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Credit boom detection methodologies (such as threshold method) lack robustness as they are based on univariate detrending analysis and resort to ratios of credit to real activity. I propose a quantitative indicator to detect atypical behavior of credit from a multivariate system - a monetary VAR. This methodology explicitly accounts for endogenous interactions between credit, asset prices and real activity and detects atypical credit expansions and contractions in the Euro Area, Japan and the U.S. robustly and timely. The analysis also proves useful in real time.
The analyses of intersectoral linkages of Leontief (1941) and Hirschman (1958) provide a natural way to study the transmission of risk among interconnected banks and to measure their systemic importance. In this paper we show how classic input-output analysis can be applied to banking and how to derive six indicators that capture different aspects of systemic importance, using a simple numerical example for illustration. We also discuss the relationship with other approaches, most notably network centrality measures, both formally and by means of a simulated network.
We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel - monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and tends to concentrate on the bank funding side. Then, to rationalize this evidence we build a macro model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on results from the true model. We apply our method to a calibrated affine model and fine that relative wealth equivalent losses are below 1.16% if the jump size is stochastic and below 1% if the jump size is constant and γ ≥ 5. We perform robustness checks for various levels of risk-aversion, expected jump size, and jump intensity.
Mindfully Resisting the Bandwagon – IT Implementation and Its Consequences in the Financial Crisis
(2013)
Although the ”financial meltdown” between 2007 and 2009 can be substantially attributed to herding behaviour in the subprime market for credit default swaps, a “mindless” IT implementation of participating financial services providers played a major role in the facilitation of the underlying bandwagon. The problem was a discrepancy between two core complementary capabilities: (1.) the (economic-rationalistic) ability to execute financial transactions (to comply with the herd) in milliseconds and (2.) the required contextualized mindfulness capabilities to comprehend the implications of the transactions being executed and the associated IT innovation decisions that enabled these transactions.
We develop a dynamic network model whose links are governed by banks' optmizing decisions and by an endogenous tâtonnement market adjustment. Banks in our model can default and engage in firesales: risk is transmitted through direct and cascading counterparty defaults as well as through indirect pecuniary externalities triggered by firesales. We use the model to assess the evolution of the network configuration under various prudential policy regimes, to measure banks' contribution to systemic risk (through Shapley values) in response to shocks and to analyze the effects of systemic risk charges. We complement the analysis by introducing the possibility of central bank liquidity provision.
This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
In this paper we provide new evidence that corporate financing decisions are associated with managerial incentives to report high equity earnings. Managers rely most heavily on debt to finance their asset growth when their future earnings prospects are poor, when they are under pressure due to past declines in earnings, negative past stock returns, and excessively optimistic analyst earnings forecasts, and when the earnings yield is high relative to bond yields so that from an accounting perspective equity is ‘expensive’. Managers of high debt issuing firms are more likely to be newly appointed and also more likely to be replaced in subsequent years. Abnormal returns on portfolios formed on the basis of asset growth and debt issuance are strongly positively associated with the contemporaneous changes in returns on assets and on equity as well as with earnings surprises. This may account for the finding that debt issuance forecasts negative abnormal returns, since debt issuance also forecasts negative changes in returns on assets and on equity and negative earnings surprises. Different mechanisms appear to be at work for firms that retire debt.
The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model.