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When markets are incomplete, social security can partially insure against idiosyncratic and aggregate risks. We incorporate both risks into an analytically tractable model with two overlapping generations and demonstrate that they interact over the life-cycle. The interactions appear even though the two risks are orthogonal and they amplify the welfare consequences of introducing social security. On the one hand, the interactions increase the welfare benefits from insurance. On the other hand, they can in- or decrease the welfare costs from crowding out of capital formation. This ambiguous effect on crowding out means that the net effect of these two channels is positive, hence the interactions of risks increase the total welfare benefits of social security.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.
We outline a procedure for consistent estimation of marginal and joint default risk in the euro area financial system. We interpret the latter risk as the intrinsic financial system fragility and derive several systemic fragility indicators for euro area banks and sovereigns, based on CDS prices. Our analysis documents that although the fragility of the euro area banking system had started to deteriorate before Lehman Brothers' file for bankruptcy, investors did not expect the crisis to affect euro area sovereigns' solvency until September 2008. Since then, and especially after November 2009, joint sovereign default risk has outpaced the rise of systemic risk within the banking system.
We examine the relationship between household wealth and self-control. Although self-control has been linked to consumption and financial behavior, its measurement remains an open issue. We employ a definition of self-control failure that follows literature in psychology, suggesting that three factors can render self-control defective: lack of planning, lack of monitoring, and lack of commitment to pre-set plans. Our measure combines those three ingredients and can be computed using a standard representative survey. We find that self-control failure is strongly associated with different household net wealth measures and with self-assessed financial distress.
How special are they? - Targeting systemic risk by regulating shadow banking : (October 5, 2014)
(2014)
This essay argues that at least some of the financial stability concerns associated with shadow banking can be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules. It shows that the general policy goals of prudential banking regulation remain constant over time despite dramatic transformations in the financial and technological landscape. Moreover, these overarching policy goals also legitimize intervention in the shadow banking sector. On these grounds, this essay encourages a more normative construction of available rules that potentially limits both the scope for regulatory arbitrage and the need for ever more rapid updates and a constant increase in the complexity of the regulatory framework. By tying the regulatory treatment of financial innovation closely to existing prudential rules and their underlying policy rationales, the proposed approach potentially ends the socially wasteful race between hare and tortoise that signifies the relation between regulators and a highly dynamic industry. In doing so it does not generally hamper market participants’ efficient discoveries where disintermediation proves socially beneficial. Instead, it only weeds-out rent-seeking circumventions of existing rules and standards.
Previous research has documented strong peer effects in risk taking, but little is known about how such social influences affect market outcomes. The consequences of social interactions are hard to isolate in financial data, and theoretically it is not clear whether peer effects should increase or decrease risk sharing. We design an experimental asset market with multiple risky assets and study how exogenous variation in real-time information about the portfolios of peer group members affects aggregate and individual risk taking. We find that peer information ameliorates under-diversification that occurs in a market without such information. One reason is that peer information increases risk aversion and induces a concern for relative income position that may reduce or amplify risk taking, depending on whether the context highlights the most or least successful trader. Thus, contrary to conventional wisdom, we show that social interactions may help to reduce earnings volatility in financial markets, and we discuss implications for institutional design.
This paper contrasts the recent European initiatives on regulating corporate groups with alternative approaches to the phenomenon. In doing so it pays particular regard to the German codified law on corporate groups as the polar opposite to the piecemeal approach favored by E.U. legislation.
It finds that the European Commission’s proposal to submit (significant) related party transactions to enhanced transparency, outside fairness review, and ex ante shareholder approval is both flawed in its design and based on contestable assumptions on informed voting of institutional investors. In particular, the contemplated exemption for transactions with wholly owned subsidiaries allows controlling shareholders to circumvent the rule extensively. Moreover, vesting voting rights with (institutional) investors will not lead to the informed assessment that is hoped for, because these investors will rationally abstain from active monitoring and rely on proxy advisory firms instead whose competency to analyze non-routine significant related party transactions is questionable.
