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We contribute to the debate about the future of capital markets and corporate finance, which has ensued against the background of a significant boom in private markets and a corresponding decline in the number of firms and the amount of capital raised in public markets in the US and Europe.
Our research sheds light on the fluctuating significance of public and private markets for corporate finance over time, and challenges the conventional view of a linear progression from one market to the other. We argue instead that a more complex pattern of interaction between public and private markets emerges, after taking a long-term perspective and examining historical developments more closely.
We claim that there is a dynamic divide between these markets, and identify certain factors that determine the degree to which investors, capital, and companies gravitate more towards one market than the other. However, in response to the status quo, other factors will gain momentum and favor the respective other market, leading to a new (unstable) equilibrium. Hence, we observe the oscillating domains of public and private markets over time. While these oscillations imply ‘competition’ between these markets, we unravel the complementarities between them, which also militate against a secular trend towards one market. Finally, we examine the role of regulation in this dynamic divide as well as some policy implications arising from our findings.
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.
An unfamiliar term in the not-too-distant past, “net zero” has become a headline-maker in the business and financial world with the growing importance of climate change. Succumbing to increasing pressure, companies and financial institutions around the world have come to adopt net-zero transition plans and targets, pledging to hit certain emission-reduction targets in a long-term period. Moreover, regulators around the world have started to require the disclosure or adoption of net-zero transition plans and targets.
However, an unintended consequence of net-zero transition commitments has been the increased popularity of divestments. That is, many firms seeking to fulfill a net-zero plan are passing on carbon-intensive assets (i.e., oil, gas, and coal assets) to other firms that are likely to be non-committal to environmental goals or that operate under less pressure from investors, stakeholders, and regulators. Such divestments, technically mergers and acquisitions (M&A) transactions, present an ideal opportunity to improve a divesting firm’s environmental record and reach ambitious net-zero goals, creating the impression that an emission reduction has occurred. However, the key is how acquiring firms handle these assets. If they continue operating as before, there will not be an overall improvement for the global climate. Worse, such assets can be operated by new owners in a way that causes more emissions. In any case, such divestments undermine the credibility and value of net-zero ambitions by allowing firms to reach targets by simply divesting assets.
This article explores the reasons and motivations for divestments or, more broadly M&As of carbon-intensive assets and explains why the increased role of net-zero commitments can be undermined by those transactions. We provide some evidence to illustrate the landscape of such transactions and the concerns they give rise to. Lastly, we explore several policy options to address the problem.
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.
This paper analyzes the current implementation status of sustainability and taxonomy-aligned disclosure under the Sustainable Finance Disclosure Regulation (SFDR) as well as the development of the SFDR categorization of funds offered via banks in Germany. Examining data provided by WM Group, which consists of more than 10,000 investment funds and 2,000 index funds between September 2022 and March 2023, we have observed a significant proportion of Article 9 (dark green) funds transitioning to Article 8 (light green) funds, particularly among index funds. As a consequence of this process, the profile of the SFDR classes has sharpened, which reflects an increased share of sustainable investments in the group of Article 9 funds. When differentiating between environmental and social investments, the share of environmental investments increased, but the share of social investments decreased in the group of Article 9 funds at the beginning of 2023. The share of taxonomy-aligned investments is very low, but slightly increasing for Article 9 funds. However, by March 2023 only around 1,000 funds have reported their sustainability proportions and this picture might change due to legal changes which require all funds in the scope of the SFDR to report these proportions in their annual reports being published after 1 January 2023.
Biodiversity loss poses a significant threat to the global economy and affects ecosystem services on which most large companies rely heavily. The severe financial implications of such a reduced species diversity have attracted the attention of companies and stakeholders, with numerous calls to increase corporate transparency. Using textual analysis, this study thus investigates the current state of voluntary biodiversity reporting of 359 European blue-chip companies and assesses the extent to which it aligns with the upcoming disclosure framework of the Task Force on Nature-related Financial Disclosures (TNFD). The descriptive results suggest a substantial gap between current reporting practices and the proposed TNFD framework, with disclosures largely lacking quantification, details and clear targets. In addition, the disclosures appear to be relatively unstandardized. Companies in sectors or regions exposed to higher nature-related risks as well as larger companies are more likely to report on aspects of biodiversity. This study contributes to the emerging literature on nature-related risks and provides detailed insights on the extent of the reporting gap in light of the upcoming standards.
