Recent Financial Turmoil: Whats New

1
Recent Financial TurmoilWhats New?

• Peter Dunne, Queens University Belfast
• Co-authored by Andrey Zholos
• Presentation at
• The Society of Investment Analysts (Ireland)
• 28th Nov 2007

2
A Role for Financial Structure?

• Traditionally money was at the centre of macro
  theory of crashes
• Gertler (1988) blames the Keynesian revolution
  and monetarists for redirecting attention.
• Gurley and Shaw (1955) focused on Credit supply
  rather than monetary aggregates.

3
Revisionists

• Bernanke (1983) on the relative importance of
  monetary versus financial factors in the Great
  Depression.
• The breakdown in banking affected real activity
  by choking off financial flows to certain sectors
  of the economy, sectors consisting of borrowers
  who did not have easy access to non-intermediated
  credit.
• ..worsening of balance sheets resulting from the
  jump in debt service shrank borrowers
  collateral

4
Revisionists

• Bernanke (1983) found that financial variables
  were important determinants of output
• Liabilities of failed banks and businesses and
  spreads between risky and safe bond rates added
  considerable explanatory power to Barro-type
  output equations.
• Disruption of credit markets was not simply a
  response to anticipations of future output
  decline.
• Hamilton (1987) and many others provide further
  evidence supporting this view.

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Information asymmetryMoral hazard

• Akerlof's (1969) market for lemons influenced
  Jaffee Russell (1976) and Stiglitz Weiss
  (1981)
• Lemons theory explains how unobserved
  differences in borrower quality induces credit
  rationing.
• Mankiw (1986) analyzes a credit market plagued by
  lemons problemsa small rise in the riskless
  interest rate can lead to collapse.
• The increase in the loan rate reduces the average
  quality of borrowers.
• This forces the loan rate up further to offset
  the lemons effect.
• If the lemons problem is severe enough, the
  market will collapse.

6
Information asymmetry

• Myers Majluf (1984) and
• Greenwald, Stiglitz Weiss (1984)
• Equity financing effects of information asymmetry
  regarding the value of a firm's existing assets.
• Bernanke and Gertler (1986)
• Resurrect balance sheet effects also known as
  collateral effects, financial capacity
  effects or debt deflation.
• Gan(2007)
• Shows such effects in the Japanese economy after
  the property decline of the late 1980s.

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Lessons from recent panics/crashesSeeds of a
moral hazard problem?

• Japan late 1980sBoJ too slow!
• A warning to other monetary authorities.
• Crash of 1987
• The beginning of the Greenspan put?
• South-Asian currency and bank crises 19971998
• Is the current turmoil just a repeat of this but
  with Western banks now at the centre of the
  storm?
• Russian debt moratorium 1998
• Unobserved exposures through derivatives mkts
• LTCM
• Bailing out of LTCM inviting moral hazard problem
• Spread of systemic risk through collapse of
  markets
• Particularly derivatives mkts

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Any difference this time?

• Low interest rates, cheap money, yield chasing?
• Not so different from before
• Too few investment opportunities.
• Was the macro environment too loose given that
  inflation was been kept under control by other
  factors?
• Inefficient credit ratings not a new problem?
• Peek and Rosengren (1998) report that throughout
  1995 and 1996 Libor quotes for major Japanese
  banks for eurodollar and euroyen borrowing rarely
  differed by more than a few basis points, even
  though there were substantial differences in
  their credit ratings provided by the major rating
  agencies.

9
Any difference this time?

• More concentrated and more integrated markets?
• More Bank Regulation
• Stronger bank balance sheets following Basel I?
• More off-balance sheet activity!
• More systemic reaction to crisis.all trying to
  beef-up liquidity at the same time
• More transparency.MiFID, NMS etc.
• Increasing the risks in financial intermediation

10
Any difference this time?
Sovereign funds Complications arising from
politics of BRICK current account surpluses in
dollars. Bad taste resulting from DPW sell-off
of ports to AIG and some reluctance to invest in
US colateralized debt. Slide of dollar could
transmit problems to BRICK Collateralized Debt
Obligations All the lemons problems you could
wish for! But not that new! The tail has wagged
the dog before. During LTCM crisis derivative
positions threatened other markets
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US EU Market integration - volatility

