Animal spirits and environmental, social and governance asset prices: does market sentiment drive stock returns?

Gerardo Martinez

In 1936, John Maynard Keynes coined the famous term ‘Animal Spirits’ to illustrate how people take decisions based on urges, overlooking the benefits and drawbacks of their actions. To what extent are prices of Environmental, Social and Governance (ESG) assets driven by the sentiment of market participants, as opposed to economic fundamentals? To answer this question, I make use of Natural Language Processing (NLP) tools and an original corpus of tweets to capture market sentiment around climate change. Estimating a factor model, I find that sentiment is associated with immediate returns of climate change related stock indices. These results are stronger for days with the most extreme returns. Market sentiment might be particularly useful in explaining large movements in ESG asset prices.

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What does the rise in the inflation mean for financial stability?

Kristina Bluwstein, Sudipto Karmakar and David Aikman

Introduction

Inflation reached almost 9% in July 2022, its highest reading since the early 1990s. A large proportion of the working age population will never have experienced such price increases, or the prospect of higher interest rates to bring inflation back under control. In recent years, many commentators have been concerned about risks to financial stability from the prolonged period of low rates, including the possibility of financial institutions searching for yield by taking on riskier debt structures. But what about the opposite case? What financial stability risks do high inflation and increasing interest rates pose?

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‘There is all the difference in the world between paying and being paid’: margin calls and liquidity demand in volatile commodity markets

Gerardo Ferrara, Gerardo Martinez, Pelagia Neocleous, Pierre Ortlieb and Manesh Powar

The Russian invasion of Ukraine in February 2022 and subsequent sanctions led to unprecedented increases in key commodity prices. While prices briefly abated in late spring and early summer, these surged again over late July and August, with EU and UK gas prices reaching new peaks on 26 August. These moves created a sudden and significant demand for liquidity from market participants with derivatives positions. This post examines how non-financial firms (henceforth ‘commodity traders’) reacted to this liquidity pressure, and how their reactions impacted the functioning of commodity derivatives markets. Commodity derivative markets are important for the real economy and the recent events underscored the need to better understand the interdependencies between margin and counterparty risk management practices.

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How does remuneration regulation affect bankers’ pay?

Ieva Sakalauskaite and Qun Harris

Following the Global Financial Crisis of 2007–08, some regulators introduced rules on bankers’ bonuses with an aim to mitigate incentives to take excessive risks, and in turn promote financial stability. In a recent paper we use detailed data on remuneration of staff in six large UK banks to look at how two of those rules – the bonus cap and deferral – affected bankers’ pay. We find that the bonus cap did not reduce bankers’ total remuneration but rather shifted it from the variable to the fixed part of the package. And while requirements to defer bonus pay can be expected to affect bankers’ risk-taking incentives, we find some evidence that they increased their total compensation.

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The Bank Underground Christmas Quiz 2022

Before Bank Underground takes a festive break, it’s time for the Annual Bank Underground Christmas Quiz. Test yourself against our 10 festively themed questions on economics, finance and all things central banking…

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Precautionary facilities: stitches for a fragmented financial safety net

Daniel Christen and Nicola Shadbolt

Geoeconomic fragmentation is one of the greatest risks to the international monetary and financial system at present, particularly since Russia’s war of aggression against Ukraine. Fragmentation is likely to have wide-ranging implications for the global economy, including increasing the volatility of capital flows and exposing gaps in the global financial safety net (GFSN). In this post, we argue that increased take up of the IMF’s ‘precautionary facilities’ would reinforce the GFSN and help prepare it for these challenges. The IMF’s upcoming review of precautionary facilities is an opportune moment to find ways to reduce stigma and increase uptake.

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Strengthening the resilience of market-based finance

Naoto Takemoto, Simon Jurkatis and Nicholas Vause

In less than two decades, the system of market-based finance (MBF) – which involves mainly non-bank financial institutions (NBFIs) providing credit to the economy through bonds rather than loans – has both mitigated and amplified the economic effects of financial crises. It mitigated effects after the global financial crisis (GFC), when it substituted for banks in providing credit. But it amplified effects at the outbreak of the Covid pandemic, when NBFIs propagated a dash for cash (DFC), and more recently when pension fund gilt sales exacerbated increases in yields. This post outlines five different aspects of MBF that contribute to such amplification and summarises some policy proposals – suggested and debated internationally by regulators, academics and market participants – to make MBF more resilient.

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When the lights go out: why does operational risk matter for financial stability?

Rachel Adeney and Amy Fraser

Operational risk is rapidly becoming one of the most important threats to the financial system but is also one of the least well understood. Cyber attacks are regularly cited as one of the top risks faced by firms in the financial sector and one of the most challenging to manage. But they are only one part of operational risk, which includes losses from any kind of business disruption or human error, including power outages or natural disasters. In this post we discuss why operational risk matters for financial stability, how policymakers have responded to increasing risks from operational disruptions and the future challenges that may arise in this space.

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Capitalising climate risks: what are we weighting for?

David Swallow and Chris Faint

Policymakers have been investing heavily, to an accelerated timeline, to better understand the financial risks from climate change and to ensure that the financial system is resilient to those risks. Against that background, some commentators have observed that the most carbon-intensive sectors may be subject to the greatest increase in transition risk. They argue that these risks are not currently included within risk weights in the banking prudential framework and that regulators should adjust the framework to include them. Conceptually, this argument sounds credible – so how might UK regulators approach whether to adjust the risk-weighted asset (RWA) framework to include potential increases in risks? This post updates on some of the latest thinking to help answer this question.

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Old problems with new assets: some of crypto’s challenges look strangely familiar

John Lewis

Cryptoassets and the crypto ecosystem as a whole has to face many of the same challenges as conventional assets and the regular financial system do. The same classic problems which are staple of economics textbooks (and history books), such as maturity mismatch, liquidity shortages, credibility, and collateral feedback loops. But whereas the conventional system has learned from the past and evolved to deal with them, much of the crypto ecosystem seems to have overlooked them. In this post I draw out the parallels between previous issues in the traditional financial system and recent crypto turbulence. I argue that when crypto goes wrong, it often goes wrong in strikingly conventional, even old-fashioned ways.

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