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Deciphering the Liquidity and Credit Crunch 2007-08
Abstract
This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.
... Brunnermeier identified the trigger for the bursting of the housing bubble in the United States as the unsustainable increase in mortgage lending coinciding with declining house prices, leading to a liquidity crisis and necessitating the design of a new financial architecture (Brunnermeier 2009). However, the full implementation of this new architecture remains pending. ...
... Brunnermeier's paper was published just after the 2007 bubble and is by far the most influential. In this document, the author explains the economic mechanisms that led to the great crisis, a few years after it occurred, in a didactic way and with a descriptive value relevant to any text that seeks to understand this phenomenon (Brunnermeier 2009). Schiller's book, an expert on price bubbles, is also highly cited, and attempts to provide a precautionary view of the development of new crises similar to those of 2007, indicating the elements that could establish similar scenarios (Shiller 2015). ...
... This paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large dislocations and turmoil in the financial markets, and describes common economic threads that explain the plethora of market declines, liquidity dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007. (Brunnermeier 2009) With high stock and bond prices and the rising cost of housing, the post-subprime boom may well turn out to be another illustration of Shiller's influential argument that psychologically driven volatility is an inherent characteristic of all asset markets. In other words, Irrational Exuberance is as relevant as ever. ...
This article presents the results of a bibliometric review of the study of real estate bubbles in the scientific literature indexed in Web of Science and Scopus, from 2007 to 2022. The analysis was developed using a sample of 2276 documents, which were reviewed in R software and analyzed with the assistance of the Bibliometrix package of the same software. The results indicate that there has been considerable productivity on the topic of real estate bubbles since 2007, with an emphasis on housing price formation processes and the social effects when bubbles burst. The authors found that there were not many case studies located in Latin America or Africa, nor were there approaches with advanced predictive modeling techniques using machine learning or artificial intelligence. The article provides an understanding of the state of the art in real estate bubble research and situates new research in front of the influential literature previously published.
... For instance, when interest rates are low, economic actors might prefer debt contracts requiring fewer payments. Conversely, an increase in interest rates could make refinancing more difficult or even impossible in the short term (Brunnermeier 2009). Agents may thus fail to fulfil their obligations when rollover problems arise. ...
... Interbank market transactions are relevant in two opposite situations. In normal circumstancesi.e., when reserve levels do not exceed the reserve requirementbanks might be willing to borrow in the interbank market even at rates higher than the central bank's ceiling not to signal their liquidity troubles to the market (Brunnermeier 2009;Lavoie 2010). In the zero-lower bound period of the global financial crisis (GFC), central banks injected unprecedented amounts of liquidity into the banking system through unconventional means. ...
... According to the 'lending channel', credit providers tend to restrict their lending activitiesin the event of limited capital capacityout of precautionary hoarding preferences or moral hazard. Leaving moral hazard concerns outside this paper's scope, lenders will hoard liquidity if they fear it will be difficult to obtain external funds (Brunnermeier 2009). This behaviour is especially relevant in the interbank market when banks do not know whetherand to what extentother banks are experiencing similar difficulties. ...
Banks’ refusal to roll over short-term interbank debts has received increased attention since the global financial crisis. Yet, heterodox monetary theories ignore interbank transactions and rollover channels despite recognising the importance of banks’ debt-renewal practices. Against this backdrop, this research contextualises banks’ refinancing vulnerabilities within heterodox monetary theories and relates them to the literature on rollover-induced interbank frictions. This study also reveals a further shock amplifier. Due to the interplay between maturity-rollover and market-funding liquidity cycles, a rollover-circuit may emerge. This circuit may lead to additional threats to the operation of the interbank market and financial stability, compelling monetary theories not to further neglect banks’ refinancing issues.
... To test these somewhat contradicting predictions, our third hypothesis reads: Hypothesis 3. Subsidiaries of parents with lower capital to asset ratio are more affected by solvency shocks to parents. Brunnermeier (2009) and Brunnermeier & Pedersen (2009) show that the lending channel can dry-up if banks that rely heavily on wholesale funding lose access to it and cannot roll-over their debt. Our next hypothesis, therefore, postulates: ...
... This differs from the findings documented in a number of studies (see, e.g., Ivashina &Scharfstein 2010 andGoldberg 2012b). A possible explanation for this result is that wholesale shocks may transmit only to foreign subsidiaries of parents that may rely more on wholesale funding, which is a less stable strategy than funding primarily through deposits (see, e.g., Brunnermeier 2009 andBrunnermeier &Pedersen 2009). We find empirical support for that in this section. ...
... This differs from the findings documented in a number of studies (see, e.g., Ivashina &Scharfstein 2010 andGoldberg 2012b). A possible explanation for this result is that wholesale shocks may transmit only to foreign subsidiaries of parents that may rely more on wholesale funding, which is a less stable strategy than funding primarily through deposits (see, e.g., Brunnermeier 2009 andBrunnermeier &Pedersen 2009). We find empirical support for that in this section. ...
In this paper, we investigate the drivers of transmission of solvency and wholesale funding shocks to 84 OECD parent banks on the lending of 375 foreign subsidiaries. We find evidence for the transmission of both types of shocks. Parent undercapitalization affects the transmission of solvency shocks, while wholesale shocks transmit to subsidiaries of parents that rely primarily on wholesale funding. We further document that parent banks tend to guard investment markets at the expense of funding markets and to channel any excess liquidity to improve lending growth in lagging markets. These results have important theoretical and policy implications and add to our understanding of the transmission of solvency and wholesale shocks across borders.
... Paola (2002) believes that the generation of liquidity risk is related to the improper risk control strategies of commercial banks [5]. Brunnermeier (2009) proved that liquidity risk came from financial institutions through evidence during the US subprime mortgage crisis [6]. Yang Zhongyuan & Xu Wen (2011) believe that the liquidity risk control strategy of banks can be studied from the perspective of the time matching of assets and liabilities [7]. ...
... Paola (2002) believes that the generation of liquidity risk is related to the improper risk control strategies of commercial banks [5]. Brunnermeier (2009) proved that liquidity risk came from financial institutions through evidence during the US subprime mortgage crisis [6]. Yang Zhongyuan & Xu Wen (2011) believe that the liquidity risk control strategy of banks can be studied from the perspective of the time matching of assets and liabilities [7]. ...
Affected by the deterioration of the international environment, risks in China's financial market are constantly accumulating, which puts forward higher requirements for financial risk control. In particular, the liquidity risk control of commercial banks has become the focus of academic attention. To control financial risks, we must first control the liquidity risk of commercial banks. With the help of the deep neural network model, this paper, based on the financial data of Chinese commercial banks in 2020, conducts research on financial risk control problems, aiming to explore effective financial risk control strategies.
... The interconnections among financial institutions can propagate and amplify shocks during financial crises [1,2], the risks of which are often unexpected a priori. One striking instance is the 2007 subprime crisis, where subprime mortgage backed securities -initially perceived as a minor asset class -unleashed a wave of catastrophic economic losses and incited a global recession [3]. This progression, wherein exogenous shocks snowball into substantial losses, is conceptualized as contagion effects. ...
... To address these challenges, researchers propose the concept of XAI to enhance the transparency of ML models in FinTech. 3 XAI aims to generate more comprehensible models without compromising learning performance, thereby enabling humans to better understand, trust, and manage their artificially intelligent counterparts [29]. Existing XAI methods can generally be categorized into two types: intrinsic interpretability and post-hoc interpretability [12]. ...
... The interconnections among financial institutions can propagate and amplify shocks during financial crises [1,2], the risks of which are often unexpected a priori. One striking instance is the 2007 subprime crisis, where subprime mortgage backed securities -initially perceived as a minor asset class -unleashed a wave of catastrophic economic losses and incited a global recession [3]. This progression, wherein exogenous shocks snowball into substantial losses, is conceptualized as contagion effects. ...
... To address these challenges, researchers propose the concept of XAI to enhance the transparency of ML models in FinTech. 3 XAI aims to generate more comprehensible models without compromising learning performance, thereby enabling humans to better understand, trust, and manage their artificially intelligent counterparts [29]. Existing XAI methods can generally be categorized into two types: intrinsic interpretability and post-hoc interpretability [12]. ...
