‘As safe as houses’: How a small corner of the US mortgage market nearly brought down the global financial system

Johnny Elliot and Benjamin King

In August 2007 problems were emerging in the US sub-prime mortgage market. Rising numbers of borrowers were getting behind on their repayments, and some investors exposed to the mortgages were warning that they were difficult to value. But projected write-downs were small: less than half a percent of GDP. Just over a year later, Lehman Brothers had failed, the global financial system was on the brink of collapse and the world was plunged into recession. So how did a seemingly small corner of the US mortgage market unleash a global crisis? And what lessons did the turmoil of autumn 2008 reveal about the financial system?

Continue reading “‘As safe as houses’: How a small corner of the US mortgage market nearly brought down the global financial system” →

Core Design Principles for a Central Bank Digital Currency

Clare Noone and Michael Kumhof

Does the introduction of a central bank digital currency (CBDC) crowd out bank funding? Does it open the door to runs on the aggregate banking system? In a recent Staff Working Paper we provide insights on these questions. We find that some of the major risks to financial stability posed by CBDC can be addressed by a set of four core design principles for a CBDC system. Implementing these principles, however, is non-trivial and risks would remain.

Continue reading “Core Design Principles for a Central Bank Digital Currency” →

Sterling weakness: FX mismatch risks in the UK corporate sector

Rajveer Berar

What could falls in sterling mean for UK firms’ ability to sustain foreign currency (FX) debt obligations? The value of sterling began falling around two years ago and dropped further after the EU referendum – remaining around these lower values ever since. There is every possibility that sterling may stay low for the foreseeable future – creating both potential winners and losers. In this piece, I investigate one particular channel for losses related to sterling weakness: whether UK firms could find meeting their FX debt obligations more challenging. By reviewing market intelligence, market prices and derivatives databases, I find limited evidence that sterling weakness has yet produced any significant changes to UK firms’ ability to manage their FX debt obligations.

Continue reading “Sterling weakness: FX mismatch risks in the UK corporate sector” →

The decline of solvency contagion risk

Marco Bardoscia, Paolo Barucca, Adam Brinley Codd and John Hill

The failure of Lehman Brothers on 15 September 2008 sent shockwaves around the world. But the losses at Lehman Brothers were only the start of the problem. The price of their bonds halved, almost overnight. Other institutions that held Lehman’s debt faced huge losses, and markets feared that those losses could trigger further failures. The good news is that our latest research suggests that risks within the UK banking system from one such contagion channel, “solvency contagion”, have declined sharply since 2008. We have developed a new model which quantifies risk from this channel, and helps us understand why it has fallen. Regulators are using the model to monitor this particular source of risk as part of the Bank’s annual concurrent stress test exercise.

Continue reading “The decline of solvency contagion risk” →

Car finance: what’s new?

Tim Pike, Phil Eckersley and Alex Golledge

Since our first post, car finance has risen up the agenda of regulators, journalists and policymakers. Here we provide an update on recent developments. Sterling’s depreciation has had little impact on car finance costs: first because pass-through to new car prices has been muted, and second because finance providers have responded by lengthening loan terms and increasing balloon payments rather than upping monthly repayments. Providers are increasingly retailing contracts where consumers have no option to purchase the car at the end. This avoids some risks associated with voluntary terminations, but it creates new risks around resale value. In sum, the industry continues to accumulate credit risk, predicated on the belief that used car values will remain robust.

Continue reading “Car finance: what’s new?” →

Low for long: what does this mean for defined-benefit pensions in the UK?

Frank Eich and Jumana Saleheen.

Despite the fact that the financial crisis erupted nearly a decade ago, its legacy is still being felt today. Disappointingly weak growth and low interest rates are arguably part of that legacy (though other developments also matter), and policy makers are increasingly worried that these are no longer temporary phenomena but instead have become permanent features. This blog assesses what a prolonged period of weak growth and low interest rates (sometimes also referred to by “secular stagnation” or “low for long”) might mean for the viability of defined-benefit (DB) occupational pension schemes in the UK and what financial stability risks might arise as a result of a changing business environment.

Continue reading “Low for long: what does this mean for defined-benefit pensions in the UK?” →

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.

Continue reading “Foreign booms, domestic busts: the global dimension of banking crises” →

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.

Continue reading “Capital Inflows: The Good, the Bad and the Bubbly” →

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.

Continue reading “The tip of the iceberg: the implications of climate change on financial markets” →

Bitesize: Sovereign debt, default and “r-g”

Mark Joy.

Government debt as a share of GDP is at its highest since WWII in advanced economies and since the 1980s debt crises in emerging markets, but so far, apart from Greece, Ukraine and some high-profile close calls in the euro area, this level of debt has caused barely a stir in financial markets. So is it okay to stop worrying?

Continue reading “Bitesize: Sovereign debt, default and “r-g”” →