Category Archives: Financial Stability

Of Goosebumps and CCP default funds

Fernando V. Cerezetti and Luis Antonio Barron G. Vicente 

A vestigial structure is an anatomical feature that no longer seems to have a purpose in the current form of an organism. Goosebumps, for instance, are considered to be a vestigial protection reflex in humans. Default funds, a pool of financial resources formed of clearing member (CM) contributions that can be tapped in a default event, are a ubiquitous part of central counterparty (CCP) safeguard structures. Their history is intertwined with the history of clearinghouses, dating back to a time when the financial sector resembled a Gentlemen’s Club. Here we would like to address the following – perhaps impertinent – question: are current mutualisation processes in CCPs a historical vestige, like goosebumps, or do they still hold an important risk reducing role?

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Filed under Financial Markets, Financial Stability, Market Infrastructure

Unintended consequences: specialising in risky mortgages under Basel II

Matteo Benetton, Peter Eckley, Nicola Garbarino, Liam Kirwin and Georgia Latsi.

Do financial regulations change bank behaviour? Does this create new risks? Under Basel II, some banks set capital requirements based on their internal risk models; others use an off-the-shelf standardised approach. These two methodologies can produce very different capital requirements for similar assets. See Figure 1, which displays a snapshot of recent risk weights for UK mortgages. In a new working paper we show empirically that this discrepancy causes lenders to adjust their interest rates and to specialise in which borrowers they target.

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Filed under Banking, Financial Stability, Macroprudential Regulation, Microprudential Regulation

Macroprudential policy beyond banking

Jon Frost and Julia Giese.

A seismic shift is occurring in the European financial system. Since 2008, the aggregate size of bank balance sheets in the EU is essentially flat, while market-based financing has nearly doubled. This shift presents challenges for macroprudential policy, which has a mandate for the stability of the financial system as a whole, but is still focused mostly on banks. As such, macroprudential policymakers are focusing increasing attention on potential systemic risks beyond the banking sector. Drawing from a European Systemic Risk Board (ESRB) strategy paper which we helped write along with five others, we take a step back and set out a policy strategy to address risks to financial stability wherever they arise in the financial system.

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Filed under Financial Stability, Insurance, Macroprudential Regulation, Market Infrastructure

What happened to competition between UK deposit takers over the past 25 years?

Sebastian J A de-Ramon and Michael Straughan.

The landscape for competition between UK deposit takers (retail banks and building societies) was reset in the 1980s with the removal of the bank “corset” (1981), the Big Bang reforms and the Building Societies Act (both in 1986). These reforms facilitated entry and expansion of different business models into markets that had previously been off-limits. What followed was a significant restructuring of the deposit taking sector in the UK. In a new paper, we show that competition between UK deposit takers weakened substantially in the years leading up to the financial crisis.

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Filed under Banking, Economic History, Financial Stability, New Methodologies

Foreign booms, domestic busts: the global dimension of banking crises

Ambrogio Cesa-Bianchi, Fernando Eguren Martin and Gregory Thwaites.

Why do banking crises happen in “waves” across countries? Do global developments matter for domestic financial stability? Is there such a thing as a global cycle in domestic credit? In this post we link these ideas and show that foreign financial developments in general, and global credit growth in particular, are powerful predictors of domestic banking crises. Channels seem to be financial rather than related to trade, and these include transmission of market sentiment, cross-border portfolio flows and direct crisis contagion.

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Filed under Banking, Financial Stability, International Economics

Capital Inflows: The Good, the Bad and the Bubbly

Glenn Hoggarth, Carsten Jung and Dennis Reinhardt.

Supporters of financial globalisation argue that global finance allows investors to diversify risks, it increases efficiency and fosters technology transfer. The critics point to the history of financial crises which were associated with booms and busts in capital inflows.  In our recent paper ‘Capital inflows – the good, the bad and the bubbly’, we argue that the risks depend on the type of capital inflow, the type of lender and also the currency denomination of the inflows. We find that equity inflows are more stable than debt, foreign banks are more flighty than non-bank creditors, and flows denominated in local currency are more stable than in foreign currency.  We also find evidence that macroprudential policies can make capital inflows more stable.

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Filed under Financial Stability, International Economics, Macroprudential Regulation

How should regulators deal with uncertainty? Insights from the Precautionary Principle

Ian Webb, David Baumslag and Rupert Read.

One September morning, the Lord Mayor of London was called to inspect a fire that had recently started in the City. Believing that it posed little threat, he refused to permit the demolition of nearby houses, probably due to the expense of compensating the owners. The fire spread and ultimately destroyed most of the city. The Great Fire of London had begun. Only when the fire became too extensive to be readily halted did the full extent of the danger become evident. Financial regulators today face a similar challenge preventing financial crises- action causes significant costs to some but the consequences of inaction are much more uncertain. To combat this, we argue they should apply the precautionary principle.

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Filed under Financial Stability, Macroprudential Regulation

The tip of the iceberg: the implications of climate change on financial markets

Yuliya Baranova, Carsten Jung and Joseph Noss.

There has been a recent increase in awareness of investors that limiting emissions to prevent climate change might leave a substantial proportion of the world’s carbon reserves unusable, and that this could lead to revaluations across a range of financial assets. If risks are left unaddressed, this could result in large losses for some investors. But is this adjustment in financial market prices likely to be abrupt?  And – even if it is – is it likely to pose risks to financial stability?  We argue that the answer to both these questions could be yes:  financial valuations can move sharply even if the transition to sustainable energy were smooth.  And exposures are sufficiently large to warrant attention from both investors and policymakers.

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Filed under Financial Markets, Financial Stability, International Economics

Unto us a lender of last resort is born: Overend Gurney goes bust in 1866

John Lewis.

The 1866 collapse of Overend Gurney sparked widespread panic as investors flocked to banks and other institutions demanding their money back.  Failure to provide substantial liquidity threatened to bring down the entire financial system.  The Governors of the Bank of England asked the Chancellor to relax the constraints of the 1844 Bank Charter Act, by granting an indemnity to allow the issue of unbacked currency.  The Chancellor’s reply, and the policy response it initiated, would save the day, and go down in central banking history as pivotal in the foundation of the “lender of last resort”, a function which has been fundamental to central banking practice ever since.

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Filed under Banking, Economic History, Financial Markets, Financial Stability

The Nightmare before Christmas: Financial crises go global in 1857

Tobias Neumann.

A railway boom in America’s Midwest goes spectacularly bust.  Sixty-two of New York’s commercial banks close – out of sixty-three. Meanwhile in Britain, a decade gilt-edged by gold discoveries in Australia and fuelled by the Crimean War was beginning to lose its lustre.  Thus the scene was set for the first global financial crisis shaking markets in New York, London, Paris and across the world.  A crisis so severe it forced the Bank of England to “break the law” to survive.

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Filed under Banking, Economic History, Financial Stability, Macroeconomics