G01 Financial Crises (Updated!)
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The lack of a European Deposit Insurance Scheme (EDIS) – often referred to as the ‘third pillar’ of Banking Union – has been criticized since the inception of the EU Banking Union. The Crisis Management and Deposit Insurance (CMDI) framework needs to rely heavily on banks’ internal loss absorbing capacity and provides little flexibility in terms of industry resolution funding. This design has, among others, led to the rare application of the CMDI, particularly in the case of small and medium sized retail banks. This reluctance of resolution authorities weakens any positive impact the CMDI may have on market discipline and ultimately financial stability. After several national governments pushed back against the establishment of an EDIS, the Commission recently took a different approach and tried to reform the CMDI comprehensively, without seeking to erect a ‘third pillar’. The overarching rationale of the CMDI Proposal is to make resolution funding more flexible. To this end, the proposal seeks to facilitate contributions from (national) deposit guarantee schemes (DGS). At the same time, the CMDI Proposal tries to broaden the scope of resolution to include smaller and medium sized banks. This paper provides an assessment of the CMDI Proposal. It argues that the CMDI Proposal is a step in the right direction but cannot overcome fundamental deficiencies in the design of the Banking Union.
The lack of a European Deposit Insurance Scheme (EDIS) – often referred to as the ‘third pillar’ of Banking Union – has been criticized since the inception of the EU Banking Union. The Crisis Management and Deposit Insurance (CMDI) framework needs to rely heavily on banks’ internal loss absorbing capacity and provides little flexibility in terms of industry resolution funding. This design has, among others, led to the rare application of the CMDI, particularly in the case of small and medium sized retail banks. This reluctance of resolution authorities weakens any positive impact the CMDI may have on market discipline and ultimately financial stability. After several national governments pushed back against the establishment of an EDIS, the Commission recently took a different approach and tried to reform the CMDI comprehensively, without seeking to erect a ‘third pillar’. The overarching rationale of the CMDI Proposal is to make resolution funding more flexible. To this end, the proposal seeks to facilitate contributions from (national) deposit guarantee schemes (DGS). At the same time, the CMDI Proposal tries to broaden the scope of resolution to include smaller and medium sized banks. This paper provides an assessment of the CMDI Proposal. It argues that the CMDI Proposal is a step in the right direction but cannot overcome fundamental deficiencies in the design of the Banking Union.
Different insurance activities exhibit different levels of persistence of shocks and volatility. For example, life insurance is typically more persistent but less volatile than non-life insurance. We examine how diversification among life, non-life insurance, and active reinsurance business affects an insurer's contribution and exposure to the risk of other companies. Our model shows that a counterparty's credit risk exposure to an insurance group substantially depends on the relative proportion of the insurance group's life and non-life business. The empirical analysis confirms this finding with respect to several measures for spillover risk. The optimal proportion of life business that minimizes spillover risk decreases with leverage of the insurance group, and increases with active reinsurance business.
Through the lens of market participants' objective to minimize counterparty risk, we provide an explanation for the reluctance to clear derivative trades in the absence of a central clearing obligation. We develop a comprehensive understanding of the benefits and potential pitfalls with respect to a single market participant's counterparty risk exposure when moving from a bilateral to a clearing architecture for derivative markets. Previous studies suggest that central clearing is beneficial for single market participants in the presence of a sufficiently large number of clearing members. We show that three elements can render central clearing harmful for a market participant's counterparty risk exposure regardless of the number of its counterparties: 1) correlation across and within derivative classes (i.e., systematic risk), 2) collateralization of derivative claims, and 3) loss sharing among clearing members. Our results have substantial implications for the design of derivatives markets, and highlight that recent central clearing reforms might not incentivize market participants to clear derivatives.
Market risks account for an integral part of life insurers' risk profiles. This paper explores the market risk sensitivities of insurers in two large life insurance markets, namely the U.S. and Europe. Based on panel regression models and daily market data from 2012 to 2018, we analyze the reaction of insurers' stock returns to changes in interest rates and CDS spreads of sovereign counterparties. We find that the influence of interest rate movements on stock returns is more than 50% larger for U.S. than for European life insurers. Falling interest rates reduce stock returns in particular for less solvent firms, insurers with a high share of life insurance reserves and unit-linked insurers. Moreover, life insurers' sensitivity to interest rate changes is seven times larger than their sensitivity towards CDS spreads. Only European insurers significantly suffer from rising CDS spreads, whereas U.S. insurers are immunized against increasing sovereign default probabilities.
