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There is mounting evidence that retail investors make predictable, costly investment mistakes, including underinvestment, naïve diversification, and payment of excessive fund fees. Over the past thirty-five years, however, participant-directed 401(k) plans have largely replaced professionally managed pension plans, requiring unsophisticated retail investors to navigate the financial markets themselves. Policy-makers have struggled with regulatory interventions designed to improve the quality of investment decisions without a clear understanding of the reasons for investor mistakes. Absent such an understanding, it is difficult to design effective regulatory responses. This article offers a first step in understanding the investor decision-making process. We use an internet-based experiment to disentangle possible explanations for inefficient investment decisions. The experiment employs a simplified construct of an employee’s allocation among the options in a retirement plan coupled with technology that enables us to collect data on the specific information that investors choose to view. In addition to collecting general information about the process by which investors choose among mutual fund options, we employ an experimental manipulation to test the effect of an instruction on the importance of mutual fund fees. Pairing this instruction with simplified fee disclosure allows us to distinguish between motivation-limits and cognition-limits as explanations for the widespread findings that investors ignore fees in their investment decisions. Our results offer partial but limited grounds for optimism. On the one hand, within our simplified experimental construct, our subjects allocated more money, on average, to higher-value funds. Furthermore, subjects who received the fees instruction paid closer attention to mutual fund fees and allocated their investments into funds with lower fees. On the other hand, the effects of even a blunt fees instruction were limited, and investors were unable to identify and avoid clearly inferior fund options. In addition, our results suggest that excessive, naïve diversification strategies are driving many investment decisions. Although our findings are preliminary, they suggest valuable avenues for future research and important implications for regulation of retail investing.
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 for the period 1996 to 2006, we find that household demand for real estate is relatively high if the marginal investment in home equity is covered by the exemption. The home equity bias is more pronounced for younger households that face more financial uncertainty and therefore have a higher ex ante probability of bankruptcy.
We consider the continuous-time portfolio optimization problem of an investor with constant relative risk aversion who maximizes expected utility of terminal wealth. The risky asset follows a jump-diffusion model with a diffusion state variable. We propose an approximation method that replaces the jumps by a diffusion and solve the resulting problem analytically. Furthermore, we provide explicit bounds on the true optimal strategy and the relative wealth equivalent loss that do not rely on results from the true model. We apply our method to a calibrated affine model and fine that relative wealth equivalent losses are below 1.16% if the jump size is stochastic and below 1% if the jump size is constant and γ ≥ 5. We perform robustness checks for various levels of risk-aversion, expected jump size, and jump intensity.
What happened in Cyprus
(2013)
This policy letter sheds light on the economic and political backround in Cyprus and provides an analyses of the factors which lead to an intensification of the crisis there. It discusses the severe consequences of the errors made in the recent establishment of an adjustment program for Cyprus by the Europroup for European economic management as a whole.
Empirical evidence suggests that asset returns correlate more strongly in bear markets than conventional correlation estimates imply. We propose a method for determining complete tail correlation matrices based on Value-at-Risk (VaR) estimates. We demonstrate how to obtain more efficient tail-correlation estimates by use of overidentification strategies and how to guarantee positive semidefiniteness, a property required for valid risk aggregation and Markowitz{type portfolio optimization. An empirical application to a 30-asset universe illustrates the practical applicability and relevance of the approach in portfolio management.
We present a thought-provoking study of two monetary models: the cash-in-advance and the Lagos and Wright (2005) models. We report that the different approach to modeling money — reduced-form vs. explicit role — neither induces theoretical nor quantitative differences in results. Given conformity of preferences, technologies and shocks, both models reduce to one difference equation. The equations do not coincide only if price distortions are differentially imposed across models. To illustrate, when cash prices are equally distorted in both models equally large welfare costs of inflation are obtained in each model. Our insight is that if results differ, then this is due to differential assumptions about the pricing mechanism that governs cash transactions, not the explicit microfoundation of money.
This paper investigates risk-taking in the liquid portfolios held by a large panel of Swedish twins. We document that the portfolio share invested in risky assets is an increasing and concave function of financial wealth, leading to different risk sensitivities across investors. Human capital, which we estimate directly from individual labor income, also drives risk-taking positively, while internal habit and expenditure commitments tend to reduce it. Our micro findings lend strong support to decreasing relative risk aversion and habit formation preferences. Furthermore, heterogeneous risk sensitivities across investors help reconcile individual preferences with representative-agent models.
In the aftermath of the financial crisis, the ECB has experienced an unprecedented deterioration in the level of trust. This raises the question as to what factors determine trust in central banking. We use a unique cross-country dataset which includes a rich set of socio-economic characteristics and supplement it with variables meant to reflect a country’s macroeconomic condition. We find that besides individual socio-economic characteristics, macroeconomic conditions play a crucial role in the trust-building process. Our results suggest that agents are boundedly rational in the trust-building process and that current ECB market operations may even be beneficial for trust in the ECB in the long-run.