The paper further delineates that the proposed recognition of an overriding interest of the group requires strong counterbalances to adequately protect minority shareholders and creditors. Hence, if the Commission choses to go down this route it might end up with a comprehensive regulation that is akin to the unpopular Ninth Company Law Directive in spirit, though not in content. The latter prediction is corroborated by the pertinent parts of the proposal for a European Model Company Act.
Research results confirm the existence of various forms of international tax planning by multinational firms. Prominent examples for firms employing tax avoidance strategies are Amazon, Google and Starbucks. Increasing availability of administrative data for Europe has enabled researchers to study behavioural responses of European multinationals to taxation. The present paper summarizes what we can learn from these recent studies in general and about German multinationals in particular.
SAFE Professor Michalis Haliassos was a member of the National Council for Research and Technology (ESET) established by the Government of Greece for the period 2010-2013. The council, consisting of eleven scientists from a range of disciplines, has now published their communiqué "National Strategic Framework for Research and Innovation 2014 -2020".
To promote the advancement of research, technology and innovation in Greece, the strategic plan proposed by the authors seeks to identify areas of existing research strength and excellence that can be further advanced to become engines for progress and growth in Greece, as well as flaws inherent to the present system. The authors stress the need to address current constraints to growth, which include the declining education system; the confusion and weaknesses of R&D governance and management; the discontinuities and inefficiencies of resource allocation and investment; the lack of adaptation to clearly-defined national priorities; and the inadequate opportunities and funding for high-quality research and development to flourish. They stress the need for prioritisation and efficient allocation; stability of the policy frame; predictability of planning; provision of opportunity; recognition of excellence; and responsiveness to current and future needs.
How special are they? - Targeting systemic risk by regulating shadow banking : (October 5, 2014)
(2014)
This essay argues that at least some of the financial stability concerns associated with shadow banking can be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules. It shows that the general policy goals of prudential banking regulation remain constant over time despite dramatic transformations in the financial and technological landscape. Moreover, these overarching policy goals also legitimize intervention in the shadow banking sector. On these grounds, this essay encourages a more normative construction of available rules that potentially limits both the scope for regulatory arbitrage and the need for ever more rapid updates and a constant increase in the complexity of the regulatory framework. By tying the regulatory treatment of financial innovation closely to existing prudential rules and their underlying policy rationales, the proposed approach potentially ends the socially wasteful race between hare and tortoise that signifies the relation between regulators and a highly dynamic industry. In doing so it does not generally hamper market participants’ efficient discoveries where disintermediation proves socially beneficial. Instead, it only weeds-out rent-seeking circumventions of existing rules and standards.
In this paper, we investigate how the introduction of complex, model-based capital regulation affected credit risk of financial institutions. Model-based regulation was meant to enhance the stability of the financial sector by making capital charges more sensitive to risk. Exploiting the staggered introduction of the model-based approach in Germany and the richness of our loan-level data set, we show that (1) internal risk estimates employed for regulatory purposes systematically underpredict actual default rates by 0.5 to 1 percentage points; (2) both default rates and loss rates are higher for loans that were originated under the model-based approach, while corresponding risk-weights are significantly lower; and (3) interest rates are higher for loans originated under the model-based approach, suggesting that banks were aware of the higher risk associated with these loans and priced them accordingly. Further, we document that large banks benefited from the reform as they experienced a reduction in capital charges and consequently expanded their lending at the expense of smaller banks that did not introduce the model-based approach. Counter to the stated objectives, the introduction of complex regulation adversely affected the credit risk of financial institutions. Overall, our results highlight the pitfalls of complex regulation and suggest that simpler rules may increase the efficacy of financial regulation.
The recent decline in euro area inflation has triggered new calls for additional monetary stimulus by the ECB in order to counter the threat of a self‐reinforcing deflation and recession spiral. This note reviews the available evidence on inflation expectations, output gaps and other factors driving current inflation through the lens of the Phillips curve. It also draws a comparison to the Japanese experience with deflation in the late 1990s and the evidence from Japan concerning the outputinflation nexus at low trend inflation. The note concludes from this evidence that the risk of a selfreinforcing deflation remains very small. Thus, the ECB best await the impact of the long‐term refinancing operations decided in June that have the potential to induce substantial monetary accommodation once implemented for the first time in September.