We examine whether the uncertainty related to environmental, social, and governance (ESG) regulation developments is reflected in asset prices. We proxy the sensitivity of firms to ESG regulation uncertainty by the disparity across the components of their ESG ratings. Firms with high ESG disparity have a higher option-implied cost of protection against downside tail risk. The impact of the misalignment across the different dimensions of the ESG score is distinct from that of ESG score level itself. Aggregate downside risk bears a negative price for firms with low ESG disparity.
We explore how personality traits are related to household borrowing behavior. Using survey data representative for the Netherlands, we consider the Big Five personality traits (openness, conscientiousness, agreeableness, extraversion and neuroticism), as well as the belief that one is master of one’s fate (locus of control). We hypothesize that personality traits can complement as well as substitute financial knowledge of a household. We present three sets of results. First, we find that personality traits are positively correlated with borrowing expectations. Locus of control, extraversion and agreeableness are correlated with informal borrowing expectations, which is the expectation that one can borrow from family and friends. With respect to expectations on the approval of a formal loan application, it is locus of control and conscientiousness that are positively associated. Effect sizes are large and economically meaningful. Second, we find that personality traits are important for borrowing constraints. A more internal locus of control and higher neuroticism are correlated with being denied for credit, as well as discouraged borrowing. Our third set of results reports findings on personality traits and loan regret, and how traits are correlated with dealing with loan troubles. Many households in our sample express regret (21%), but more open, more agreeable and more neurotic individuals are more likely to express regret. Our results are not driven by financial knowledge, time preferences or risk attitudes. Overall these findings imply that non-cognitive traits are important for borrowing behavior of households.
The right to ask questions and voice their opinions at annual general meetings (AGMs) represents one of the few avenues for shareholders to communicate directly and publicly with the firm’s management. Examining AGM transcripts of U.S. companies between 2007 and 2021, we find that shareholders actively express their concerns about environmental, social and governance (ESG) issues in accordance with their specific relationship with the company. Further, they are also demonstrably more vocal about ESG issues at AGMs of firms with poor sustainability performance. What is more, we show that this soft engagement translates into a more negative tone which, in turn, results in lower approval rates for management proposals. Shareholders' soft engagement at AGMs is hence an effective way to "walk the talk".
The issuance of sustainability-linked loans (SLLs) has grown exponentially in recent years. Using a scoring methodology, we examine the underlying key performance indicators of a large sample of SLLs and analyze whether their design creates effective incentives for improving corporate sustainability performance. We demonstrate that the majority of loans fails to meet key requirements that would make them credible instruments for generating effective sustainability incentives. These findings call into question the actual sustainability impact that may be achieved through the issuance of ESG-linked debt.
Industry classification groups firms into finer partitions to help investments and empirical analysis. To overcome the well-documented limitations of existing industry definitions, like their stale nature and coarse categories for firms with multiple operations, we employ a clustering approach on 69 firm characteristics and allocate companies to novel economic sectors maximizing the within-group explained variation. Such sectors are dynamic yet stable, and represent a superior investment set compared to standard classification schemes for portfolio optimization and for trading strategies based on within-industry mean-reversion, which give rise to a latent risk factor significantly priced in the cross-section. We provide a new metric to quantify feature importance for clustering methods, finding that size drives differences across classical industries while book-to-market and financial liquidity variables matter for clustering-based sectors.
The recent COVID-19 pandemic represents an unprecedented worldwide event to study the influence of related news on the financial markets, especially during the early stage of the pandemic when information on the new threat came rapidly and was complex for investors to process. In this paper, we investigate whether the flow of news on COVID-19 had an impact on forming market expectations. We analyze 203,886 online articles dealing with COVID-19 and published on three news platforms (MarketWatch.com, NYTimes.com, and Reuters.com) in the period from January to June 2020. Using machine learning techniques, we extract the news sentiment through a financial market-adapted BERT model that enables recognizing the context of each word in a given item. Our results show that there is a statistically significant and positive relationship between sentiment scores and S&P 500 market. Furthermore, we provide evidence that sentiment components and news categories on NYTimes.com were differently related to market returns.