The efficacy of monetary authority actions depends primarily on the ability of the monetary authority to affect inflation expectations, which ultimately depend on agents' trust. We propose a model embedding trust cycles, as emerging from sequential coordination games between atomistic agents and the policy maker, in a monetary model. Trust affects agents' stochastic discount factor, namely the price of future risk, and their expectation formation process: these effects in turn interact with the monetary transmission mechanism. Using data from the Eurobarometer survey we analyze the link between trust on the one side and the transmission mechanism of shocks and of the policy rate on the other: data show that the two interact significantly and in a way comparable to the obtained in our model.
The paper looks at the determinants of fiscal adjustments as reflected in the primary surplus of countries. Our conjecture is that governments will usually find it more attractive to pursue fiscal adjustments in a situation of relatively high growth, but based on a simple stylized model of government behavior the expectation is that mainly high trust governments will be in a position to defer consolidation to years with higher growth. Overall, our analysis of a panel of European countries provides support for this expectation. The difference in fiscal policies depending on government trust levels may help explaining why better governed countries have been found to have less severe business cycles. It suggests that trust and credibility play an important role not only in monetary policy, but also in fiscal policy.
We investigate the theoretical impact of including two empirically-grounded insights in a dynamic life cycle portfolio choice model. The first is to recognize that, when managing their own financial wealth, investors incur opportunity costs in terms of current and future human capital accumulation, particularly if human capital is acquired via learning by doing. The second is that we incorporate age-varying efficiency patterns in financial decisionmaking. Both enhancements produce inactivity in portfolio adjustment patterns consistent with empirical evidence. We also analyze individuals’ optimal choice between self-managing their wealth versus delegating the task to a financial advisor. Delegation proves most valuable to the young and the old. Our calibrated model quantifies welfare gains from including investment time and money costs, as well as delegation, in a life cycle setting.
This paper analyzes the evolving architecture for the prudential supervision of banks in the euro area. It is primarily concerned with the likely effectiveness of the SSM as a regime that intends to bolster financial stability in the steady state.
By using insights from the political economy of bureaucracy it finds that the SSM is overly focused on sharp tools to discipline captured national supervisors and thus under-incentives their top-level personnel to voluntarily contribute to rigid supervision. The success of the SSM in this regard will hinge on establishing a common supervisory culture that provides positive incentives for national supervisors. In this regard, the internal decision making structure of the ECB in supervisory matters provides some integrative elements. Yet, the complex procedures also impede swift decision making and do not solve the problem adequately. Ultimately, a careful design and animation of the ECB-defined supervisory framework and the development of inter-agency career opportunities will be critical.
The ECB will become a de facto standard setter that competes with the EBA. A likely standoff in the EBA’s Board of Supervisors will lead to a growing gap in regulatory integration between SSM-participants and other EU Member States.
Joining the SSM as a non-euro area Member State is unattractive because the cur-rent legal framework grants no voting rights in the ECB’s ultimate decision making body. It also does not supply a credible commitment opportunity for Member States who seek to bond to high quality supervision.
This paper analyzes the evolving architecture for the prudential supervision of banks in the euro area. It is primarily concerned with the likely effectiveness of the SSM as a regime that intends to bolster financial stability in the steady state. By using insights from the political economy of bureaucracy it finds that the SSM is overly focused on sharp tools to discipline captured national supervisors and thus underincentives their top-level personnel to voluntarily contribute to rigid supervision. The success of the SSM in this regard will hinge on establishing a common supervisory culture that provides positive incentives for national supervisors. In this regard, the internal decision making structure of the ECB in supervisory matters provides some integrative elements. Yet, the complex procedures also impede swift decision making and do not solve the problem adequately. Ultimately, a careful design and animation of the ECB-defined supervisory framework and the development of inter-agency career opportunities will be critical.
The ECB will become a de facto standard setter that competes with the EBA. A likely standoff in the EBA’s Board of Supervisors will lead to a growing gap in regulatory integration between SSM-participants and other EU Member States.
Joining the SSM as a non-euro area Member State is unattractive because the current legal framework grants no voting rights in the ECB’s ultimate decision making body. It also does not supply a credible commitment opportunity for Member States who seek to bond to high quality supervision.