This essay reviews a cornerstone of the European Banking Union project, the resolution of systemically important banks. The focus is on the inherent conflict between a possible intervention by resolution authorities, conditional on a crisis situation, and effective prevention prior to a crisis. Moreover, the paper discusses the rules for bail-in debt and conversion rules for different layers of debt. Finally, some organizational requirements to achieve effective resolution results will be analyzed.
SAFE Newsletter : 2014, Q3
(2014)
We propose a novel approach on how to estimate systemic risk and identify its key determinants. For US financial companies with publicly traded equity options, we extract option-implied value-at-risks and measure the spillover effects between individual company value-at-risks and the option-implied value-at-risk of a financial index. First, we study the spillover effect of increasing company risks on the financial sector. Second, we analyze which companies are mostly affected if the tail risk of the financial sector increases. Key metrics such as size, leverage, market-to-book ratio and earnings have a significant influence on the systemic risk profiles of financial institutions.
Low interest rates are becoming a threat to the stability of the life insurance industry, especially in countries such as Germany, where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio. This contribution aims to assess and quantify the effects of the current low interest rate phase on the balance sheet of a representative German life insurer, given the current asset allocation and the outstanding liabilities. To do so, we generate a stochastic term structure of interest rates as well as stock market returns to simulate investment returns of a stylized life insurance business portfolio in a multi-period setting. Based on empirically calibrated parameters, we can observe the evolution of the life insurers' balance sheet over time with a special focus on their solvency situation. To account for different scenarios and in order to check the robustness of our findings, we calibrate different capital market settings and different initial situations of capital endowment. Our results suggest that a prolonged period of low interest rates would markedly affect the solvency situation of life insurers, leading to relatively high cumulative probability of default for less capitalized companies.
This paper analyzes how on-the-job search (OJS) by an agent impacts the moral hazard problem in a repeated principal-agent relationship. OJS is found to constitute a source of agency costs because efficient search incentives require that the agent receives all gains from trade. Further, the optimal incentive contract with OJS matches the design of empirically observed compensation contracts more accurately than models that ignore OJS. In particular, the optimal contract entails excessive performance pay plus efficiency wages. Efficiency wages reduce the opportunity costs of work effort and hence serve as a complement to bonuses. Thus, the model offers a novel explanation for the use of efficiency wages. When allowing for renegotiation, the model generates wage and turnover dynamics that are consistent with empirical evidence. I argue that the model contributes to explaining the concomitant rise in the use of performance pay and in competition for high-skill workers during the last three decades.
We study consumption-portfolio and asset pricing frameworks with recursive preferences and unspanned risk. We show that in both cases, portfolio choice and asset pricing, the value function of the investor/ representative agent can be characterized by a specific semilinear partial differential equation. To date, the solution to this equation has mostly been approximated by Campbell-Shiller techniques, without addressing general issues of existence and uniqueness. We develop a novel approach that rigorously constructs the solution by a fixed point argument. We prove that under regularity conditions a solution exists and establish a fast and accurate numerical method to solve consumption-portfolio and asset pricing problems with recursive preferences and unspanned risk. Our setting is not restricted to affine asset price dynamics. Numerical examples illustrate our approach.
We build on previous work on operational performance evaluation of private equity portfolio companies as we are able to at least partially decrypt the black box consisting of restructuring tools these investors use and the corresponding impact on their portfolio companies. Beyond answering whether private equity improves operating efficiency we figure out which of the typical restructuring tools drive operating efficiency. Using a set of over 300 international leveraged buyout transactions in the last thirty years we find that while there is vast improvement in operational efficiency these gains vary considerably. Our top performing transactions are subject to strong equity incentives, frequent asset restructuring and tight control by the investor. Furthermore, investors experience has a positive and financial leverage a negative influence on operational performance.
