All you need is cash

Andreas Joseph, Christiane Kneer, Neeltje van Horen and Jumana Saleheen

Financial crises affect firm growth not only in the short-run, but even more so in the long-run. Some firms permanently gain while others lose and cash is a crucial asset to have when the credit cycle turns. As we show in a new Staff Working Paper, having cash at hand allows firms to continue to invest during the crisis while industry rivals without cash have to divest. This gives cash-rich firms an important competitive edge that not only benefits them during the crisis but that gives them an advantage that lasts way beyond the crisis years.

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Possible pitfalls of a 1-in-X approach to financial stability

Adam Brinley Codd and Andrew Gimber

Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.

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Margin call! Cash shortfall?

Marco Bardoscia, Gerardo Ferrara and Nicholas Vause

Participants in derivative markets collect collateral from their counterparties to help secure claims against them should they default. This practice has become more widespread since the 2007-08 financial crisis, making derivative markets safer. However, it increases potential ‘margin calls’ for counterparties to top up their collateral. If future calls exceed available liquid assets, counterparties would have to borrow. Could money markets meet this extra demand? In a recent paper, we simulate stress-scenario margin calls for many of the largest derivative-market participants and see if they could meet them – including because of payments from upstream counterparties – without borrowing. We compare the sum of any shortfalls with daily cash borrowing in international money markets.

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Fluttering and falling: banks’ capital requirements for credit valuation adjustment (CVA) risk since 2014

Giulio Malberti and Thom Adcock

The financial crisis exposed banks’ vulnerability to a type of risk associated with derivatives: credit valuation adjustment (CVA) risk. Despite being a major driver of losses – around $43 billion across 10 banks according to one estimate – there had been no capital requirement to cushion banks against these losses. New rules in 2014 changed this.

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Does accepting a broader set of collateral in central bank operations incentivise the use of riskier collateral by riskier counterparties?

Calebe de Roure and Nick McLaren

Central banks accept a wide range of assets from participants as collateral in their liquidity operations – but can this lead to undesired side effects? Such an approach can enhance overall liquidity in the financial sector, by allowing participants to transform illiquid collateral into more liquid assets. But, as a result, the central bank then needs to manage the greater potential risks of holding these riskier assets on its own balance sheet. Financially weaker participants may be encouraged to hold these assets if they can benefit from the higher returns, which compensate for the greater risk. In our recent paper we investigate whether central banks’ acceptance of a broad set of collateral incentivises the concentration of risk by examining the experience of the Bank of England (BoE).

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What’s been driving long-run house price growth in the UK?

David Miles and Victoria Monro

Since the mid-1980s, the average real (RPI-adjusted) UK house price has more than doubled, rising around one and a half times as fast as incomes. Economists’ diagnoses of the root cause varies – from anaemic supply, to the consequences of financial deregulation, or even a bubble. In our recent paper, we explore the role of the long-run decline in the real risk-free rate in driving up house prices. Low interest rates push up asset prices and reduce borrowing costs. We find the decline in the real risk-free rate can account for all of the rise in house prices relative to incomes.

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Bitesize: What might pension funds do when bond yields fall?

Matt Roberts-Sklar

Government bond yields fell sharply mid-2019, especially at longer maturities. For defined benefit pension funds, lower yields tend to mean deficits widen as discounted liabilities increase by more than the value of their assets. How might pension funds respond to this?

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The ownership of central banks

David Bholat and Karla Martinez Gutierrez

Around the world, central banks have a number of different ownership structures. At one end of the spectrum are central banks, like the Bank of England, that are wholly owned by the public sector. At the other end are central banks, like the Banca d’Italia, whose shareholders are wholly private sector entities. And there are central banks, like the Bank of Japan, that lie in-between. But do these differences matter?

In this blog post, we explore the variety of central bank ownership structures, both historically and globally.  We also suggest areas for future research on the topic.

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Perceiving risk wrong: what happens when markets misprice risk?

Kristina Bluwstein and Julieta Yung

Financial markets provide insightful information about the level of risk in the economy. However, sometimes market participants might be driven more by their perception rather than any fundamental changes in risk. In a recent Staff Working Paper we study the effect of changes in risk perceptions that can lead to a mispricing of risk. We find that when agents over-price risk, banks adjust their bank lending policies, which can lead to depressed investment and output. On the other hand, when agents under-price risk, excessive lending creates a ‘bad’ credit boom that can lead to a severe recession once sentiment is reversed.

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Does liquidity spill over in the credit market? The case of CDS and corporate bonds

Robert Czech

Credit default swaps (CDS) have a notoriously bad reputation. Critics refer to CDS as a “global joke” that should be “outlawed”, not at least due to the opaque market structure. Even the Vatican labelled CDS trading as “extremely immoral”. But could there be a brighter side to these swaps? In theory, CDS contracts can reduce risks in financial markets by providing valuable insurance. In a recent paper, I show that CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.

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