Homeownership rates differ widely across European countries. We document that part of this variation is driven by differences in the fraction of adults co-residing with their parents. Comparing Germany and Italy, we show that in contrast to homeownership rates per household, homeownership rates per individual are very similar during the first part of the life cycle. To understand these patterns, we build an overlapping-generations model where individuals face uninsurable income risk and make consumption-saving and housing tenure decisions. We embed an explicit intergenerational link between children and parents to capture the three-way trade-off between owning, renting, and co-residing. Calibrating the model to Germany we explore the role of income profiles, housing policies, and the taste for independence and show that a combination of these factors goes a long way in explaining the differential life-cycle patterns of living arrangements between the two countries.
While the COVID-19 pandemic had a large and asymmetric impact on firms, many countries quickly enacted massive business rescue programs which are specifically targeted to smaller firms. Little is known about the effects of such policies on business entry and exit, investment, factor reallocation, and macroeconomic outcomes. This paper builds a general equilibrium model with heterogeneous and financially constrained firms in order to evaluate the short- and long-term consequences of small firm rescue programs in a pandemic recession. We calibrate the stationary equilibrium and the pandemic shock to the U.S. economy, taking into account the factual Paycheck Protection Program (PPP) as a specific policy. We find that the policy has only a modest impact on aggregate output and employment because (i) jobs are saved predominately in the smallest firms that account for a minor share of employment and (ii) the grant reduces the reallocation of resources towards larger and less impacted firms. Much of the reallocation effects occur in the aftermath of the pandemic episode. By preventing inefficient liquidations, the policy dampens the long-term declines of aggregate consumption and of the real wage, thus delivering small welfare gains.
The complexities of geopolitical events, financial and fiscal crises, and the ebb and flow of personal life circumstances can weigh heavily on individuals’ minds as they make critical economic decisions. To investigate the impact of cognitive load on such decisions, the authors conducted an incentivized online experiment involving a representative sample of 2,000 French households. The results revealed that exposure to a taxing and persistent cognitive load significantly reduced consumption, particularly for individuals under the threat of furlough, while simultaneously increasing their account balances, particularly for those not facing such employment uncertainty. These effects were not driven by supply constraints or a worsening of credit constraints. Instead, cognitive load primarily affected the optimality of the chosen policy rules and impaired the ability of the standard economic model to accurately predict consumption patterns, although this effect was less pronounced among college-educated subjects
We investigate how unconventional monetary policy, via central banks’ purchases of corporate bonds, unfolds in credit-saturated markets. While this policy results in a loosening of credit market conditions as intended by policymakers, we report two unintended side effects. First, the policy impacts the allocation of credit among industries. Affected banks reallocate loans from investment-grade firms active on bond markets almost entirely to real estate asset managers. Other industries do not obtain more loans, particularly real estate developers and construction firms. We document an increase in real estate prices due to this policy, which fuels real estate overvaluation. Second, more loan write-offs arise from lending to these firms, and banks are not compensated for this risk by higher interest rates. We document a drop in bank profitability and, at the same time, a higher reliance on real estate collateral. Our findings suggest that central banks’ quantitative easing has substantial adverse effects in credit-saturated economies.
The Eurosystem and the Deutsche Bundesbank will incur substantial losses in 2023 that are likely to persist for several years. Due to the massive purchases of securities in the last 10 years, especially of government bonds, the banks' excess reserves have risen sharply. The resulting high interest payments to the banks since the turnaround in monetary policy, with little income for the large-scale securities holdings, led to massive criticism. The banks were said to be making "unfair" profits as a result, while the fiscal authorities had to forego the previously customary transfers of central bank profits. Populist demands to limit bank profits by, for example, drastically increasing the minimum reserve ratios in the Eurosystem to reduce excess reserves are creating new severe problems and are neither justified nor helpful. Ultimately, the EU member states have benefited for a very long time from historically low interest rates because of the Eurosystem's extraordinary loose monetary policy and must now bear the flip side consequences of the massive expansion of central bank balance sheets during the necessary period of monetary policy normalisation.