Homestead exemptions to personal bankruptcy allow households to retain their home equity up to a limit determined at the state level. Households that may experience bankruptcy thus have an incentive to bias their portfolios towards home equity. Using US household data from the Survey of Income and Program Participation for the period 1996-2006, we find that especially households with low net worth maintain a larger share of their wealth as home equity if a larger homestead exemption applies. This home equity bias is also more pronounced if the household head is in poor health, increasing the chance of bankruptcy on account of unpaid medical bills. The bias is further stronger for households with mortgage finance, shorter house tenures, and younger household heads, which taken together reflect households that face more financial uncertainty.
Using fiscal reaction functions for 3a panel of actual euro-area countries the paper investigates whether euro membership has reduced the responsiveness of countries to increases in the level of inherited debt compared to the period prior to succession to the euro. While we find some evidence for such a loss in prudence, the results are not robust to changes in the specification, as for example an exclusion of Greece from the panel. This suggests that the current debt problems may result to a large extent from pre-existing debt levels prior to entry or from a larger need for fiscal prudence in a common currency, while an adverse change in the fiscal reaction functions for most countries does not apply.
Trust in policy makers fluctuates signi
cantly over the cycle and affects the transmission mechanism. Despite this it is absent from the literature. We build a monetary model embedding trust cycles; the latter emerge as an equilibrium phenomenon of a game-theoretic interaction between atomistic agents and the monetary authority. Trust affects agents' stochastic discount factors, namely the price of future risk, and through this it interacts with the monetary transmission mechanism. Using data from the Eurobarometer surveys, we analyze the link between trust and the transmission mechanism of macro and monetary shocks: Empirical results are in line with theoretical ones.
This paper presents a theory that explains why it is beneficial for banks to engage in circular lending activities on the interbank market. Using a simple network structure, it shows that if there is a non-zero bailout probability, banks can significantly increase the expected repayment of uninsured creditors by entering into cyclical liabilities on the interbank market before investing in loan portfolios. Therefore, banks are better able to attract funds from uninsured creditors. Our results show that implicit government guarantees incentivize banks to have large interbank exposures, to be highly interconnected, and to invest in highly correlated, risky portfolios. This can serve as an explanation for the observed high interconnectedness between banks and their investment behavior in the run-up to the subprime mortgage crisis.
We document and study international differences in both ownership and holdings of stocks, private businesses, homes, and mortgages among households aged fifty or more in thirteen countries, using new and comparable survey data. We employ counterfactual techniques to decompose observed differences across the Atlantic, within the US, and within Europe into those arising from differences in population characteristics and differences in economic environments. We then correlate the latter differences to country-level indicators. Ownership across the range of the assets considered tends to be more widespread among US households. We document that shortly prior to the current crisis, US households tended to invest larger amounts in stocks and smaller ones in homes, and to have larger mortgages in older age, even controlling for characteristics. This is consistent with the high prevalence of negative equity associated with the current crisis. More generally, we find that differences in household characteristics often play a small role, while differences in economic environments tend to explain most of the observed differences in ownership rates and in amounts held. The latter differences are much more pronounced among European countries than among US regions, suggesting further potential for harmonization of policies and institutions.
Regulation of investor access to financial products is often based on product familiarity indicated by previous use. The underlying premise that lack of familiarity with a product class causes unwarranted participation is difficult to test. This paper uses household-level data from the ‘experiment’ of German reunification that (exogenously) offered to East Germans access to capitalist products (exogenously) unfamiliar to them. We compare the evolution of post-unification participation of former East and West Germans in financial products, controlling for relevant household characteristics. We vary familiarity differentials by considering (i) both unfamiliar ‘capitalist’ products (stocks, bonds, and consumer credit) and ones available in the East (savings accounts and life insurance); and (ii) cohorts with different exposure to capitalism. We find that East Germans participated immediately in unfamiliar risky securities, at rates comparable to West Germans of similar characteristics. They phased out disproportionate participation in previously familiar assets as familiarity with capitalist products grew. They were more likely to use consumer debt, partly to catch up with richer new peers. We find no signs of abrupt participation drops that could suggest mistakes or regret related to lack of familiarity.
