idols of the market and the nation state.
The market-government relationship is, of course, as old as society itself. But in the last two centuries it has entered a new era fraught with opportunities and challenges that we do not understand fully and master even less. The 2007-20xx crisis is not an incidental blip on the screen of history, it is a strong call for political and institutional reform.