The forward guidance trap
(2023)
This paper examines the policy experience of the Fed, ECB and BOJ during and after the Covid-19 pandemic and draws lessons for monetary policy strategy and ist communication. All three central banks provided appropriate accommodation during the pandemic but two failed to unwind this accommodation in a timely manner. The Fed and ECB guided real interest rates to inappropriately negative levels as the economy recovered from the pandemic, fueling high inflation. The policy error can be traced to decisions regarding forward guidance on policy rates that delayed lift-off while the two central banks continued to expand their balance sheets. The Fed and the ECB fell into the forward guidance trap. This could have been avoided if policy were guided by a forward- looking rule that properly adjusted the nominal interest rate with the evolution of the inflation outlook.
We present determinacy bounds on monetary policy in the sticky information model. We find that these bounds are more conservative here when the long run Phillips curve is vertical than in the standard Calvo sticky price New Keynesian model. Specifically, the Taylor principle is now necessary directly - no amount of output targeting can substitute for the monetary authority’s concern for inflation. These determinacy bounds are obtained by appealing to frequency domain techniques that themselves provide novel interpretations of the Phillips curve.
In his speech at the conference „The SNB and its Watchers“, Otmar Issing, member of the ECB Governing Council from its start in 1998 until 2006, takes a look back at more than twenty years of the conference series „The ECB and Its Watchers“. In June 1999, Issing established this format together with Axel Weber, then Director of the Center for Financial Studies, to discuss the monetary policy strategy of the newly founded central bank with a broad circle of participants, that is academics, bank economists and members of the media on a „neutral ground“. At the annual conference, the ECB and its representatives would play an active role and engage in a lively exchange of view with the other participants. Over the years, Volker Wieland took over as organizer of the conference series, which also was adopted by other central banks. In his contribution at the second conference „The SNB and its Watchers“, Issing summarizes the experience gained from over twenty years of the ECB Watchers Conference.
Standard applications of the consumption-based asset pricing model assume that goods and services within the nondurable consumption bundle are substitutes. We estimate substitution elasticities between different consumption bundles and show that households cannot substitute energy consumption by consumption of other nondurables. As a consequence, energy consumption affects the pricing function as a separate factor. Variation in energy consumption betas explains a large part of the premia related to value, investment, and operating profitability. For example, value stocks are typically more energy-intensive than growth stocks and thus riskier, since they suffer more from the oil supply shocks that also affect households.
Can consumption-based mechanisms generate positive and time-varying real term premia as we see in the data? I show that only models with time-varying risk aversion or models with high consumption risk can independently produce these patterns. The latter explanation has not been analysed before with respect to real term premia, and it relies on a small group of investors exposed to high consumption risk. Additionally, it can give rise to a “consumption-based arbitrageur” story of term premia. In relation to preferences, I consider models with both time-separable and recursive utility functions. Specifically for recursive utility, I introduce a novel perturbation solution method in terms of the intertemporal elasticity of substitution. This approach has not been used before in such models, it is easy to implement, and it allows a wide range of values for the parameter of intertemporal elasticity of substitution.
Shallow meritocracy
(2023)
Meritocracies aspire to reward hard work and promise not to judge individuals by the circumstances into which they were born. However, circumstances often shape the choice to work hard. I show that people's merit judgments are "shallow" and insensitive to this effect. They hold others responsible for their choices, even if these choices have been shaped by unequal circumstances. In an experiment, US participants judge how much money workers deserve for the effort they exert. Unequal circumstances disadvantage some workers and discourage them from working hard. Nonetheless, participants reward the effort of disadvantaged and advantaged workers identically, regardless of the circumstances under which choices are made. For some participants, this reflects their fundamental view regarding fair rewards. For others, the neglect results from the uncertain counterfactual. They understand that circumstances shape choices but do not correct for this because the counterfactual—what would have happened under equal circumstances—remains uncertain.