Common systemic risk measures focus on the instantaneous occurrence of triggering and systemic events. However, systemic events may also occur with a time-lag to the triggering event. To study this contagion period and the resulting persistence of institutions' systemic risk we develop and employ the Conditional Shortfall Probability (CoSP), which is the likelihood that a systemic market event occurs with a specific time-lag to the triggering event. Based on CoSP we propose two aggregate systemic risk measures, namely the Aggregate Excess CoSP and the CoSP-weighted time-lag, that reflect the systemic risk aggregated over time and average time-lag of an institution's triggering event, respectively. Our empirical results show that 15% of the financial companies in our sample are significantly systemically important with respect to the financial sector, while 27% of the financial companies are significantly systemically important with respect to the American non-financial sector. Still, the aggregate systemic risk of systemically important institutions is larger with respect to the financial market than with respect to non-financial markets. Moreover, the aggregate systemic risk of insurance companies is similar to the systemic risk of banks, while insurers are also exposed to the largest aggregate systemic risk among the financial sector.
Historical evidence like the global financial crisis from 2007-09 highlights that sector concentration risk can play an important role for the solvency of insurers. However, current microprudential frameworks like the US RBC framework and Solvency II consider only name concentration risk explicitly in their solvency capital requirements for asset concentration risk and neglect sector concentration risk. We show by means of US insurers’ asset holdings from 2009 to 2018 that substantial sectoral asset concentrations exist in the financial, public and real estate sector, and find indicative evidence for a sectoral search for yield behavior. Based on a theoretical solvency capital allocation scheme, we demonstrate that the current regulatory approaches can lead to inappropriate and biased levels of solvency capital for asset concentration risk, and should be revised. Our findings have also important implications on the ongoing discussion of asset concentration risk in the context of macroprudential insurance regulation.
Between 2016 and 2022, life insurers in several European countries experienced negative longterm interest rates, which put pressure on their business models. The aim of this paper is to empirically investigate the impact of negative interest rates on the stock performance of life insurers. To measure the sensitivities, I estimate the level, slope, and curvature of the yield curve using the Nelson-Siegel model and empirical proxies. Panel regressions show that the effect of changes in the level is up to three times greater in a negative interest rate environment than in a positive one. Thus, a 1ppt decline in long-term interest rates reduces the stock returns of European life insurers by up to 10ppt when interest rates are below 0%. I also show that the relationship between the level and the sensitivity to interest rates is convex, and that life insurers benefit from rising interest rates across all maturity types.
In crisis times, insurance companies might feel the pressure to present an investment portfolio performance that is superior to the market, since investment portfolios back the claims of policyholders and serve as a signal for the claims’ safety. I investigate how a stock market crisis as experienced over the course of the Covid-19 pandemic influences insurance firms’ decisions on the allocation of their corporate bond portfolio. I find that insurers shift their portfolio holdings towards lower credit risk assets as financial market conditions tighten. This tendency seems to be restricted by the liquidity risk of high-yield assets, and the credit risk of lower-rated investment grade assets. Both effects lead to an increase in the fraction of less liquid assets during the crash and the recovery.
In times of crisis, insurance companies may invest into riskier assets to benefit from expected price recoveries. Using daily stock market data for 34 European insurers, I investigate how a stock market contraction, as experienced during the Covid-19 pandemic, affects insurers’ decision on the allocation of their corporate bond portfolio. I find that insurers shift their portfolio holdings pro-cyclically towards lower credit risk assets in the first month of the market contraction. As the crisis progresses, I find evidence for counter-cyclical investment behavior by insurers, which can neither be explained by credit rating downgrades of held bonds nor by hedging with CDS derivatives. The observed counter-cyclical investment behavior of insurers could be beneficial for the financial system in attenuating price declines, but excessive risk-taking by insurance companies over longer periods can also reinforce stress in the system.
Macro-finance theory predicts that financial fragility builds up when volatility is low. This “volatility paradox’” challenges traditional systemic risk measures. I explore a new dimension of systemic risk, spillover persistence, which is the average time horizon at which a firm’s losses increase future risk in the financial system. Using firm-level data covering more than 30 years and 50 countries, I document that persistence declines when fragility builds up: before crises, during stock market booms, and when banks take more risks. In contrast, persistence increases with loss amplification: during crises and fire sales. These findings support key predictions of recent macrofinance models.
This paper investigates systemic risk in the insurance industry. We first analyze the systemic contribution of the insurance industry vis-à-vis other industries by applying 3 measures, namely the linear Granger causality test, conditional value at risk and marginal expected shortfall, on 3 groups, namely banks, insurers and non-financial companies listed in Europe over the last 14 years. We then analyze the determinants of the systemic risk contribution within the insurance industry by using balance sheet level data in a broader sample. Our evidence suggests that i) the insurance industry shows a persistent systemic relevance over time and plays a subordinate role in causing systemic risk compared to banks, and that ii) within the industry, those insurers which engage more in non-insurance-related activities tend to pose more systemic risk. In addition, we are among the first to provide empirical evidence on the role of diversification as potential determinant of systemic risk in the insurance industry. Finally, we confirm that size is also a significant driver of systemic risk, whereas price-to-book ratio and leverage display counterintuitive results.
