Kieran Dent, Sinem Hacioglu Hoke and Apostolos Panagiotopoulos
The Great Financial Crisis demonstrated an important feedback loop between banks’ capitalisation and funding costs. As banks’ capitalisation declined, banks’ wholesale creditors responded by demanding higher interest rates to lend to them. In turn, higher funding costs dented banks’ profitability, further weakening their capitalisation. Quantifying the relationship between funding costs and market-based measures of leverage – a proxy for bank solvency – is key to understand how banks might fare in a future stress situation – for instance as part of regulatory stress tests.
The Covid-19 (Covid) pandemic is a major shock to the economy but unlike traditional crises or credit crunches, its origin is exogenous to the financial sector. The economy’s ability to recover from the impact of the pandemic will however depend in part on the availability of credit. This raises the question how banks absorb a large shock which originates from outside the financial sector. To answer this question this post reviews the literature on how previous pandemics and natural disasters in the developed world affected banks’ balance sheets. One key message stands out: banks that are more rooted in their market are much more likely to continue lending when faced with the economic fallout from such shock.
Fernando Eguren-Martin, Cian O’Neill, Andrej Sokol and Lukas von dem Berge
While planes were grounded, capital flew out of emerging market economies in response to the acceleration in the spread of the virus in the early stages of the Covid-19 pandemic. Was this capital flight predictable once you account for the sudden deterioration in the global financial environment? In this post we present a model that helps to think about how financial conditions and international capital flows are linked. We then apply this methodology to events observed between March and May 2020, and find that the model predicted a large increase in the likelihood of capital flight. However, the scale of outflows was abnormally large even once the sharp tightening in financial conditions is accounted for.
On 16 June 1933, as the nationwide banking crisis was reaching a new peak, freshly elected US President Franklin D. Roosevelt put his signature at the bottom of a 37-page document: the Glass-Steagall Act. Eight decades later, the debate still rages on: should retail and investment banking be separated, as Glass-Steagall required? In a recent paper, we shed new light on the consequences of this type of regulation by examining the recent UK ‘ring-fencing’ legislation. We show that ring-fencing has an important impact on banking groups’ funding structures, and find that this incentivises banks to rebalance their activities towards retail mortgage lending and away from capital markets, with important knock-on effects for competition and risk-taking across the wider banking system.
Can Gao, Ian Martin, Arjun Mahalingam and Nicholas Vause
Since Covid-19-related crashes in March, major stock indices around the world have bounced back. This is despite little or no recovery in corporate earnings expectations. As a result, forward-looking price-to-earnings ratios have increased, rising above long-run average values in most large advanced economies and approaching record highs in the United States. Commenting on such valuations, some market participants have suggested there is ‘a great deal of optimism priced into the market’ and that stock prices ‘cannot defy economic gravity indefinitely’. This post takes a closer look at stock valuations, focusing on the UK, and drawing both on a textbook model and new research from academia.
Imagine you’ve booked tickets for a flight, and go to pick them up and pay for them on the day. You arrive at the airport but find out the airline has overbooked, and already given your ticket away. Worse yet, because you’ve missed this flight you’re going to miss an onward connection. But, you’ll likely get a replacement ticket in a day or two as compensation.
What was the root cause of the financial crisis? Ask any economist or banker and undoubtedly they will at some point mention leverage (see e.g. here, here and here). Yet when a capital requirement based on leverage — the leverage ratio requirement — was introduced, fierce criticism followed (see e.g. here and here). Drawing on the insights from a working paper, and thinking about the main criticism — that a leverage ratio requirement could cause excessive risk-taking — this seems not to have been the case.
Kristina Bluwstein, Marcus Buckmann, Andreas Joseph, Miao Kang, Sujit Kapadia and Özgür Şimşek
Financial crises are recurrent events in economic history. But they are as rare as a Kraftwerk album, making their prediction challenging. In a recent study, we apply robots — in the form of machine learning — to a long-run dataset spanning 140 years, 17 countries and almost 50 crises, successfully predicting almost all crises up to two years ahead. We identify the key economic drivers of our models using Shapley values. The most important predictors are credit growth and the yield curve slope, both domestically and globally. A flat or inverted yield curve is of most concern when interest rates are low and credit growth is high. In such zones of heightened crisis vulnerability, it may be valuable to deploy macroprudential policies.
Financial markets process orders faster now than ever before. However, they remain prone to occasional dysfunction where prices move away from fundamentals. One important type of market fragility is flash events. Identifying such events is crucial to understanding them and their effects. This post displays the results from a new methodology to identify these, but also longer lasting V-shaped events, as we show here with an application to three sovereign bond markets.
Robert Czech, Shiyang Huang, Dong Lou and Tianyu Wang
Government bond yields serve as a benchmark for virtually all other rates in financial markets. But what factors drive these yields? One view is that yields only move notably when important news hit the market, for example monetary policy announcements. Others suspect that some investors have an information advantage due to their access to costly information (e.g. data providers) or more accurate interpretations of public information. In a recent paper, we show that two investor groups – hedge funds and mutual funds – have an information edge in the UK government bond (gilt) market, and that these two investor types operate through different trading strategies and over different horizons.