Financial contagion has been widely recognized as a fundamental risk to the financial system. Particularly potent is price-mediated contagion, wherein forced liquidations by firms depress asset prices and propagate financial stress, enabling crises to proliferate across a broad spectrum of seemingly unrelated entities. Price impacts are currently modeled via exogenous inverse demand functions. However, in real-world scenarios, only the initial shocks and the final equilibrium asset prices are typically observable, leaving actual asset liquidations largely obscured. This missing data presents significant limitations to calibrating the existing models. To address these challenges, we introduce a novel dual neural network structure that operates in two sequential stages: the first neural network maps initial shocks to predicted asset liquidations, and the second network utilizes these liquidations to derive resultant equilibrium prices. This data-driven approach can capture both linear and non-linear forms without pre-specifying an analytical structure; furthermore, it functions effectively even in the absence of observable liquidation data. Experiments with simulated datasets demonstrate that our model can accurately predict equilibrium asset prices based solely on initial shocks, while revealing a strong alignment between predicted and true liquidations. Our explainable framework contributes to the understanding and modeling of price-mediated contagion and provides valuable insights for financial authorities to construct effective stress tests and regulatory policies.
... What is ahead might have some similarities (liquidity and demand shocks) with the economic downturn of 2009 (triggered primarily by the Lehman Brothers collapse in 2008), characterized by suddenly declining sales, putting a squeeze on revenues, profit margins and working capital requirements (Enqvist et al. 2014). During this crisis, the liquidity of many companies was under pressure and cash became a scarce resource due to the tight credit market conditions (Brunnermeier 2009). Chen et al. (2013) have documented that the internal liquidity risk along the supply chain affects a firm's credit risk, especially during the period of economic downturns. ...
... To address some of the remaining knowledge gaps regarding the working capital behavior of companies in times of an economic downturn, we refer to the following existing streams in literature: (i) The impact of firms' financial constraints on their investment policies-especially in times of a recession (e.g., Clementi and Hopenhayn 2006;Brunnermeier 2009;Baños-Caballero et al. 2014) and (ii) the relationship between working capital and firm performance (e.g., Deloof 2003;Enqvist et al. 2014;Lazaridis and Tryfonidis 2006). At this moment, we aim to make a contribution to (iii) supply chains as an alternative source of financing (e.g., Hofmann and Kotzab 2010;Huff and Rogers 2015;Wuttke et al. 2013;Rogers et al. 2020;Hofmann et al. 2021). ...
In times of crisis, cash and liquidity play an essential role. This paper analyzes the working capital measures over the course of a business cycle. We examine (1) how companies behave in economic downturns regarding their working capital components and (2) whether firms with higher financial constraints behave differently in economic downturns regarding their working capital components. The analyses were conducted with descriptive statistics and generalized linear mixed-effects modeling. Our dataset consists of 2111 stock-listed firms and 10,555 observations spread over the period of five years during the financial crisis era. The findings indicate that days sales outstanding and shorter days inventory held are related to better financial performance while days payable outstanding had no observable effect. Furthermore, financially constrained firms have shorter days sales outstanding than average firms. In economic downturns, firms seem to reduce both working capital and fixed investments to asset ratios. The financially constrained firms pushed down their fixed investments ratio more aggressively than average firms while, in contrast, the financially strongest firms pushed down the working capital to asset ratio in comparison to average firms. Interestingly, neither the cash conversion cycle, days payable outstanding, nor company performance or fixed investments to asset ratios fully returned to the pre-shock level. The behavior of non-financially constrained firms, which also perform better, indicates a stronger supply chain orientation than that of average firms. This might indicate that the supply chain-oriented view of working capital management could provide a more favorable and resilient alternative to the prevailing self-orientation.
... Moreover, Cochrane (2017) has analyzed several macro-finance models that are oriented to address the link between asset prices and economic fluctuations. Among these models are included representations such as Habits (Campbell & Cochrane 1999), Recursive Utility (Epstein & Zin 1989), Long-Run Risks (Bansal & Yaron 2004), Idiosyncratic Risk (Constantinides & Duffie 1996), Heterogeneous Preferences (Garleanu & Panageas 2015), Rare Disasters (Reitz 1988;Barro 2006); Utility Non-Separable across Goods (Piazzesi, et al. 2007), Leverage, Balance Sheet and Institutional Finance (Brunnermeier 2009;Krishnamurthy & He 2013), Ambiguity Aversion (Hansen & Sargent 2001) and Behavioral Finance (Shiller 1981;Shiller 2014). One of the main conclusions of the analysis is that there is not a single model that could explain the observed level of equity excess returns (risk-premia) without entering in contradiction with the corresponding theoretical foundations. ...
... In the cases that EBITDA takes negative values, EBITDA growth rates are excluded from the sample This is the case of AAPL (1996, 1997 and 1998), BA (2020), GS (2008and 2009), TRV (2002and 2003 and XOM (2020). n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a n/a GS n/a n/a n/a n/a n/a 58.1 13.9 -0.9 41.4 19. ...
The aim of this paper is to present a linkage between the real economy (micro and macro) and the financial economy. This relationship is obtained from the non-arbitrage valuation of equities framework. The paper also investigates if this theoretical relationship is actually observed. For this purpose, it proposes and tests an empirical model for excess returns that includes the linkage as a crucial element. The actual observation of the linkage could be of special importance for the financial economics discipline, since it presents several features that are not usually seen in other asset pricing or macro-finance models: (a) the relationship is explicit and does not depend on the estimation of free parameters; (b) it is derived under arbitrage free arguments and does not introduce subjective concepts as utility function or risk aversion; and (c) it explains the observed level of equity risk premium without entering in contradiction with its theoretical foundations. The conclusions of the performed tests are in favor of the concepts provided by the framework, meaning that further research could offer an alternative understanding of the behavior of financial markets and their connection with the real economy.
... If we consider a constant relative risk aversion (CRRA) utility function, reasonable values for the coefficient of risk aversion range from 1 to 5. In Mehra and Prescott's model only by imposing a coefficient ranging from 15 to 40, is possible to get realistic values for the equity premium. But, an individual with a relative risk aversion equal to 20, for instance, a person with 100 dollars of initial consumption would have a certainty equivalent of less than three and one-half dollars for a lottery ticket paying a prize of 100 dollars with a probability ½. 4 People are so risk averse that companies must offer very high returns to make stocks attractive 5 . Over the past thirty years many economists have tried to find a solution to this puzzle. ...
... For a critique on the use of a standard expected utility function and Taylor expansion to infer risk aversion in case of small risks seeThomas (2016) and O'Donoghue and Somerville (2018).5 To complicate things even further, assuming a really high level of risk aversion makes it impossible to explain why the riskless real interest rate has been so low in the same period of time (the so-called "risk-free interest rate puzzle). ...
This paper evaluates the magnitude of the equity premium in the European financial markets of the last twenty years. We document a substantial decrease in its value, especially after the onset of Great Recession. A habit consumption model predicts a value for the equity premium much higher than observed in data. Conversely, a simple general equilibrium model in the spirit of Mehra and Prescott (1985) is now able to explain the premium without resorting to extremely high coefficients for risk aversion. JEL classification numbers: G11, G12, G14. Keywords: Equity premium puzzle, Habit formation: Stock returns.
... Ceci a entraîné une multiplication des émissions d'obligations titrisées et abaissé les barrières entre les investisseurs institutionnels et le marché des créances hypothécaires. Enfin, le cadre réglementaire n'a pas réussi à éviter la formation de niveaux de crédit excessifs (Brunnermeier 2009). ...
... Elles n'ont pas été en mesure d'appréhender pleinement la complexité croissante des produits financiers ou la complexité découlant de l'interdépendance de plus en plus forte des institutions financières. En outre, elles ont eu recours à des modèles fondés sur des taux de non-remboursement et d'impayés historiquement bas, d'où une sous-estimation des risques (Brunnermeier 2009). ...