In this paper we investigate the implications of providing loan officers with a compensation structure that rewards loan volume and penalizes poor performance versus a fixed wage unrelated to performance. We study detailed transaction information for more than 45,000 loans issued by 240 loan officers of a large commercial bank in Europe. We examine the three main activities that loan officers perform: monitoring, originating, and screening. We find that when the performance of their portfolio deteriorates, loan officers increase their effort to monitor existing borrowers, reduce loan origination, and approve a higher fraction of loan applications. These loans, however, are of above-average quality. Consistent with the theoretical literature on multitasking in incomplete contracts, we show that loan officers neglect activities that are not directly rewarded under the contract, but are in the interest of the bank. In addition, while the response by loan officers constitutes a rational response to a time allocation problem, their reaction to incentives appears myopic in other dimensions.
In this study prepared for the ECON Committee of the European Parliament, Gellings, Jungbluth and Langenbucher present a graphic overview on core legislation in the area of economic and financial services in Europe. The mapping overview can serve as background for further deliberations. The study covers legislation in force, proposals and other relevant provisions in fourteen policy areas, i.e. banking, securities markets and investment firms, market infrastructure, insurance and occupational pensions, payment services, consumer protection in financial services, the European System of Financial Supervision, European Monetary Union, Euro bills and Coins and statistics, competition, taxation, commerce and company law, accounting and auditing.
This paper contributes to the ongoing debate on the relationship between austerity measures and economic growth. We propose a general equilibrium model where (i) agents have recursive preferences; (ii) economic growth is endogenously driven by investments in R&D; (iii) the government is committed to a zero-deficit policy and finances public expenditures by means of a combination of labor taxes and R&D taxes. We find that austerity measures that rely on reducing resources available to the R&D sector depress economic growth both in the short- and long-run. High debt EU members are currently implementing austerity measures based on higher taxes and/or lower investments in the R&D sector. This casts some doubts on the real ability of these countries to grow over the next years.
The implications of delegating fiscal decision making power to sub-national governments has become an area of significant interest over the past two decades, in the expectation that these reforms will lead to better and more efficient provision of public goods and services. The move towards decentralization has, however, not been homogeneously implemented on the revenue and expenditure side: decentralization has materialized more substantially on the latter than on the former, creating "vertical fiscal imbalances". These imbalances measure the extent to which sub-national governments’ expenditures are financed through their own revenues. This mismatch between own revenues and expenditures may have negative consequences for public finances performance, for example by softening the budget constraint of sub-national governments. Using a large sample of countries covering a long time period from the IMF’s Government Finance Statistics Yearbook, this paper is the first to examine the effects of vertical fiscal imbalances on fiscal performance through the accumulation of government debt. Our findings suggest that vertical fiscal imbalances are indeed relevant in explaining government debt accumulation, and call for a degree of caution when promoting fiscal decentralization.
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
We develop a model of managerial compensation structure and asset risk choice. The model provides predictions about how inside debt features affect the relation between credit spreads and compensation components. First, inside debt reduces credit spreads only if it is unsecured. Second, inside debt exerts important indirect effects on the role of equity incentives: When inside debt is large and unsecured, equity incentives increase credit spreads; When inside debt is small or secured, this effect is weakened or reversed. We test our model on a sample of U.S. public firms with traded CDS contracts, finding evidence supportive of our predictions. To alleviate endogeneity concerns, we also show that our results are robust to using an instrumental variable approach.
The Eurozone fiscal crisis has created pressure for institutional harmonization, but skeptics argue that cultural predispositions can prevent convergence in behavior. Our paper derives a robust cultural classification of European countries and utilizes unique data on natives and immigrants to Sweden. Classification based on genetic distance or on Hofstede’s cultural dimensions fails to identify a single ‘southern’ culture but points to a ‘northern’ culture. Significant differences in financial behavior are found across cultural groups, controlling for household characteristics. Financial behavior tends to converge with longer exposure to common institutions, but is slowed down by longer exposure to original institutions.