Insurance guarantee schemes aim to protect policyholders from the costs of insurer insolvencies. However, guarantee schemes can also reduce insurers’ incentives to conduct appropriate risk management. We investigate stock insurers’ risk-shifting behavior for insurance guarantee schemes under the two different financing alternatives: a flat-rate premium assessment versus a risk-based premium assessment. We identify which guarantee scheme maximizes policyholders’ welfare, measured by their expected utility. We find that the risk-based insurance guarantee scheme can only mitigate the insurer’s risk-shifting behavior if a substantial premium loading is present. Furthermore, the risk-based guarantee scheme is superior for improving policyholders’ welfare compared to the flat-rate scheme when the mitigating effect occurs.
The article makes two points regarding the fundamental rights dimensions of intellectual property (IP). First, it explains why the prevailing approach to balancing the fundamental right to intellectual property with conflicting fundamental freedoms as if they were of equal rank is conceptually flawed and should be replaced by a justification paradigm. Second, it highlights the pre-eminent role of the legislature and the much more limited role of the judiciary in developing IP law. The arguments are based on an analysis of the jurisprudence of the European Court of Human Rights (ECHR), the Court of Justice of the European Union (CJEU) and last but not least the German Constitutional Court, the Bundesverfassungsgericht, regarding the respective inter-/supra-/national fundamental-rights regimes.
This note reviews the legal issues and concerns that are likely to play an important role in the ongoing deliberations of the Federal Constitutional Court of Germany concerning the legality of ECB government bond purchases such as those conducted in the context of its earlier Securities Market Programme or potential future Outright Monetary Transactions.
This note reviews the legal issues and concerns that are likely to play an important role in the ongoing deliberations of the Federal Constitutional Court of Germany concerning the legality of ECB government bond purchases such as those conducted in the context of its earlier Securities Market Programme or potential future Outright Monetary Transactions.
This study contains articles based on speeches and presentations at the 14th CFS-IMFS Conference "The ECB and its Watchers" on June 15, 2012 by Mario Draghi, John Vickers, Peter Praet, Lucrezia Reichlin, Vitor Gaspar, Lucio Pench and Stefan Gerlach and a post-conference outlook by Helmut Siekmann and Volker Wieland.
We provide an assessment of the determinants of the risk remia paid by non-financial corporations on long-term bonds. By looking at 5,500 issues over the period 2005-2012, we find that in recent years the sovereign debt market turbulence has been a major driver of corporate risk. Compared with the three-year period 2005-07 before the global financial crisis, in the years 2010-12 Italian, Spanish and Portuguese firms paid on average between 70 and 120 basis points of additional premium due to the negative spillovers from the sovereign debt crisis, while German firms got a discount of 40 basis points.
This study presents an empirical analysis of capital and liability management in eight cases of bank restructurings and resolutions from eight different European countries. It can be read as a companion piece to an earlier study by the author covering the specific bank restructuring programs of Greece, Spain and Cyprus during 2012/13.
The study portrays for each case the timelines between the initial credit event and the (last) restructuring. It proceeds to discuss the capital and liability management activity before restructuring and the restructuring itself, launches an attempt to calibrate the extent of creditor participation as well as expected loss by government, and engages in a counterfactual discussion of what could have been a least cost restructuring approach.
Four of the eight cases are resolutions, i.e. the original bank is unwound (Anglo Irish Bank, Amagerbanken, Dexia, Laiki), while the four other banks have de-facto or de-jure become nationalized and are awaiting re-privatization after the restructuring (Deutsche Pfandbriefbank/Hypo Real Estate, Bankia, SNS Reaal, Alpha Bank). The case selection follows considerations of their model character for the European bank restructuring and resolution policy discussion while straddling both the U.S. (2007 - 2010) and the European (2010 - ) legs of the financial crisis, which each saw very different policy responses....
The 2011 European short sale ban on financial stocks: a cure or a curse? : [version 31 july 2013]
(2013)
Did the August 2011 European short sale bans on financial stocks accomplish their goals? In order to answer this question, we use stock options’ implied volatility skews to proxy for investors’ risk aversion. We find that on ban announcement day, risk aversion levels rose for all stocks but more so for the banned financial stocks. The banned stocks’ volatility skews remained elevated during the ban but dropped for the other unbanned stocks. We show that it is the imposition of the ban itself that led to the increase in risk aversion rather than other causes such as information flow, options trading volumes, or stock specific factors. Substitution effects were minimal, as banned stocks’ put trading volumes and put-call ratios declined during the ban. We argue that although the ban succeeded in curbing further selling pressure on financial stocks by redirecting trading activity towards index options, this result came at the cost of increased risk aversion and some degree of market failure.
In this note, a new concept for a European deposit guarantee scheme is proposed, which takes account of the strong political reservations against a mutualization of the liability for bank deposits. The three-stage model for deposit insurance outlined in the text builds on existing national deposit guarantee schemes, offering loss compensation on a European level and at the same time preventing excessive risk and moral hazard taking by individual banks.
We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability.