Le recul durable de l’inflation dans les années 1990 a entraîné une baisse structurelle des taux d’intérêt directeurs et à court terme dans les principaux pays industrialisés. L’endettement est ainsi devenu bon marché, ce qui a contribué au développement de ratios d’endettement excessifs et à une dépendance importante de bon nombre d’investisseurs vis-à-vis des marchés financiers de gros. Le passif des bilans des investisseurs a ainsi été exposé à des risques accrus. L’afflux massif de capitaux des pays émergents d’Asie vers les États-Unis a fait baisser les taux d’intérêt à long terme. Les investisseurs européens et américains ont été évincés et se sont de plus en plus orientés vers les obligations titrisées. Cette évolution a accentué les risques pesant sur l’actif des bilans de bon nombre d’établissements financiers. La propension des intermédiaires à accepter des risques plus élevés s’est conjuguée au désir de bon nombre de ménages de s’endetter davantage. Le crédit bon marché et facile s’est substitué à l’augmentation des revenus, ces derniers subissant une baisse de leurs niveaux relatifs et une croissance en termes réels limitée. Dans le même temps, les régimes de pension par capitalisation ont été privilégiés de façon croissante. Par ailleurs, la concentration de la richesse s’est accentuée. Ces deux évolutions se sont traduites par une augmentation des fonds des investisseurs institutionnels, en particulier aux États-Unis et en Europe, et ont fondamentalement modifié la structure de la demande sur les marchés financiers. La demande d’actifs sûrs a augmenté alors que, parallèlement, la quête de rendement s’intensifiait. Les obligations titrisées et la montée en puissance d’un système bancaire parallèle ont favorisé la création d’opportunités d’investissement apparemment aussi sures que rentables et séduisantes pour les investisseurs institutionnels. C’est principalement par ces biais que les fonds institutionnels ont été canalisés vers le marché des créances hypothécaires américain. Si les obligations titrisées se sont vu attribuer des notations sures, c’est cependant en raison de lacunes structurelles dans les modèles de notation sous-jacents. Parallèlement, l’attribution de notations élevées a été rendue possible en partie par le transfert de certains risques aux bilans des banques. Ce phénomène a été facilité par une gestion insuffisante des risques et par les mécanismes d’incitation inadéquats influençant les hauts responsables des entreprises. Enfin, l’environnement réglementaire n’est pas parvenu à remédier aux problèmes qui s’accumulaient sur les marchés financiers. De nombreux instruments bancaires parallèles contournaient les obligations réglementaires, et les risques qu’ils faisaient naître n’ont pas été suffisamment pris en compte par les autorités de tutelle. En particulier, la capture réglementaire et le manque de coordination entre les pays ont conduit à une réglementation molle et modérée. Cette situation a été encore aggravée par des biais fiscaux structurels.
... Driven by panic, bank runs are often contagious, and a run on one bank can rapidly spread to other banks (Aharony & Swary, 1983;Gorton, 1985;Gilbert, 1988;Gay et al., 1991;Docking et al., 1997;Allen & Gale, 2000). Moreover, funding problems at one bank can spill over to other banks, e.g., financially distressed banks may artificially raise their deposit rates in order to attract new depositors or retain existing ones (forcing other banks to do the same) or they may engage in asset fire sales, which depress market prices and in turn bring damage toother banks holding similar assets (Allen & Gale, 1994;Brunnermeier, 2009;Tirole, 2011;Shleifer & Vishny, 2011;Diamond & Rajan, 2011;Egan et al., 2017). − Second, protecting depositors, especially the smaller ones. ...
Last year, at around the same time, two reforms of deposit insurance systems were announced – one in the United States and the other in the European Union. The American proposal of the reform was triggered by the banking crisis of March 2023 (bank runs and failures) and it was put forward by the Federal Deposit Insurance Corporation in May 2023. In Europe, the European Commission published in April 2023 its legislative proposal to reform the current EU framework for crisis management in the banking sector (including both deposit insurance and bank resolution). The EU proposal for the reform was the culmination of a few years of preparatory work based on practical experience from the functioning of the EU crisis management framework which is part of the Banking Union established ten years ago. This article examines key problems that have to be addressed by the proposed reforms as well as potential policy options. The American options include various levels of deposit insurance coverage (limited, targeted, unlimited), while the European approach covers changes to resolution scope and funding (slight or substantial) as well as a broad reform including a common deposit guarantee scheme in the Banking Union. The article discusses advantages and disadvantages of these policy options, presents arguments for and against them, makes an attempt to evaluate the proposed reforms, and indicates how both of the reforms differ from each other and how they are similar.
... with j ∈ {A, B, C}, µ b t (τ j ) given by (13) (with ω suppressed), I b t = I b t (τ j ) given by (14), and ...
... This paper relates to the literature on banking development and performance evaluation during the recent crisis (see e.g. [10], [11], [12]). We consider a large data set of worldwide banks retrieved from Bloomberg, focusing on financial statements spanning from 2001 to 2013. ...
The role of Network Theory in the study of the financial crisis has been widely spotted in the latest years. It has been shown how the network topology and the dynamics running on top of it can trigger the outbreak of large systemic crisis. Following this methodological perspective we introduce here the Accounting Network, i.e. the network we can extract through vector similarities techniques from companies' financial statements. We build the Accounting Network on a large database of worldwide banks in the period 2001-2013, covering the onset of the global financial crisis of mid-2007. After a careful data cleaning, we apply a quality check in the construction of the network, introducing a parameter (the Quality Ratio) capable of trading off the size of the sample (coverage) and the representativeness of the financial statements (accuracy). We compute several basic network statistics and check, with the Louvain community detection algorithm, for emerging communities of banks. Remarkably enough sensible regional aggregations show up with the Japanese and the US clusters dominating the community structure, although the presence of a geographically mixed community points to a gradual convergence of banks into similar supranational practices. Finally, a Principal Component Analysis procedure reveals the main economic components that influence communities' heterogeneity. Even using the most basic vector similarity hypotheses on the composition of the financial statements, the signature of the financial crisis clearly arises across the years around 2008. We finally discuss how the Accounting Networks can be improved to reflect the best practices in the financial statement analysis.
... with j ∈ {A, B, C}, µ b t (τ j ) given by (13) (with ω suppressed), I b t = I b t (τ j ) given by (14), and ...
We develop a theory of trust in lending that distinguishes between reputation and trust. Banks emerge as more trusted lenders than non-banks. We show that trust severs the link between performance and the cost and availability of financing for lenders, but trust can be lost and is difficult to regain. Banks survive an erosion of trust better than non-banks. Banks' trust advantage arises from the lower cost of funding due to insured deposits and an endogenous belief revision channel that complements the effect of the funding cost advantage. The results have novel policy relevance for deposit insurance scope.
... More often it is associated with asset-liability duration mismatch as depository institutions tend to borrow short and lend long. Altough this duration gap persists naturally it causes severe liquidity problems especially during times of financial turmoil and distress that are characterized by sudden deposit outflows and spikes in non-performing loans (Holmstrom and Tirole, 2000;Jedidia ve Hamza, 2014;Deep and Schafer 2004;Berger and Bouwman, 2006;Saunders and Corunet, 2006;Brunnermeier, 2009;Yang ve Xu, 2009). Therefore, liquidity risk has always been monitored closely by all market participants and has been regulated formally by both national banking authorities and international committees such as BASEL. ...
Banking and risk are synonymous concepts. The risk concepts for both conventional and Islamic banks are broadly similar, and liquidity risk is among the most important risks that all banks are exposed to. The management process of liquidity risk, which arises when banks do not have enough assets to meet their liabilities at maturity, may differ in conventional and Islamic banks. This study aims to present a comparative analysis of the liquidity determinants of conventional and Islamic banks operating in Turkey. Using the data of 3 Islamic and 17 conventional banks for the period between 2011Q1-2022Q2, the analysis, which also aims to see the short and long-term effects, concludes that the determinants of liquidity risk for conventional and Islamic banks are largely similar. However, the liquidity of Islamic banks is more sensitive to bank-specific variables. The findings showed that Islamic banks, which cannot use all of the conventional liquidity management tools in the liquidity management process for different reasons, have to hold higher liquid assets than conventional banks in the short term, even if they are balanced in the long term.