A key solution for public good provision is the voluntary formation of institutions that commit players to cooperate. Such institutions generate inequality if some players decide not to participate but cannot be excluded from cooperation benefits. Prior research with small groups emphasizes the role of fairness concerns with positive effects on cooperation. We show that effects do not generalize to larger groups: if group size increases, groups are less willing to form institutions generating inequality. In contrast to smaller groups, however, this does not increase the number of participating players, thereby limiting the positive impact of institution formation on cooperation.
Many consumers care about climate change and other externalities associated with their purchases. We analyze the behavior and market effects of such “socially responsible consumers” in three parts. First, we develop a flexible theoretical framework to study competitive equilibria with rational consequentialist consumers. In violation of price taking, equilibrium feedback non-trivially dampens a consumer’s mitigation efforts, undermining responsible behavior. This leads to a new type of market failure, where even consumers who fully “internalize the externality” overconsume externality-generating goods. At the same time, socially responsible consumers change the relative effectiveness of taxes, caps, and other policies in lowering the externality. Second, since consumer beliefs about and preferences over dampening play a crucial role in our framework, we investigate them empirically via a tailored survey. Consistent with our model, consumers are predominantly consequentialist, and on average believe in dampening. Inconsistent with our model, however, many consumers fail to anticipate dampening. Third, therefore, we analyze how such “naive” consumers modify our theoretical conclusions. Naive consumers behave more responsibly than rational consumers in a single-good economy, but may behave less responsibly in a multi-good economy with cross-market spillovers. A mix of naive and rational consumers may yield the worst outcomes.
Dynamics of life course family transitions in Germany: exploring patterns, process and relationships
(2023)
This paper explores dynamics of family life events in Germany using discrete time event history analysis based on SOEP data. We find that higher educational attainment, better income level, and marriage emerge as salient protective factors mitigating the risk of mortality; better education also reduces the likelihood of first marriage whereas, lower educational attainment, protracted period, and presence of children act as protective factors against divorce. Our key finding shows that disparity in mean life expectancies between individuals from low- and high-income brackets is observed to be 9 years among males and 6 years among females, thereby illustrating the mortality inequality attributed to income disparities. Our estimates show that West Germans have low risk of death, less likelihood of first marriage, and they have a high risk of divorce and remarriage compared to East Germans.
We study the redistributive effects of inflation combining administrative bank data with an information provision experiment during an episode of historic inflation. On average, households are well-informed about prevailing inflation and are concerned about its impact on their wealth; yet, while many households know about inflation eroding nominal assets, most are unaware of nominal-debt erosion. Once they receive information on the debt-erosion channel, households update upwards their beliefs about nominal debt and their own real net wealth. These changes in beliefs causally affect actual consumption and hypothetical debt decisions. Our findings suggest that real wealth mediates the sensitivity of consumption to inflation once households are aware of the wealth effects of inflation.
We study the interplay of capital and liquidity regulation in a general equilibrium setting by focusing on future funding risks. The model consists of a banking sector with long-term illiquid investment opportunities that need to be financed by shortterm debt and by issuing equity. Reliance on refinancing long-term investment in the middle of the life-time is risky, since the next generation of potential short-term debt holders may not be willing to provide funding when the return prospects on the long-term investment turn out to be bad. For moderate return risk, equilibria with and without bank default coexist, and bank default is a self-fulfilling prophecy. Capital and liquidity regulation can prevent bank default and may implement the first-best. Yet the former is more powerful in ruling out undesirable equilibria and thus dominates liquidity regulation. Adding liquidity regulation to optimal capital regulation is redundant.
The pricing of digital art
(2023)
The intersection of recent advancements in generative artificial intelligence and blockchain technology has propelled digital art into the spotlight. Digital art pricing recognizes that owners derive utility beyond the artwork’s inherent value. We incorporate the consumption utility associated with digital art and model the stochastic discount factor and risk premiums. Furthermore, we conduct a calibration analysis to analyze the effects of shifts in the real and digital economy. Higher returns are required in a digital market upswing due to increased exposure to systematic risk and digital art prices are especially responsive to fluctuations in business cycles within digital markets.