This is a chapter for a forthcoming volume Oxford Handbook of Financial Regulation (Oxford University Press 2014) (eds. Eilís Ferran, Niamh Moloney, and Jennifer Payne). It provides an overview of EU financial regulation from the first banking directive up until its most recent developments in the aftermath of the financial crisis, focusing on the multiple layers of multi-level governance and their characteristic conceptual difficulties. Therefore the paper discusses the need to accommodate cross-border capital flows following from the EU internal market and the resulting regulatory strategies. This includes a brief overview of the principle of home country control and the ensuing Financial Services Action Plan. Dealing with the accommodation of cross-border capital flows and their regulation necessarily require an orchestration of the underlying supervisory structures, which is therefore also discussed. In the aftermath of the financial crisis of 2007-09 an additional aspect of necessary orchestration has emerged, that is the need to control systemic risk. Specific attention is paid to microprudential supervision by the newly established European Supervisory Authorities and macroprudential supervision in the European Banking Union, the latter’s underlying drivers and the accompanying Single Supervisory Mechanism, including the SSM’s institutional framework as well as the consideration of its rationales and the Single Resolution Mechanism closely linked to it.
On January 29, 2014, EU Commissioner Barnier published a draft law proposing a ban for proprietary trading by big banks in Europe. In this opinion piece, published in a German newspaper on 30 January, 2014, Jan Pieter Krahnen, who was a member of the Liikanen Commission, argues that the proposal could prove to be effective in preventing systemic risk.
In the wake of the Global Financial Crisis that started in 2007, policymakers were forced to respond quickly and forcefully to a recession caused not by short-term factors, but rather by an over-accumulation of debt by sovereigns, banks, and households: a so-called “balance sheet recession.” Though the nature of the crisis was understood relatively early on, policy prescriptions for how to deal with its consequences have continued to diverge. This paper gives a short overview of the prescriptions, the remaining challenges and key lessons for monetary policy.
n a contribution prepared for the Athens Symposium on “Banking Union, Monetary Policy and Economic Growth”, Otmar Issing describes forward guidance by central banks as the culmination of the idea of guiding expectations by pure communication. In practice, he argues, forward guidance has proved a misguided idea. What is presented as state of the art monetary policy is an example of pretence of knowledge. Forward guidance tries to give the impression of a kind of rule-based monetary policy. De facto, however, it is an overambitious discretionary approach which, to be successful, would need much more (or rather better) information than is currently available. In Issing's view, communication must be clear and honest about the limits of monetary policy in a world of uncertainty.
This European Policy Analysis discusses the need to strengthen the institutions underpinning the euro and makes several policy recommendations. The Stability and Growth Pact must be reinforced, have greater automaticity and entail graduated sanctions. Fiscal surveillance must be improved through the establishment of a European Fiscal Stability Agency. Finally, the European Financial Stability Facility must be made permanent.
How to be a good European...
(2010)
Unter der Überschrift "Ich kaufe griechische Staatsanleihen weil..." sollten Persönlichkeiten aus Politik, Wirtschaft und Kultur kurz begründen, warum sie griechische Staatsanleihen gekauft haben bzw. kaufen werden--idealerweise unter Nachweis ihres finanziellen Engagements. Zum jetzigen Zeitpunkt kaufe ich keine griechischen Staatsanleihen...
At the upcoming G20 meetings the issue what can be done to avoid a repetition of the current deep financial crisis will again be debated. Much attention and criticism will be directed to central banks. That is unavoidable: central banks must never again permit the development of financial imbalances that are large enough to lead to the collapse of major parts of the financial system when they unwind. In the future, policy makers must “lean against the wind” and tighten financial conditions if they perceive that imbalances are forming, even if there is little hard data to rely on. And they must be mindful that the costs of acting too late can dwarf those of acting too early.
In the event of a Greek exit from the Eurozone, the stronger members of the monetary union, especially Germany, face at least two risks: First, the debt of the Greek National Bank vis-à-vis the Eurosystem of central banks will most likely be lost. Secondly, the large flow of capital from Greece and other periphery countries to Germany will accelerate inflation.