... The financial crisis of 2007-2008, often regarded as the most severe since the Great Depression, unfolded globally, surpassing the scale of previous region-specific crises. Brunnermeier pointed out that the financial crisis of 2007-2008 is widely considered to be the worst financial crisis since the Great Depression of the 1930s [1]. Moreover, the one-day fall in stock prices was even greater than the 1930s Great Depression [2]. ...
The global financial crisis of 2007-2008, stemming from the United States subprime mortgage crisis, was a profound and widespread calamity with far-reaching implications for economies, enterprises, and investors worldwide. This essay posits that the root cause of this crisis lies in the failure of corporate governance, asserting that the outbreak unfolded through three stages: the accumulation, amplification, and outbreak of governance risks. Crucially, the first stage reveals a convergence of internal and external governance failures, marking the conjunction of internal governance lapses—specifically in risk management, executive compensation, board operations, and information disclosure—and external governance deficiencies in government regulation, legal requirements, and social accountability. The multifaceted impact of the crisis, leading to the bankruptcy of prominent financial institutions globally and unprecedented government interventions, underscored the urgency of addressing governance issues. Scholars and researchers globally have since dissected the crisis, identifying lessons and recommending reforms. This essay examines the intricate balance between internal and external governance, emphasizing the imperative of effective interaction. Proposals for improvement include enhancing board structures, implementing substantive disclosure rules, fortifying government regulation, and fostering international cooperation. The aftermath of the crisis, while posing challenges, also presents an opportunity for corporate governance reform. The lessons learned highlight the indispensability of robust governance mechanisms in protecting investor and shareholder interests. Effectively navigating the evolving landscape requires staying abreast of contemporary needs and embracing reforms that align with the dynamic nature of global finance. Ultimately, the financial crisis underscores the pivotal role of effective corporate governance in mitigating risks, fostering sustainable development, and safeguarding societal interests.
... The World Council of Credit Unions (WCOCU) defines credit unions as a member owned, nonprofit financial cooperatives whose main role is to provide savings, credit and other financial services to members. They are referred to in various names around the world for example savings and credit cooperative which is the term commonly used in Africa; and Islamic investment and finance cooperatives (Brunnermeier, 2009). The membership of a credit union is based on a common bond shared by borrowers and savers who either belong to a specific organization, community or religion. ...
... The necessity to comprehend the interplay between financial fraud and credit risk has become more pronounced in recent years. A series of financial crises has underscored the need for deeper insights into the mechanisms through which financial fraud can exacerbate credit risk and, in turn, jeopardize banking stability (Brunnermeier 2009). ...
The intricate relationship between financial fraud and credit risk, and their combined impact on banking stability, is a vital and under-researched aspect of financial system integrity. To fill this knowledge gap, this study embarked on a thorough bibliometric analysis of the field, utilizing 2790 documents from various sources, including 1853 articles, 504 books, and 177 reviews, spanning the years 1990 to 2023. Utilizing advanced tools, like Biblioshiny and VOSviewer, this study illuminated key geographical, thematic, and intellectual trends, shedding light on an annual growth rate of 13.43% in the related literature and an average citation per document of 28.29. This detailed analysis offered valuable insights into the current research landscape, emphasizing areas such as author collaboration, with 20.32% international co-authorships, and the prevalence of single-authored documents, at 1100. Despite the existing body of research, the interconnected dynamics between financial fraud and credit risk and their implications for banking stability remain underexplored. Therefore, this study sought to unravel this complex relationship and examine its effects at both the micro (individual banks) and macro (banking sector and wider economy) levels. The findings carry significant practical implications, informing policy development, shaping risk management strategies, and contributing to regulatory measures. Despite its limitations, including the potential transformation of identified trends due to evolving financial systems and financial crimes, this study represents a significant contribution to scholarly discourse in the field. It lays the groundwork for future research and facilitates a more secure and resilient banking sector, reflecting the data-driven insights obtained from the research.
... The recent global financial crisis (GFC) had contributed to global dependence shifts and portfolio losses, mainly due to changes in joint dynamics and network-dependence relationships, and the large increases in volatility spillovers between international financial markets (Brunnermeier, 2009;Moshirian, 2011;Florackis et al., 2014). Doubtlessly, the severe financial fluctuations, which resulted from this global crisis, have put into question the reliability and the estimation abilities of the status quo mathematical and statistical models used in dependence estimation and portfolio optimization. ...
This study proposes an integrated framework to model and estimate relatively large dependence matrices using pair vine copulas and minimum risk optimal portfolios with respect to five risk measures within the context of the global financial crisis. We apply this methodology to two 20-asset mining (gold and iron ore-nickel) sector portfolios from the Australian Securities Exchange. The pair vine copulas prove to be powerful tools for the modeling of changing dependence risk under three different period scenarios combined with the optimization of portfolios that have complex patterns of dependence. The portfolio optimization results converge, on average, in some stocks.
... Taken together or individually, these risks can impact market activities negatively. In studying currency crashes from the financial crisis, Brunnermeier (2009) highlights the importance of liquidity in the forex market. A decline in forex liquidity impacts carry traders and triggers liquidity spirals. ...
This study determined the relationship between credit risks and the financial performance of quoted commercial banks in Nigeria. The credit risk variables studied were exchange rate, interest rate and liquidity rate. Financial performance was measured using return on assets. The research design employed in this study was the Ex-post facto research design. The population comprised the top 10 commercial banks in Nigeria as of December 2021 with updated financial statements up to 2021. The banks were ranked in terms of assets. The study covered a period of five years-2017 to 2021. The study utilized secondary data that were extracted from the annual report and accounts of the commercial banks. Descriptive statistics were used to summarize the mean, median, standard deviation, maximum and minimum mean values of the study variables. Regression analysis was used to analyze the research hypotheses. The findings of the study revealed a significant relationship between liquidity ratios and financial performance, but no significant relationship between exchange rate, interest rate and financial performance. As the exchange rate and interest rate rose, the return on assets reduced. The study concluded that high-interest rates have a negative effect on bank performance. It was recommended that banks should mitigate credit risks by using appropriate risk management strategies through forwards, futures, swaps, options, and insurance as well as securitization techniques.
... Last, our article is related to work on rollover risk (e.g., He and Xiong (2012)), which contributed to the severity of the 2008 financial crisis (e.g., Brunnermeier (2009), Krishnamurthy (2010). In that episode, banks were exposed to a maturity mismatch, having financed longer-term investments with short-term liabilities like repurchase agreements. ...
Is there a trade-off between the short-run and long-run real effects of monetary policy “leaning against the wind”? We provide novel evidence on this question from the United States in 1920–1921. Our identification strategy exploits county-level variation in access to the Federal Reserve’s discount window, and hand-collected data on banking and agriculture in Illinois. In the short term, tightened conditions at the discount window decreased bank lending and lowered crop prices and farm revenues. In the long term, however, they lowered debt-to-output levels and led to greater farmland utilization, suggesting an avoidance of debt overhang problems.
... 22 The modern laws governing financial products are not always perfect. For instance, that lack of transparency in over-the-counter derivatives markets is considered one of the contributing factors to the financial crisis of -2008(Brunnermeier 2009), which was ultimately addressed by conventional regulators in the Dodd-Frank Act. Islamic jurists have introduced the "Islamic" version of financial derivatives; however, they could have contributed to improving the conventional laws governing transparency in the derivatives markets. ...
This manuscript critically discusses the current implications of the scriptural injunctions against gharar and maysir. It elaborates how overlooking the features of the contemporary world and adopting a formalistic approach in Islamic jurisprudence have led to absurdity in the implication of the doctrines of gharar and maysir for Muslims' financial activities. The manuscript also underscores the necessity of adopting the maqāsid approach (purposivism) in Islamic jurisprudence. It propounds that the cogent concern of the injunctions could have been an initiative for Islamic scholars to establish an advanced contract law and to promote transparency in economic activities if a maqāsid approach had been adopted in Islamic jurisprudence.
