Many commentators on the global financial crisis identified ‘fire sales’ as one of the key mechanisms by which shocks to banks were amplified and transmitted across the wider financial system. When firms in distress sell assets held by other institutions at discounted prices, losses can spread through the financial system as prices fall, amplifying the initial stress. In a working paper published last year, we explored this mechanism by presenting a new model of fire sales. In doing so, we answer the following questions: Which types of financial shocks combine to produce fire sales? How can banks optimally liquidate their portfolios when forced to do so? How big a risk are bank fire sales?
Faced with unprecedented declines in corporate revenue, the Covid-19 shock represents a loss of cash flow of indeterminate duration for many firms. It is too early to tell how exactly firms will be affected by this crisis and how scarring it will be, but the crisis will likely have a significant impact on most corporates. This post reviews the literature on factors affecting firms’ ability to withstand the Covid-19 shock and what large corporates did to shore up their finances.
Matteo Benetton, Philippe Bracke, João F Cocco and Nicola Garbarino
Academics have made the case for mortgage products with equity features, so that gains and losses due to fluctuations in house values are shared between the household and an outside investor. In theory, the equity component expands the set of affordable properties, without increasing household debt, and default risk. These products have not become mainstream, but in a recent paper, we study a large UK experiment with equity-based housing finance — the Help To Buy Equity Loan scheme. We find that equity loans are mainly used to overcome credit constraints, rather than to reduce investment risk. Unconstrained household prefer mortgage debt over equity loans, suggesting optimism about house price risk. Equity loans could still contribute to house price inflation: we don’t find evidence that houses purchased with equity loans are overpriced, but an assessment of the aggregate effects is beyond the scope of the paper.
The great American baseball sage, Yogi Berra, is thought to have once remarked: ‘It’s tough to make predictions, especially about the future’. That is certainly true, but thankfully the accelerating development and deployment of machine learning methodologies in recent years is making prediction easier and easier. That is good news for many sectors and activities, including microprudential regulation. In this post, we show how machine learning can be applied to help regulators. In particular, we outline our recent research that develops an early warning system of bank distress, demonstrating the improved performance of machine learning techniques relative to traditional approaches.
Capital flows are fickle. In the UK, the largest and most volatile component of inflows from foreign investors are so-called ‘other investment flows’ – the foreign capital which flows into banks and other financial institutions. But where do these funds ultimately go and which sectors are particularly exposed to fickle capital inflows? Do capital inflows allow domestic firms to borrow more? Or does capital from abroad ultimately finance mortgages of UK households? Some of the foreign capital could also get passed on to the financial sector or flow back abroad.
The Payment Protection Insurance (PPI) mis-selling scandal has rumbled on for years. But how did PPI impact loan margins pre-crisis?
This post argues
that income from cross-selling PPI substantially offset lenders’ margins on
personal loans between 2004 and 2009, and compares the pre-crisis PPI-adjusted
margin to loan spreads today.
How do banks adjust when faced with a sudden rise in capital requirements? The most frequent response, in the theoretical literature, is that they reduce lending or “deleverage” (see, e.g., Aiyagari and Gertler (1999); Gertler and Kiyotaki (2010). This is particularly true in crisis episodes when raising equity can be costly. However, in a new paper co-authored with Hans Degryse and Artashes Karapetyan, I show this is only part of the story. Banks may also ask borrowers to provide more collateral; collateralised exposures carry lower risk weights on average and hence enhance capital ratios. This requirement can adversely affect young and new borrowers that typically lack collateral to pledge and are also unlikely to have longstanding banking relationships.
Qun Harris, Analise Mercieca, Emma Soane and Misa Tanaka.
The bonus regulations were introduced based on the consensus amongst financial regulators that compensation practices were a contributing factor to the 2008-9 financial crisis. But little is known about how they affect behaviour in practice. So we conducted a lab experiment to examine how different bonus structures affect individuals’ risk and effort choices. We find that restrictions on bonuses, such as a bonus cap, can incentivise people to take less risk. But their risk-mitigating effects weaken or disappear once bonus payment is made conditional on hitting a high performance target. We also find some evidence that bonus cap discourages effort to search for better projects.
Sebastian de-Ramon, Bill Francis and Michael Straughan.
There is a debate in the regulatory and academic community about whether competition is good or bad for bank stability, particularly following the financial crisis (see Chapter 6 of the Independent Commission on Banking final report). The debate tends to be seen as a head-to-head argument between two camps: those that see competition as bad for stability (competition-fragility) versus those that see competition as good (competition-stability). In new research, we look at how competition affects the stability of banks in the UK. We find that competition affects less stable firms differently than more stable firms and that focussing on what happens to the average firm may not be sufficient.