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.
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.
Rhiannon Sowerbutts, Vesko Karadotchev, Richard Harris and Evarist Stoja
While communication has been recognised as an important aspect of monetary policy for over three decades and received an enormous amount of attention in the academic literature, there has been almost no attention paid to the importance and effects of financial stability communication. In a new working paper we examine financial markets’ reaction to the Financial Stability Report.
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.
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.
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.
UK household debt is high relative to income. But is it “unsustainable”? Some commentators say “it is”; others say “there is no reason to worry”. To investigate, we build a simple model of the economic relationships between household debt, house prices and real interest rates which we believe must hold in the long run. In our model there is no single threshold beyond which debt suddenly becomes unsustainable, but we argue that household debt should be broadly sustainable under any rise in real interest rates of up to about 2 percentage points (pp) from current levels. We also show that falling real interest rates may have contributed around 20-25pp to the rise in the household debt-to-GDP ratio since the 1980s.
Certain policy actions require a high level of precision to be successful. In a recent paper, we find that using margins on derivative trades as a macroprudential tool would require such precision. Such a policy could force derivative users to hold more liquid assets. This would help them to meet larger margin calls and avoid fire-selling their derivatives, which could affect other market participants by moving prices. We find that perfect calibration of such a policy would completely eliminate this fire-sale externality and achieve the best possible outcome, while simple rules are almost as effective. However, calibration errors in any rule could amplify fire-sales and leave the financial system worse off than if there had been no policy at all.