... ISSN 1948-5433 2016 One can infer from the above table, the central Bank of Jordan's Keenness on the banks of Jordan's commitment to the decisions of Basel 111. The level of this Keenness was increased during the occurrence of the global financial crisis, especially, that liquidity shortage in banks formed a big reason to the crisis occurrence (Brunnermeier, 2008). Moreover, liquidity ratio in banks measures the ability of the bank to meet the short-term obligations depending on liquid assets and it is calculated by this equation ...
p>Banks liquidity is the main driver of banking operations, and the lack of the sufficient liquidity prevents banks from performing their role as a mediator between money owners and funding seekers, in addition to inability to meet the costs of daily operations including employees’ salaries. And this puts the bank in a risky situation threatening the bank survival. So bank liquidity shortage has consequences damages of social and economic. Where this shortage may deprive the funding seeker from establishing a business or industrial project or etc. of projects, which may contribute in economic development in the country in the one hand, and deprive his family from gaining additional income to improve their livelihood from the other hand.
Therefore, one can find that banks have paying increased attention towards liquidity, and Central Banks Keep on liquidity ratios that banks should keep them. As long as banking deposits facilities, and profits are the actual drives of banks liquidity, this study examines in the effects of these activities on liquidity in Jordanian Commercial banks.</p
... At last, the uncertainty generated by the pandemic may induce banks to reduce their interbank funding, drying the availability of liquidity within the banking system and increasing banks' funding costs. This outcome further leads to illiquidity and eventually to the "liquidity spiral" (Brunnermeier and Pedersen, 2007;Brunnermeier, 2008;Hameed et al., 2010) that may cause a domino effect when banks are imposed to the distress associated with illiquidity. Table 2 also shows some other factors that have a significant impact on a bank's marginal contribution to systemic risk. ...
Purpose
This study tends to investigate how the outbreak of the coronavirus disease 2019 (COVID-19) pandemic has affected banks' contribution to systemic risk. In addition, the authors examine whether the impact of the pandemic may vary across advanced/emerging economies, and with banks with differed characteristics.
Design/methodology/approach
The authors construct the bank-specific conditional value at risk (CoVaR) and marginal expected shortfall (MES) to measure their contribution to systemic risk and define the outbreak of the COVID-19 pandemic by the timing when countries report more than 100 confirmed cases. The authors use the approach of difference-in-differences to assess the impact of the COVID-19 pandemic on banks' contribution to systemic risk. This sample comprises monthly panel data of around 900 listed commercial banks in 39 advanced and emerging economies.
Findings
The authors find that, firstly, the COVID-19 pandemic increased banks' contribution to systemic risk significantly around the world. Secondly, the impact of the COVID-19 virus was more pronounced in developed countries than in emerging economies. Finally, banks with a larger size and higher loan-to-deposit ratio are more greatly affected by the COVID-19 pandemic, while a higher capitalization for banks is insufficient to shelter them from the adverse impact of such pandemic.
Originality/value
The authors assess the impact of the COVID-19 pandemic on banks' contribution to systemic risk. Using the conditional value at risk (marginal expected shortfall) of banks as the measure, this study’s results suggest that banks' contribution to systemic risk increases by around 25% (48%) amid the COVID-19 pandemic. This study’s findings may shed some light on the potential policies that financial regulators may employ to ameliorate the adverse outcomes of the ongoing pandemic.
... Тази огромна сума бледнееше пред потенциалните загуби на финансовите институции притежаващи или издаващи деривативни инструменти базиращи стойността си на стойността на секюритизираните от банките ипотечни кредити. Финансовият трус доведе до загуба на богатство на пазарите на акции в размер на 8 трилиона долара за периода от достигнатият през октомври 2007 г връх до октомври 2008 г (Brunnermeier, 2009). Безпрецедентният стрес за американската финансова система доведе до заплаха за вълна от фалити във финансовия сектор и принуди Федералният резерв на САЩ да инициира безпрецедентна по мащабите си програма за осигуряване на ликвидност на финансовата система (Mizen, 2008). ...
... Furthermore, the concentration risk was an important factor for the recent two banking crises. Namely, the Global Financial crisis of 2007/08 was triggered by the high concentration of the American banks to the mortgage loans (Brunnermeier, 2009), and the concentrated banks' lending to poorly performing European countries contributed to the subsequent European debt crisis during 2011 and 2012 (Acharya et al., 2014). Thus, the concentration risk necessitates close monitoring from both banks and supervisors because when mismanaged, it materializes as credit default with a severe damaging impact on the overall economy. ...
Banks lend large funds to big clients and are exposed to concentration risk. The concentration risk is indirect credit risk exposure for the banks and it might cause large losses in case of default of the big clients. Therefore, prudent banks would increase their capital surplus as the concentration exposure rises in order to preserve their stability against deteriorating performances of the big clients. Thus, this paper investigates the effect of the single-name concentration risk on the capital surplus in the Macedonian banking sector. The analysis was done by employing Vector Error Correction Model on quarterly data from 2006q1 to 2018q4. The results suggest that the Macedonian banking sector is prudent and increases the capital surplus from 0.65 percentage points (p.p.) to 2.20 p.p., as the single-name concentration risk rises by 1 p.p. More concretely, a future increase of the banking sectors' large exposures by 53.7 million of euros (1 p.p. of the total gross loans as of 2018q4), would require an increase of the capital surplus by the minimum amount of 3.1 million of euros (0.65 p.p. of the minimum capital requirement as of 2018q4), under the assumption of not changing both the total gross loans and the minimum capital requirement, compared to 2018q4.
... Bankaları ciddi şekilde olumsuz etkileyen ve bankacılık sisteminin genel istikrarına zarar veren bir finansal kriz sırasında ve hemen sonrasında, dahili olarak oluşturulan fonların var olması oldukça önemlidir (Blank vd., 2009). Küresel kriz dönemlerinde kredi sınırlaması nedeniyle borçla finansman imkânının azalması, bankalardan kaynaklanan olumsuz etkilerin reel ekonomiye aktarılmasına sebep olmaktadır (Brunnermeier, 2009;Shleifer ve Vishny, 2010). Fakat Covid-19 döneminde tüm dünyada olduğu gibi Türkiye'de de devlet işletmelerin kredi ve fonlara erişimini kolaylaştırmak için çeşitli uygulamalar geliştirmiştir (Ayaydın ve Pilatin, 2021). ...
... Kedua, lesunya perekonomian juga berdampak pada menurunnya kapasitas debitur dalam memenuhi kewajibannya kepada bank, sehingga menurunkan kualitas kredit perbankan secara drastis. Jika keduanya tidak segera diatasi, dikhawatirkan dapat mengganggu stabilitas sistem keuangan, dan berpotensi memicu risiko sistemik yang berpengaruh negative terhadap pertumbuhan ekonomi (Brunnermeier, 2009;Acharya, Shin & Yorulmazer, 2011;Ehrentraud, J & Zamil, R., 2020;Disemadi & Shaleh, 2020;). ...
The Covid-19 pandemic has had a direct or indirect impact on banking. This study aims to investigate the conditions and perceptions of the banking industry in dealing with the Covid-19 pandemic and credit restructuring policies in Indonesia. This study is the result of a survey of 35 Perbanas member banks representing all bank groups based on their core capital. The results of the descriptive analysis found that the banking industry was quite strong, responded well to the shocks that occurred, and had strong optimism about the banking recovery. This condition is considered to support Indonesia's financial stability.
... Tang Huailin (2019) pointed out that the sudden exhaustion of financial market liquidity is the key factor leading to the financial crisis, and understanding the relationship between liquidity and liquidity risk and asset pricing mechanism is the core of understanding the financial crisis [13] . Brunnermeier et al. (2009) divided liquidity into market liquidity and funding liquidity, and put forward the "liquidity spirals" effect, which provided a good explanation for the reasons of market liquidity exhaustion and the stock market crash [14][15] . ...