The European low-carbon transition began in the last few decades and is accelerating to achieve net-zero emissions by 2050. This paper examines how climate-related transition indicators of a large European corporate firm relate to its CDS-implied credit risk across various time horizons. Findings show that firms with higher GHG emissions have higher CDS spreads at all tenors, including the 30-year horizon, particularly after the 2015 Paris Agreement, and in prominent industries such as Electricity, Gas, and Mining. Results suggest that the European CDS market is currently pricing, to some extent, albeit small, the exposure to transition risk for a firm across different time horizons. However, it fails to account for a company’s efforts to manage transition risks and its exposure to the EU Emissions Trading Scheme. CDS market participants seem to find challenging to risk-differentiate ETS-participating firms from other firms.
This study examines the recent literature on the expectations, beliefs and perceptions of investors who incorporate Environmental, Social, Governance (ESG) considerations in investment decisions with the aim to generate superior performance and also make a societal impact. Through the lens of equilibrium models of agents with heterogeneous tastes for ESG investments, green assets are expected to generate lower returns in the long run than their non- ESG counterparts. However, at the short run, ESG investment can outperform non-ESG investment through various channels. Empirically, results of ESG outperformance are mixed. We find consensus in the literature that some investors have ESG preference and that their actions can generate positive social impact. The shift towards more sustainable policies in firms is motivated by the increased market values and the lower cost of capital of green firms driven by investors’ choices.
Who should hold bail-inable debt and how can regulators police holding restrictions effectively?
(2023)
This paper analyses the demand-side prerequisites for the efficient application of the bail-in tool in bank resolution, scrutinises whether the European bank crisis management and deposit insurance (CMDI) framework is apt to establish them, and proposes amendments to remedy identified shortcomings.
The first applications of the new European CMDI framework, particularly in Italy, have shown that a bail-in of debt holders is especially problematic if they are households or other types of retail investors. Such debt holders may be unable to bear losses, and the social implications of bailing them in may create incentives for decision makers to refrain from involving them in bank resolution. In turn, however, if investors can expect resolution authorities (RAs) to behave inconsistently over time and bail-out bank capital and debt holders despite earlier vows to involve them in bank rescues, the pricing and monitoring incentives that the crisis management framework seeks to invigorate would vanish. As a result, market discipline would be suboptimal and moral hazard would persist. Therefore, the policy objectives of the CMDI framework will only be achieved if critical bail-in capital is not held by retail investors without sufficient loss-bearing capacity. Currently, neither the CMDI framework nor capital market regulation suffice to assure that this precondition is met. Therefore, some amendments are necessary. In particular, debt instruments that are most likely to absorb losses in resolution should have a high minimum denomination and banks should not be allowed to self-place such securities.
The loan impairment rules recently introduced by IFRS 9 require banks to estimate their future credit losses by using forward-looking information. We use supervisory loan-level data from Germany to investigate how banks apply their reporting discretion and adjust their lending upon the announcement of the new rules. Our identification strategy exploits a cut-off for the level of provisions at the investment grade threshold based on banks’ internal rating of a borrower. We find that banks required to adopt the new rules assign better internal ratings to exactly the same borrowers compared to banks that do not apply IFRS 9 around this cut-off. This pattern is consistent with a strategic use of the increased reporting discretion that is inherent to rules requiring forward-looking loss estimation. At the same time, banks also reduce their lending exposure to exactly those borrowers at the highest risk of experiencing a rating downgrade below the cutoff. These loans would be associated with additional provisions in future periods, both in the intensive and extensive margin. The lending change thus mitigates some of the negative effects of increased reporting opportunism on banks’ crisis resilience. However, when these firms with internal ratings around the investment grade cut-off obtain less external funding through banks, the introduction of IFRS 9 will likely also be associated with real economic effects
We employ a proprietary transaction-level dataset in Germany to examine how capital requirements affect the liquidity of corporate bonds. Using the 2011 European Banking Authority capital exercise that mandated certain banks to increase regulatory capital, we find that affected banks reduce their inventory holdings, pre-arrange more trades, and have smaller average trade size. While non-bank affiliated dealers increase their market-making activity, they are unable to bridge this gap - aggregate liquidity declines. Our results are stronger for banks with a higher capital shortfall, for non-investment grade bonds, and for bonds where the affected banks were the dominant market-maker.