We investigate the relationship between anchoring and the emergence of bubbles in experimental asset markets. We show that setting a visual anchor at the fundamental value (FV) in the first period only is sufficient to eliminate or to significantly reduce bubbles in laboratory asset markets. If no FV-anchor is set, bubble-crash patterns emerge. Our results indicate that bubbles in laboratory environments are primarily sparked in the first period. If prices are initiated around the FV, they stay close to the FV over the entire trading horizon. Our insights can be related to initial public offerings and the interaction between prices set on pre-opening markets and subsequent intra-day price dynamics.
he observed hump-shaped life-cycle pattern in individuals' consumption cannot be explained by the classical consumption-savings model. We explicitly solve a model with utility of both consumption and leisure and with educational decisions affecting future wages. We show optimal consumption is hump shaped and determine the peak age. The hump results from consumption and leisure being substitutes and from the implicit price of leisure being decreasing over time; more leisure means less education, which lowers future wages, and the present value of foregone wages decreases with age. Consumption is hump shaped whether the wage is hump shaped or increasing over life.
This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis allows to capture individual behavior across various levels of ambiguity, ranging from low to high. Attitudes towards risk and attitudes towards ambiguity are disentangled, providing pure measures of ambiguity aversion. Ambiguity aversion is captured in several ways, i.e. as a discount factor net of a risk premium, and as an estimated parameter in a generalized utility function. We find that ambiguity aversion varies across individuals, and with the level of ambiguity, being most prominent for intermediate levels. Around one third of subjects show no aversion, one third show maximum aversion, and one third show intermediate levels of ambiguity aversion, while there is almost no ambiguity seeking. While most theoretical work on ambiguity builds on maxmin expected utility, our results provide evidence that MEU does not adequately capture individual attitudes towards ambiguity for the majority of individuals. Instead, our results support models that allow for intermediate levels of ambiguity aversion. Moreover, we find risk aversion to be statistically unrelated to ambiguity aversion on average. Taken together, the results support the view that ambiguity is an important and distinct argument in decision making under uncertainty.
The idea of appointing a non-national as Central Bank Governor remains surprisingly controversial. Nevertheless, given the skills required by the Governor in order to manage what no doubt are increasingly complex institutions, considering non-nationals makes good sense for at least two reasons. First, increasing the pool of candidates to include those with broader skills and backgrounds makes it easier to find a suitable person for the job. Second, non-nationals are less likely to be beholden to domestic pressure groups and could help better insulate the central bank from political pressures.
The exceptional circumstances in which the ECB has been operating in the past years are testing not only the currency union itself, but also its institutional design. While the Governing Council of the ECB was designed to mainly set interest rates optimally for the union as a whole, the recent crisis has expanded the tools of the ECB to include unconventional monetary policy actions that potentially increase the risk exposure of its balance sheet. Since each country would contribute to the losses according to its capital key, a different voting mechanism that takes into account the single country’s contribution to the ECB’s capital could be advisable.
SAFE Newsletter : 2014, Q2
(2014)
The European Commission's Green Paper "Audit Policy: Lessons from the Crisis" raises 38 questions regarding how the audit function could be enhanced in order to contribute to increased financial stability. The authors comment on these 38 questions, arguing that the general level of audit quality can be enhanced by extending the duties of care and by tightening the regulations on liability.
This article discusses the effects of the countercyclical premium discussed in insurance supervision in the context of Solvency II. While the basic principle of introducing countercyclical elements into Solvency II is endorsed, the authors argue for a system based on market scenarios which would enforce stricter capital requirements in boom times and less strict requirements in times of crisis.
The European Commission's Green Paper "The EU corporate governance framework" raises 25 questions in order to assess the effectiveness of the current corporate governance framework for European companies. The authors contribute to the EU's consultation, respond to the 25 questions and comment on the suggestions set out in the Green Paper.
We study consumption-portfolio and asset pricing frameworks with recursive preferences and unspanned risk. We show that in both cases, portfolio choice and asset pricing, the value function of the investor/representative agent can be characterized by a specific semilinear partial differential equation. To date, the solution to this equation has mostly been approximated by Campbell-Shiller techniques, without addressing general issues of existence and uniqueness. We develop a novel approach that rigorously constructs the solution by a fixed point argument. We prove that under regularity conditions a solution exists and establish a fast and accurate numerical method to solve consumption-portfolio and asset pricing problems with recursive preferences and unspanned risk. Our setting is not restricted to affine asset price dynamics. Numerical examples illustrate our approach.