In recent years, the systemic risks of China's stock market has broken out frequently. Many scholars believe that leverage is an important factor that affects systemic risk. Based on Acharya(2010)，this paper studies the relationship between leverage, Marginal Expected Shortfall and Systemic Expected Shortfall of stocks in China under the background of the global financial crisis in 2008, the COVID-19 epidemic in 2020 and the Federal Reserve's interest rate hike as well as the Russia-Ukraine conflict in 2022 respectively. The results show that: in the global financial crisis in 2008, and under the Russia-Ukraine conflict as well as Federal Reserve's interest rate hike in 2022, stocks with higher leverage and higher Marginal Expectation Shortfall will have greater Systemic Expected Shortfall; However, due to "supply-side reform" and "deleveraging", the effect was not significant under the COVID-19 epidemic in 2020. In addition, the manufacturing industry has performed significant heterogeneity under the two shocks in 2020 and 2022.
... For instance, when federal banks or central banks freeze the quantity of money supply, liquidity shrinks, perturbing investor confidence. The impact would be in the form of higher borrowing costs and diminished investment activity by investors because there are pessimistic about investment performance (Brunnermeier and Pederson, 2009). This may lead to the withdrawal of investment activity by investors due to the prevailing uncertainty in the market. ...
Purpose
The purpose of this paper is to examine the effect of economic policy uncertainty (EPU) of China on investment opportunities in five ASEAN economies.
Design/methodology/approach
This paper employs advanced empirical approaches, such as Multivariate DCC-GARCH and Continuous Wavelet Transform (CWT) to test the research objective. The period of analysis involved monthly data from 2003 until 2019.
Findings
This paper provides evidence where the Malaysian stock market to be the least exposed to risks emanating from Chinese EPU, followed by Singapore, the Philippines, Thailand and Indonesia. Results for investment opportunities based on time horizon suggest, for a short-term holding period, investors are better off investing in Singapore and Indonesia, while, for medium-term holding periods, all ASEAN markets appear lucrative except for the Philippines.
Practical implications
From a managerial perspective, the outcome or findings of this study are expected to aid the retail and institutional investors in designing better strategies on diversifying a stock portfolio with different holding periods.
Originality/value
Theoretically, the findings of this study contribute fresh insights into an emerging strand of literature focusing on the transmission of regional policy. Methodologically as well, this study is a novel venture to the best of authors' knowledge.
... If the originator does not hold the credit it originates, but distributes the loan and its risks to other entities through securitization, the originator has a reduced incentive to monitor the credit granting process. Thus, this model brings with it a major principal-agent problem in the credit screening process, because the credit incentives of the originator are not aligned with those of the entity that ultimately holds the loan (Brunnermeier, 2009;Demyanyk and Van Hemert, 2011;Purnanandam, 2011). Prior research also documents that the use of securitization was associated with increased problems in renegotiating distressed assets and failures in valuing complex securitization instruments (Benmelech and Dlugosz, 2009;Michalak and Uhde, 2012). ...
This study compares credit spreads and pricing determinants of securitization vis‐à‐vis covered bonds. Our analysis reveals that although ratings are the most important pricing determinant for ABS and MBS, investors place relatively more importance on contractual, macroeconomic, and banks’ characteristics rather than ratings in pricing covered bonds. We find evidence of a mispricing effect in structured finance markets: ABS and MBS have higher credit spreads than similarly rated public covered bonds and mortgage covered bonds, and security prices reflect information beyond credit ratings. We find no evidence of borrowing costs affecting banks’ choice between securitization and covered bonds. This article is protected by copyright. All rights reserved.
... Once action schemes are set in a path-dependent process, it is not always easy to classify them as herding or swarming behaviour. But independent from specific processes, social dynamics can be recognised and can become societally relevant such as in flashmobs, hypes of speculation, e.g. on crypto-currencies like Bitcoin or high-risk stocks like GameStop, or in the US real estate bubble triggering the global financial crisis in 2008/2009 (Brunnermeier, 2009;Stein, 2011). These can start out by swarming behaviour initiating an exponential increase in participants triggering further dynamics. ...
Digitalisation, digital networks, and artificial intelligence are fundamentally changing our lives! We must understand the various developments and assess how they interact and how they affect our regular, analogue lives. What are the consequences of such changes for me personally and for our society? Digital networks and artificial intelligence are seminal innovations that are going to permeate all areas of society and trigger a comprehensive, disruptive structural change that will evoke numerous new advances in research and development in the coming years. Even though there are numerous books on this subject matter, most of them cover only specific aspects of the profound and multifaceted effects of the digital transformation. An overarching assessment is missing. In 2016, the Federation of German Scientists (VDW) has founded a study group to assess the technological impacts of digitalisation holistically. Now we present this compendium to you. We address the interrelations and feedbacks of digital innovation on policy, law, economics, science, and society from various scientific perspectives. Please consider this book as an invitation to contemplate with other people and with us, what kind of world we want to live in!
... The 2007 financial debacle, however, highlighted the role of capital markets and market risk along with credit risk in initiating and propagating the crisis. See Adrian and Shin (2010); Kashyap et al. (2014);and Brunnermeier (2009). These sources of risk coexist on the same balance sheet of a BHC, and could potentially interact and affect the overall risk profile of the bank with implications for financial stability and the rest of the economy. ...
We develop a dynamic model of a BHC that encompasses both a trading desk and a loan desk, and explore the role of risk attitude and overleveraging by the trading desk. We trace the impact of monetary policy and market innovations on bank behavior in the presence of Basel III type regulations. We show that the value of the BHC is enhanced by operating both desks. We explore alternative regulatory remedies to ongoing efforts to ring-fence the proprietary trading business, and show that regulations that target bank governance can mitigate possible rogue trading and the overleveraging problem.
Uncertainty is a powerful concept in many ways, particularly so for economic ideas. The convictions before the financial crisis in 2007-8 that business cycles had been tamed was not the first time neglect of uncertainty proved devastating. This essay discusses the famous Currency controversy in mid-19th century Britain and the failure to take uncertainty into consideration, which ultimately lead to the banking crisis of 1847. The unintended consequences of the Bank Act of 1844 revealed themselves spectacularly in 1847, in the same way convictions about the Great Moderation fell apart in 2007-8.
History has seen severe global credit crisis in 2007-2009, which has raised many concerns. One of the serious concerns are the leverage, performance relationship and the role of financial crisis in the performance of the private firms. Therefore, this study aims to examine the leverage, performance relationship and the impact of financial crisis on performance of private firms. To achieve our goal, the study used fixed effects regression model. Data for the study is extracted from the FAME database UK, for the period of 2004-2009. The results reveal that leverage and financial crisis have negatively affected the performance of private firms. Size and growth have positive impact on performance of private firms, while tangible assets have negative impact on performance. Further analysis reveals that both small and large firms were exposed to financial crisis. The findings of the study documents variations in the supply of finance and credit which has serious implications on their growth and performance. The findings of the study thus has implications for policy makers and financial regulations in the country.
Este trabajo discute los argumentos analíticos que se usaron para explicar la crisis financiera internacional que se desató a partir de 2007. Empezamos con la hipótesis del «exceso de ahorro» desarrollada por Ben Bernanke, quien sostiene que la causa de los desequilibrios financieros en EEUU fue exógena, generada, básicamente, por acciones de países en desarrollo, y que sus efectos escapaban al manejo de las autoridades monetarias y financieras norteamericanas. Luego revisamos la crítica que se le hizo y la corrección que él mismo procesó en la que se admite, como elemento prioritario, la existencia de otros factores distintos de las acciones de los países en desa- rrollo. A continuación, presentamos la hipótesis del «desarrollo del crédito y falencias regulatorias» en las que se destaca la ampliación sin precedentes del crédito y el apalancamiento financiero, en medio de creciente desregulación financiera. En tercer lugar, revisamos las ideas centrales de Hyman Minsky que destacan el carácter sistémico de las crisis en la economía capitalista.La hipótesis de crédito y falencia regulatorias nos parece la más acertada, pues la evidencia a su favor es sustancial y, además, también Bernanke corrige su enfoque inicial e incorpora los elementos de este segundo enfoque. El reciente trabajo Reinhart y Rogoff (2009) siendo bastante más amplio, pues estudia varios siglos de crisis, con respecto a la crisis reciente podría ser ubicado dentro de la hipótesis del «desarrollo del crédito y falencias regulatorias».
