All bark but no bite? What does the yield curve tell us about growth?

Carlo Favero, Sebastian Vismara and Iryna Kaminska

The slope of the yield curve has decreased in the US and the UK over the last few years (Chart 1). This development is attracting significant attention, because the yield curve slope (i.e. the difference between longer term government bond yields and shorter term government bond yields) is a popular business cycle indicator, and a fall of longer term yields below shorter term yields (i.e. an ‘inversion’ of the yield curve) has historically been considered as a powerful signal of recessions, particularly in the US.

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CCP porting, are there lessons to be learnt from elsewhere?

Fernando V. Cerezetti and Gerardo Ferrara

Post-crisis regulatory reforms have reshaped and increased the amount of clearing activity in the OTC derivatives market. An emerging issue is so-called “client porting” – i.e. how central counterparties (CCPs) can transfer positions from one clearing member (CM) to another in the aftermath of one member defaulting. In this post, we discuss possible ways to offer clients temporary access to clearing services following a CM default, which we believe could increase the likelihood of successfully porting clients and avoiding further pressure on prices and market stability.

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What happens when ‘angels fall’?

Yuliya Baranova, Harry Goodacre and Jamie Semark.

Over the past 20 years, the share of outstanding corporate bonds rated BBB, the lowest investment-grade rating, has more than doubled. This has left a large volume of securities on the edge of a cliff, from which they could drop to a high-yield rating and become so-called ‘fallen angels’. Some investors may be forced to sell ‘fallen angels’, for example if their mandate prevents them from holding high-yield bonds. And this selling pressure could push bond prices down, beyond levels consistent with the downgrade news. In this post we explore the impact that sales of ‘fallen angels’ could have on market functioning, finding that they could test the liquidity of the sterling high-yield corporate bond market.

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Currency Mispricing and Dealer Balance Sheets

Gino Cenedese, Pasquale Della Corte and Tianyu Wang

Deviations from covered interest parity (CIP) represent an arbitrage opportunity, at least in theory. In a new paper, we show that post-crisis financial regulation may explain why this mispricing persists and cannot be arbitraged away. Our exercise uses a unique dataset on contract-level foreign exchange derivatives coupled with an exogenous variation associated with the public disclosure of the leverage ratio. We find that dealers with a higher leverage ratio demand an extra premium from their clients for synthetic dollar funding (e.g., borrowing in euros and swapping into dollars) relative to direct dollar funding (i.e., borrowing dollars in the money market), resulting in CIP deviations.

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The Great War and the Bank of England as Market Maker of Last Resort

Mike Anson, David Bholat, Mark Billings, Miao Kang and Ryland Thomas

During the global financial crisis, some central banks acted as market makers of last resort, buying and selling securities in financial markets when trading in them had stalled. Some commentators claimed this role was “a completely new” one for central banks. In this blog, we show, on the contrary, that the Bank of England acting as a ‘market maker of last resort’ has precedent. Using newly transcribed micro-level data which we are publishing today, we detail how officials intervened in the 1914 financial crisis in a way that has at least a passing resemblance to the actions the Bank took during the Great Financial Crisis (GFC) of 2007-09.

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Give me more! Higher Capital Requirements and Loan Collateralisation

Sudipto Karmakar

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.

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Bitesize: How volatile is Bitcoin?

Giulio Malberti and Thom Adcock

In late 2017, Bitcoin was in the spotlight for its extraordinary return. But how volatile is it?

To consider Bitcoin volatility, we look at 10-day returns (capital standards typically estimate market risk over a 10-day period) since 19 July 2010, when Bloomberg’s Bitcoin data start. We compare Bitcoin with assets in three categories – currency pairs, commodities and equities – and for each we have picked one low-volatility asset and one more volatile asset. For currency pairs and commodities, we chose the most and least volatile ones (in terms of standard deviation of 10-day returns) out of the most liquid in each category. And we chose the most and least volatile FTSE 100 equities (again, in terms of standard deviation of 10-day returns).

For stable assets we expect a peaked distribution with short tails, as returns cluster near 0%. Figure 1 shows that Bitcoin has been more volatile than any other asset in our sample.

Figure 1

But people are often interested in the downside risk of assets. We therefore consider how Bitcoin’s Value at Risk (VaR) compares to other assets. VaR is the maximum loss over a given time interval under normal market conditions at a given confidence interval (eg 99%). A 10-day 99% VaR of -10% tells you that 99% of the time your 10-day return on the asset would be no worse than a 10% loss.

Figure 2 shows Bitcoin’s VaR is high, but the VaR of the other most liquid crypto-assets is higher. TRON’s VaR to date (-84%) is almost twice Bitcoin’s (-44%).

Figure 2

Giulio Malberti and Thom Adcock work in the Bank’s Banking Policy Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied.Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

Bitesize: Trading activity during the Corporate Bond Purchase Scheme

David Mallaburn, Matt Roberts-Sklar and Laura Silvestri.

The Bank of England’s August 2016 monetary policy package included the £10bn ‘Corporate Bond Purchase Scheme’ (CBPS). But who did the BoE buy those bonds from?

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Look abroad! Global financial conditions and risks to domestic growth

Fernando Eguren-Martin and Andrej Sokol

What’s the relationship between financial conditions and risks to growth in an economy? And, in a world of highly integrated financial markets, to what extent are these “local” risks rather than reflections of global developments? In this post we offer some tentative answers. Financial conditions, measured across a broad range of asset classes and countries, display an important common component reflecting global developments. Loose financial conditions today increase the likelihood of a growth boom over the following few quarters, but when global financial conditions are loose, they increase the chances of a sharp contraction further ahead, highlighting some of the challenges of managing risks to growth across time from a policy maker’s perspective.

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Does competition help or hinder bank stability in the UK?

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.

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