Life insurance convexity
(2023)
Life insurers sell savings contracts with surrender options, which allow policyholders to prematurely receive guaranteed surrender values. These surrender options move toward the money when interest rates rise. Hence, higher interest rates raise surrender rates, as we document empirically by exploiting plausibly exogenous variation in monetary policy. Using a calibrated model, we then estimate that surrender options would force insurers to sell up to 2% of their investments during an enduring interest rate rise of 25 bps per year. We show that these fire sales are fueled by surrender value guarantees and insurers’ long-term investments.
This paper documents that the bond investments of insurance companies transmit shocks from insurance markets to the real economy. Liquidity windfalls from household insurance purchases increase insurers' demand for corporate bonds. Exploiting the fact that insurers persistently invest in a small subset of firms for identification, I show that these increases in bond demand raise bond prices and lower firms' funding costs. In response, firms issue more bonds, especially when their bond underwriters are well connected with investors. Firms use the proceeds to raise investment rather than equity payouts. The results emphasize the significant impact of investor demand on firms' financing and investment activities.
Gradient capital allocation, also known as Euler allocation, is a technique used to redistribute diversified capital requirements among different segments of a portfolio. The method is commonly employed to identify dominant risks, assessing the risk-adjusted profitability of segments, and installing limit systems. However, capital allocation can be misleading in all these applications because it only accounts for the current portfolio composition and ignores how diversification effects may change with a portfolio restructuring. This paper proposes enhancing the gradient capital allocation by adding “orthogonal convexity scenarios” (OCS). OCS identify risk concentrations that potentially drive portfolio risk and become relevant after restructuring. OCS have strong ties with principal component analysis (PCA), but they are a more general concept and compatible with common empirical patterns of risk drivers being fat-tailed and increasingly dependent in market downturns. We illustrate possible applications of OCS in terms of risk communication and risk limits.
Most insurers in the European Union determine their regulatory capital requirements based on the standard formula of Solvency II. However, there is evidence that the standard formula inaccurately reflects insurers’ risk situation and may provide misleading steering incentives. In the second pillar, Solvency II requires insurers to perform a so-called “Own Risk and Solvency Assessment” (ORSA). In their ORSA, insurers must establish their own risk measurement approaches, including those based on scenarios, in order to derive suitable risk assessments and address shortcomings of the standard formula. The idea of this paper is to identify scenarios in such a way that the standard formula in connection with the ORSA provides a reliable basis for risk management decisions. Using an innovative method for scenario identification, our approach allows for a simple but relatively precise assessment of marginal and even non-marginal portfolio changes. We numerically evaluate the proposed approach in the context of market risk employing an internal model from the academic literature and the Solvency Capital Requirement (SCR) calculation under Solvency II.
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.
Testing frequency and severity risk under various information regimes and implications in insurance
(2023)
We build on Peter et al. (2017) who examined the benefit of testing frequency risk under various information regimes. We first consider testing only severity risk, and whether the principle of indemnity, i.e. the usual contract term that excludes claims payments above the resulting insured loss, affects the insurance contracts offered and purchased. Under information regimes which are less restrictive (in terms of obtaining and using customer information), it is possible for the insurer to offer different contracts for tested and untested individuals. In the absence of the principle of indemnity, individuals will test their severity risk and a separating equilibrium ensues. With the principle of indemnity, given an actuarially fair pooled contract, individuals will not test for severity under less restrictive information regimes; a pooling equilibrium thus ensues. Under more restrictive information regimes, the insurer offers separating contracts. Individuals will test for severity and purchase appropriate contracts. We also consider testing for both frequency and severity risk. The results here are more varied. The highest gain in efficiency from testing results from one of the more restrictive information regimes. Generally under all information regimes, there is a greater gain in efficiency without the principle of indemnity than with the principle of indemnity.