This study is among the first to examine the theory and practice of monetary policy in South Korea. Woosik Moon provides a detailed analysis of the central bank of South Korea, one of the most successful and important economies in Asia. He covers everything from monetary policy to inflation targeting and macroprudential regulation, explaining how these policy tools were used to deal with the aftermath of the 2007-2011 financial crisis. He then brings his study into our current moment, speculating as to how the use of these policies will change in order to deal with the fallout of the Covid-19 pandemic. This book offers in-depth investigations and the provision of the most up-to-date information about the Bank of Korea's monetary and financial actions, serving as essential reading for central bankers and professionals of financial markets around the world, as well as anyone interested in monetary policy-making.
Squatting and the State offers a new theoretical and methodological approach for analyzing state response to squatting, homelessness, empty land, and housing. Embedded in local, national, and transnational contexts, and reaching beyond conventional property theories, this important work sets out a fresh analytical paradigm for understanding the deep, interlocking problems facing not just the traditional 'victims' of narratives about homelessness and squatting but also a variety of other participants in these conflicts. Against the backdrop of economic, social, and political crises, Squatting and the State offers readers important insights about the changing natures of property, investment, housing, communities, and the multi-level state, and describes the implications of these changes for how we think and talk about property in law.
This book presents the theory and evidence on the effect of market liquidity and liquidity risk on asset prices and on overall securities market performance. Illiquidity means incurring a high transaction cost, which includes a large price impact when trading and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise trading cost. The book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation. Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis which leads to downward price and liquidity spiral. Overall, the volume demonstrates the important role of liquidity in asset pricing.
Are bank resolution regimes effective enough to improve financial stability? We look at the effect of the new bank resolution reforms on the systemic risk of big financial conglomerates. We find that in developed countries, parent banks in a stricter resolution regime have lower systemic risk contributions, compared to their foreign subsidiaries. The opposite is true for parent banks from developing countries. We explain these results as financial conglomerates exploiting differences in resolution tools between parent and subsidiary banks, in particular in developing countries where rules enforcement is weaker. These results suggest that centralized regulation has heterogeneous effects depending on the country's development degree. Only the bail-in tool reduces systemic risk across the board, which has important implications for policymakers. JEL Classification: G01, G21, G28
We investigate whether the U.S. stock market disciplines asset-backed commercial paper (ABCP) liquidity guarantors who exploit a regulatory loophole that exempts at least 90% of the risk capital charge. We find that the market reduces liquidity guarantors’ franchise value when a short ABCP maturity causes the conduit credit losses to remain with guarantors rather than being transferred to investors. Banks with franchise value more sensitive to the ABCP guarantee cost maintain a higher risk capital buffer. We interpret our findings as evidence that market discipline—complexity of the shadow banking system notwithstanding—alleviates the consequence of regulatory arbitrage.
China’s decades-long endeavor in introducing a deposit insurance scheme does not look like an “easy win” for the reform of the financial sector. The layout of the system has its own distinctive features, which underlines the need to carry out an evaluation of its salient legal and institutional elements. This article offers a detailed analysis over four key issues linked with the framework: the legal status of this deposit insurance scheme should be elevated to the level of laws instead of subordinate administrative regulations; the creation of a deposit insurance scheme makes it essential to have a bank resolution process in place; the cost of maintaining coverage would not be a heavy burden to banks; and bank bailouts could only happen as a last resort to those systemically important banks. For a sound legal system and a robust institutional mechanism of deposit insurance in China, the author expects a gradual phasing in of a multi-year plan following the adoption its first deposit insurance scheme. Even so, shifting from an implicit to explicit deposit insurance represents a remarkable volte-face in both government thinking and the setup of China’s banking sector. This first part of the article explores key features of the Deposit Insurance Regulation (“DIR”). The final parts of the article, which will appear in upcoming issues of The Banking Law Journal, will discuss the immediate impact of the DIR on China’s financial stability and potentially serious flaws in the DIR.
Open climate and green finance issues concern the lack of a comprehensive taxonomy of green and brown assets and the uncertainty over the substantial advantage in investing in green projects (e.g., greenium). Barriers to environmental-related investments boil-down to the lack of a stable climate policy framework coupled with the lack of knowledge about climate change effects, suitable financial instruments, liquidity in the market, and climate-related disclosure. Among this developing framework, financial actors have conceived innovative instruments to overcome some of those barriers in line with the peculiarities of sustainability-oriented investments. Via collecting relevant instances, this work investigates the possible role financial innovations can play in the transition towards sustainability. In some cases, existing structures were adjusted to include environmental-oriented projects extending de-facto their use-of-proceeds (e.g., green securitization, green covered bonds). Some other instruments have been developed, including non-financial dimensions within their pricing models (e.g., weather derivatives). Considering the peculiarities of sustainability-oriented investments, new financial products were designed to merge existing ones (i.e., PRS). New technologies (i.e., blockchain) have improved existing business models favoring alternative ways of financing (i.e., microfinance, crowdfunding) with the pivotal role of public-private initiatives (i.e., Blended Finance, PACE). As the potentialities of financial innovations have been at the core of recent societal turmoil (e.g., 2008 financial crisis), a more cohesive institutional framework could lead to more comprehensive analyses of the effects (positive or negative) they might have on this transition.
Economic neoliberalism promises social efficiency with self-interested participants and free competition. This doctrine is challenged by the extensive production of wasteful goods and services in the contemporary West. By studying three types of wasteful production: conspicuous goods, conspicuous profession, and information overproduction, this article argues that the cause of wasteful production is nothing but the producers' profit motive. The discussion of wasteful production provides a first attempt to extend Weber's interpretivist sociology to the study of Nietzscheism, an ideal-type worldview preaching self-realization and power struggle. It adds novel empirical and theoretical support to the Weber thesis by showing that ascetic Protestantism facilitates productive efficiency by reducing not only hedonistic idleness and laziness, but also egoistic power-seeking and the induced wasteful production.
We consider default by firms that are part of a single clearing mechanism. The obligations of all firms within the system are determined simultaneously in a fashion consistent with the priority of debt claims and the limited liability of equity. We first show, via a fixed-point argument, that there always exists a "clearing payment vector" that clears the obligations of the members of the clearing system; under mild regularity conditions, this clearing vector is unique. Next, we develop an algorithm that both clears the financial system in a computationally efficient fashion and provides information on the systemic risk faced by the individual system firms. Finally, we produce qualitative comparative statics for financial systems. These comparative statics imply that, in contrast to single-firm results, even unsystematic, nondissipative shocks to the system will lower the total value of the system and may lower the value of the equity of some of the individual system firms.
This paper addresses a basic, yet unresolved, question: Do claims on private assets provide sufficient liquidity for an efficient functioning of the productive sector? Or does the state have a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means? In our model, firms can meet future liquidity needs in three ways: by issuing new claims, by obtaining a credit line from a financial intermediary, and by holding claims on other firms. When there is no aggregate uncertainty, we show that these instruments are sufficient for implementing the socially optimal (second-best) contract between investors and firms. However, the implementation may require an intermediary to coordinate the use of scarce liquidity, in which case contracts with the intermediary impose both a maximum leverage ratio and a liquidity constraint on firms. When there is only aggregate uncertainty, the private sector cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income. Government bonds command a liquidity premium over private claims. The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government-supplied liquidity and for its active management.
Demandable-debt finance by banks warrants explanation because it entails costs of bank suspension, liquidation, and idle reserve holdings. An explanation is developed in which demandable debt provides incentive-compatible intermediation where the banker has comparative advantage in allocating investment funds but may act against the interests of uninformed depositors. Demandable debt attracts funds by giving depositors an option to force liquidation. Its usefulness in transacting follows from information-sharing between monitors and nonmonitors. Copyright 1991 by American Economic Association.
This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts. This article is reprinted from the Journal of Political Economy (June 1983, vol. 91, no. 3, pp. 401--19) with the permission of the University of Chicago Press. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. ...