• Granger causality tests (daily data for 2 years)
• Variables
• VIX..SP volatility from options
• EUR10 iTRAXX Euro 10Y CDS prem
• VOL10 iTRAXX High Vol 10Y CDS prem
• SEN10 iTRAXX Sen Financial 10Y CDS prem
• SUB10 iTRAXX Sub Financial 10Y CDS prem
• Cross10 iTRAXX Cross 10Y CDS prem
• USV2 UST 2year yield volatility
• USV10.. UST 10year yield volatility

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What causes what?
Points of interest? (1) VIX driven by iTRAXX
Financials (2) VIX feedsback to iTRAXX
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Interaction of Volatility Market Quality

• Granger causality tests (daily data for 5 years)
• Variables
• VIXSP volatility from options
• USV2 ..Volatility of UST yields
• ITV2 Volatility of Italian yields
• spra_10Y_US Bid-ask spread in UST mkt
• spra_10Y_ITBid-ask spread in IT(MTS)

14
What causes what?
Points of interest! (1) VIX drives UST
volatility (2) US Bid-Ask drives EU Bid-Ask
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Recent warnings

• Giddy(1981) comment regarding the functioning of
  the interbank eurocurrency market
• Indeed, if it is true that the market places
  great store on central bank support, it will
  continue to grant credit without discrimination
  to large banks. In effect the market will test
  central banks mettle, and if ever the rule of
  central bank rescues is broken, severe credit
  rationing will occur.
• Mervin King threatened such a rule break!

16
Recent warnings

• G10 central banks report 1992
• the heightened concern with credit risk,
  reflecting both a perception of increased default
  risk and greater difficulties in assessing
  counterparties strength, has led many banks to
  reduce the size of interbank credit exposures
  that can be authorised, to shorten the maturity
  of the business they are willing to take on, and
  to limit dealing activities that yield low
  profits but give rise to large counterparty
  exposures

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Yields at the short and long maturities
18
Liquidity provision at the short and long
maturities
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Recent warnings

• Bernard Bisignano (BIS, 2000)
• Interbank lending to Asia grew enormously prior
  to the Asian crisis, at times with arguably
  little recognition of the quality of the
  borrowing institution. International interbank
  credit also declined dramatically after the
  crisis erupted, contributing to a major collapse
  in economic activity.
• Short term IIBM borrowing was funding low quality
  sovereign debt.
• Giddy (1981) and Clarke (1983) pointed to the
  widespread belief among market participants that
  central banks would step in to support the market
  if it came under stress.
• Clarke reported that inquiries about
  counterparties balance sheets were considered to
  be in rather bad taste. Particularly if the
  bank in question was a very large bank more
  likely to be bailed out.

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Effects already

• Liquidity effects
• Feedback from dollar concerns
• Sovereign funds worry
• Higher yields on even govies in Europe
• Having a futures market helped Bunds
• Better functioning markets also means more
  concentration in activity and therefore more
  direct linkages between banking organizations and
  therefore more systemic risk.

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Towards solutions

• What drives the assumption that central banks
  will provide a safety-net?
• Is it worthwhile trying to reduce moral hazard
  and how can it be done?
• Can bubbles be detected? viewed as a dead
  science in academia and policy circles.
• Would it be possible to coordinate CB policy so
  as to reduce cheap fuelling of leveraged
  investments internationally?

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Towards solutions

• By-pass the intermediary (Sell direct to surplus
  countries)
• This assumes intermediaries add nothing
• Can high real interest rates be good?
• In very well developed economies
• Should central banks monitor the type of
  investment going on.

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Towards solutions

• Can transparency help?
• Counterparty transparency is problematic.
• No incentive to reveal debt positions so lemons
  problem.
• If revealed it would reduce the costs of credit
  analysis and counterparty risk but increase
  position risk
• Would it reduce moral hazard risk?
• Bester (1985) suggested that simultaneously
  offering loan rates and collateral requirements
  would help.
• Good borrowers would then prefer lower rates and
  greater collateral given their lower probability
  of potential default.
• But the tail can wag the dog unless
  transparency abounds.

24
Hold on to your hat!

• Still a rough ride ahead!
• We may be spared a Japanese style finish
• Deflation is rather unlikely