European insurers are allowed to make discretionary decisions in the calculation of Solvency II capital requirements. These choices include the design of risk models (ranging from a standard formula to a full internal model) and the use of long-term guarantees measures. This article examines the impact and the drivers of discretionary decisions with respect to capital requirements for market risks. In a first step of our analysis, we assess the risk profiles of 49 stock insurers using daily market data. In a second step, we exploit hand-collected Solvency II data for the years 2016 to 2020. We find that long-term guarantees measures substantially influence the reported solvency ratios. The measures are chosen particularly by less solvent insurers and firms with high interest rate and credit spread sensitivities. Internal models are used more frequently by large insurers and especially for risks for which the firms have already found adequate immunization strategies.
Market risks account for an integral part of insurers' risk profiles. We explore market risk sensitivities of insurers in the United States and Europe. Based on panel regression models and daily market data from 2012 to 2018, we find that sensitivities are particularly driven by insurers' product portfolio. The influence of interest rate movements on stock returns is 60% larger for US than for European life insurers. For the former, interest rate risk is a dominant market risk with an effect that is five times larger than through corporate credit risk. For European life insurers, the sensitivity to interest rate changes is only 44% larger than toward credit default swap of government bonds, underlining the relevance of sovereign credit risk.
The financial sector plays an important role in financing the green transformation. Various regulatory initiatives in the EU aim to improve transparency in relation to the sustainability of financial products and the sustainability of economic activities of non-financial and financial undertakings. For credit institutions, the Green Asset Ratio (GAR) has been established by the European regulatory authorities as a key performance indicator (KPI) for measuring the proportion of Taxonomy-aligned on-balance-sheet exposure in relation to the total assets. The breakdown of the total GAR by type of counterparty, environmental objective and type of asset provides in-depth information about the sustainability profile of a credit institution. This information, which has not been available to date, may also initiate discussions between management and shareholders or other stakeholders regarding the future sustainability strategy of credit institutions. This paper provides an overview of the regulatory background and the method of calculating the GAR along different dimensions. Finally, the potential benefits and limitations of the GAR are discussed.
In current discussions on large language models (LLMs) such as GPT, understanding their ability to emulate facets of human intelligence stands central. Using behavioral economic paradigms and structural models, we investigate GPT’s cooperativeness in human interactions and assess its rational goal-oriented behavior. We discover that GPT cooperates more than humans and has overly optimistic expectations about human cooperation. Intriguingly, additional analyses reveal that GPT’s behavior isn’t random; it displays a level of goal-oriented rationality surpassing human counterparts. Our findings suggest that GPT hyper-rationally aims to maximize social welfare, coupled with a strive of self-preservation. Methodologically, our esearch highlights how structural models, typically employed to decipher human behavior, can illuminate the rationality and goal-orientation of LLMs. This opens a compelling path for future research into the intricate rationality of sophisticated, yet enigmatic artificial agents.
Flows of funds run by banks or by firms that belong to the same financial group as a bank are less volatile and less sensitive to bad past performance. This enables bank-affiliated funds to better weather distress and to hold lower precautionary cash buffers in comparison with their unaffiliated peers. Banks provide liquidity support to distressed affiliated funds by buying shares of those funds that are experiencing large outflows. This, in turn, diminishes the severity of strategic complementarities in investors’ redemptions. Liquidity support and other benefits of bank affiliation are conditional on the financial health of the parent company. Distress in the banking system spills over to the mutual fund sector via ownership links. Our research high-lights substantial dependencies between the banking system and the asset management industry, and identifies an important channel via which financial stability risks depend on the organisational structure of the financial sector.
Contagious stablecoins?
(2023)
Can competing stablecoins produce efficient and stable outcomes? We study competition among stablecoins pegged to a stable currency. They are backed by interest-bearing safe assets and can be redeemed with the issuer or traded in a secondary market. If an issuer sticks to an appropriate investment and redemption rule, its stablecoin is invulnerable to runs. Since an issuer must pay interest on its stablecoin if other issuers also pay interest, competing interest-bearing stablecoins, however, are contagious and can render the economy inefficient and unstable. The efficient allocation is uniquely implemented when regulation prevents interest payments on stablecoins.