This book presents the theory and evidence on the effect of market liquidity and liquidity risk on asset prices and on overall securities market performance. Illiquidity means incurring a high transaction cost, which includes a large price impact when trading and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise trading cost. The book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation. Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis which leads to downward price and liquidity spiral. Overall, the volume demonstrates the important role of liquidity in asset pricing.
Banks can create liquidity precisely because deposits are fragile and prone to runs. Increased uncertainty makes deposits excessively fragile, creating a role for outside bank capital. Greater bank capital reduces the probability of financial distress but also reduces liquidity creation. The quantity of capital influences the amount that banks can induce borrowers to pay. Optimal bank capital structure trades off effects on liquidity creation, costs of bank distress, and the ability to force borrower repayment. The model explains the decline in bank capital over the last two centuries. It identifies overlooked consequences of having regulatory capital requirements and deposit insurance.
Banks and other lenders often transfer credit risk in order to liberate capi- tal for further loan intermediation. Beyond selling loans outright, lenders are increasingly active in the markets for syndicated loans, collateralized loan obliga- tions (CLOs), credit default swaps, credit derivative product companies, "spe- cialty finance companies," and other financial innovations designed for credit risk transfer. My purpose here is to explore the design, prevalence, and effec- tiveness of credit risk transfer. My focus will be the costs and benefits for the
During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwind of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector - in a completely unrelated set of markets and instruments - suggesting that systemic risk in the hedge-fund industry may have increased in recent years.
What causes a financial crisis? Can financial crises be anticipated or even avoided? What can be done to lessen their impact? Should governments and international institutions intervene? Or should financial crises be left to run their course? In the aftermath of the Asian financial crisis, many blamed international institutions, corruption, governments, and flawed macro and microeconomic policies not only for causing the crisis but also unnecessarily lengthening and deepening it. Based on ten years of research, the authors develop a theoretical approach to analyzing financial crises. Beginning with a review of the history of financial crises and providing readers with the basic economic tools needed to understand the literature, the authors construct a series of increasingly sophisticated models. Throughout, the authors guide the reader through the existing theoretical and empirical literature while also building on their own theoretical approach. The text presents the modern theory of intermediation, introduces asset markets and the causes of asset price volatility, and discusses the interaction of banks and markets. The book also deals with more specialized topics, including optimal financial regulation, bubbles, and financial contagion.
This paper investigates the spectacular rise and fall of structured finance. The essence of structured finance activities is the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and to create "safe" assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised. We examine how the process of securitization allowed trillions of dollars of risky assets to be transformed into securities that were widely considered to be safe. We highlight two features of structured finance products - the extreme fragility of their ratings to modest imprecision in evaluating underlying risks, and their exposure to systematic risks - that go a long way in explaining the spectacular rise and fall of structured finance. We conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.
We argue that arbitrage is limited if rational traders face uncertainty about when their peers will exploit a common arbitrage opportunity. This synchronization risk—which is distinct from noise trader risk and fundamental risk—arises in our model because arbitrageurs become sequentially aware of mispricing and they incur holding costs. We show that rational arbitrageurs “time the market” rather than correct mispricing right away. This leads to delayed arbitrage. The analysis suggests that behavioral influences on prices are resistant to arbitrage in the short and intermediate run.
Many corporate assets, particularly growth opportunities, can be viewed as call options. The value of such ‘real options’ depends on discretionary future investment by the firm. Issuing risky debt reduces the present market value of a firm holding real options by inducing a suboptimal investment strategy or by forcing the firm and its creditors to bear the costs of avoiding the suboptimal strategy. The paper predicts that corporate borrowing is inversely related to the proportion of market value accounted for by real options. It also rationalizes other aspects of corporate borrowing behavior, for example the practice of matching maturities of assets and debt liabilities.
A central question surrounding the current subprime crisis is whether the securitization process reduced the incentives of financial intermediaries to carefully screen borrowers. We examine this issue empirically using data on securitized subprime mortgage loan contracts in the United States. We exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance of lenders' portfolios around the ad hoc threshold. Conditional on being securitized, the portfolio with greater ease of securitization defaults by around 10%-25% more than a similar risk profile group with a lesser ease of securitization. We conduct additional analyses to rule out differential selection by market participants around the threshold and lenders employing an optimal screening cutoff unrelated to securitization as alternative explanations. The results are confined to loans where intermediaries' screening effort may be relevant and soft information about borrowers determines their creditworthiness. Our findings suggest that existing securitization practices did adversely affect the screening incentives of subprime lenders. (c) 2010 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology..
The role of credit market imperfections as source of amplification and persistence of temporary exogenous shocks to the economy is widely accepted in the literature. Little attention has been paid to the possibility that credit frictions also generate instability. This paper proposes a theory of business fluctuations where the source of the oscillatory dynamics is an agency problem between investors and entrepreneurs. A central tenet of the theory is that investment decisions depend upon entrepreneurs' incentive to exert effort ex-ante and investors' incentive to control entrepreneurs ex-post. This double-sided incentive is used to show how recessions prevent entrepreneurs from engaging in unproductive activity and booms facilitate the adoption of unproductive arrangements, so that recessions sow the seeds for a subsequent boom while economic expansions create the conditions for their own demise.
Loans are illiquid when a lender needs relationship-specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.
The majority of asset-management intermediaries (e.g., mutual funds, hedge funds) are structured on an open-end basis, even
though it appears that the open-end form can be a serious impediment to arbitrage. I argue that when funds compete to attract
investors' dollars, the equilibrium degree of open-ending in an economy can be excessive from the point of view of these investors.
One implication of the analysis is that, even absent short-sales constraints or other frictions, economically large mispricings
can coexist with rational, competitive arbitrageurs who earn small excess returns.
The authors study an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained. They analyze how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring. The authors show that all forms of capital tightening (a credit crunch, a collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that interest rate effects and the intensity of monitoring will depend on relative changes in the various components of capital. The predictions of the model are broadly consistent with the lending patterns observed during the recent financial crises. Copyright 1997, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
The authors explore the determinants of liquidation values of assets, particularly focusing on the potential buyers of assets. When a firm in financial distress needs to sell assets, its industry peers are likely to be experiencing problems themselves, leading to asset sales at prices below value in best use. Such illiquidity makes assets cheap in bad times and so ex ante is a significant private cost of leverage. The authors use this focus on asset buyers to explain variation in debt capacity across industries and over the business cycle, as well as the rise in U.S. corporate leverage in the 1980s. Copyright 1992 by American Finance Association.
We propose a multiperiod model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. In our model, arbitrage activity benefits all investors because arbitrageurs supply liquidity to the market. However, arbitrageurs might fail to take a socially optimal level of risk, in the sense that a change in their positions can make all investors better off. We characterize conditions under which arbitrageurs take too much or too little risk.
In his article Determinants of Corporate Borrowing, Myers (1977) says that it is not guaranteed that the maximum value of the firm is reached before the maximum value of the debt is utilized in the case in which the interest payment is fully tax deductible, but the tax shield is lost if the firm goes bankrupt. I have shown here that even in such a case the maximum value of the firm will always be achieved before the maximum available debt is utilized.
Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market-wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty-driven crises. Copyright (c) 2008 The American Finance Association.
Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented. When new information raises the probability a fixed income asset may default, its drop in price may be much greater than its objective drop in value because the drop in value reduces the relative wealth of its natural buyers, who disproportiantely own the asset through leveraged purchases. When the information also shortens the horizon over which the asset might default, its price falls still further because the margin requirement for its purchase endogenously rises. There may be spillovers in which other assets also crash in price even though their probability of default did not change.
Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them. Copyright 1997 by American Finance Association.
Banks and other lenders often transfer credit risk to liberate capital for further loan intermediation. This paper aims to explore the design, prevalence and effectiveness of credit risk transfer (CRT). The focus is on the costs and benefits for the efficiency and stability of the financial system. After an overview of recent credit risk transfer activity, the following points are discussed: motivations for CRT by banks; risk retention; theories of CDO design; specialty finance companies. As an illustration of CLO design, an example is provided showing how the credit quality of the borrowers can deteriorate if efforts to control their default risks are costly for issuers. An appendix is provided on CDS index tranches.
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