We would study not style as such, but style 'at the scale of the sentence': the lowest level, it seemed, at which style as a distinct phenomenon became visible. Implicitly, we were defining style as a combination of smaller linguistic units, which made it, in consequence, particularly sensitive to changes in scale—from words to clauses to whole sentences.
A natural experiment in which customer-owned mutual companies converted to publicly listed firms created a plausibly exogenous shock to the stock market participation status of tens of thousands of people. We find the shock changed the way people vote in the affected areas, with a 10% increase in share-ownership rate being followed by a 1.3%–3.1% increase in right-of-center vote share. The institutional details and additional tests suggest that wealth, liquidity, and tax-related incentives cannot fully explain the results. A plausible explanation is that the associated increase in the salience of stock ownership causes a shift in voters’ attention.
Stability maintenance at the grassroots: China’s weiwen apparatus as a form of conflict resolution
(2013)
This working paper explores the history and potential of “stability maintenance” (weiwen) as a form of conflict resolution in China. Its emphasis on conflict resolution is novel. Previous examinations of the weiwen apparatus have concentrated on its political function, namely to manage resistance within society and maintain the authority of the party-state. This avenue of investigation has proved fruitful as a means of characterising the political motivation and the higher-level strategies involved in stability maintenance. Nonetheless, there remain significant conceptual and empirical gaps relating to how stability maintenance offices and processes actually function, particularly out of larger cities and at local levels. The research described in this paper aims to consider the effectiveness of stability maintenance as a part of the “market” for conflict resolution in local China, and to test the hypothesis that conflict resolution as facilitated by weiwen is the most pragmatic and effective means of actually resolving conflicts in the current Chinese political context, notwithstanding the closeness of the stability maintenance discourse to state authority and its relative distance from rule of law-based methods of dispute resolution...
Sovereign bond risk premiums
(2013)
Credit risk has become an important factor driving government bond returns. We therefore introduce an asset pricing model which exploits information contained in both forward interest rates and forward CDS spreads. Our empirical analysis covers euro-zone countries with German government bonds as credit risk-free assets. We construct a market factor from the first three principal components of the German forward curve as well as a common and a country-specific credit factor from the principal components of the forward CDS curves. We find that predictability of risk premiums of sovereign euro-zone bonds improves substantially if the market factor is augmented by a common and an orthogonal country-specific credit factor. While the common credit factor is significant for most countries in the sample, the country-specific factor is significant mainly for peripheral euro-zone countries. Finally, we find that during the current crisis period, market and credit risk premiums of government bonds are negative over long subintervals, a finding that we attribute to the presence of financial repression in euro-zone countries.
This paper shows equivalence of applicative similarity and contextual approximation, and hence also of bisimilarity and contextual equivalence, in LR, the deterministic call-by-need lambda calculus with letrec extended by data constructors, case-expressions and Haskell's seqoperator. LR models an untyped version of the core language of Haskell. Bisimilarity simplifies equivalence proofs in the calculus and opens a way for more convenient correctness proofs for program transformations.
The proof is by a fully abstract and surjective transfer of the contextual approximation into a call-by-name calculus, which is an extension of Abramsky's lazy lambda calculus. In the latter calculus equivalence of similarity and contextual approximation can be shown by Howe's method. Using an equivalent but inductive definition of behavioral preorder we then transfer similarity back to the calculus LR.
The translation from the call-by-need letrec calculus into the extended call-by-name lambda calculus is the composition of two translations. The first translation replaces the call-by-need strategy by a call-by-name strategy and its correctness is shown by exploiting infinite tress, which emerge by unfolding the letrec expressions. The second translation encodes letrec-expressions by using multi-fixpoint combinators and its correctness is shown syntactically by comparing reductions of both calculi. A further result of this paper is an isomorphism between the mentioned calculi, and also with a call-by-need letrec calculus with a less complex definition of reduction than LR.
The recent wave of randomized trials in development economics has provoked criticisms regarding external validity. We investigate two concerns—heterogeneity across beneficiaries and implementers—in a randomized trial of contract teachers in Kenyan schools. The intervention, previously shown to raise test scores in NGO- led trials in Western Kenya and parts of India, was replicated across all Kenyan provinces by an NGO and the government. Strong effects of shortterm contracts produced in controlled experimental settings are lost in weak public institutions: NGO implementation produces a positive effect on test scores across diverse contexts, while government implementation yields zero effect. The data suggests that the stark contrast in success between the government and NGO arm can be traced back to implementation constraints and political economy forces put in motion as the program went to scale.
Until about 25 years ago, almost all European countries had a so-called “three pillar” banking system comprising private banks, (public) savings banks and (mutual) cooperative banks. Since that time, several European countries have implemented far-reaching changes in their banking systems, which have more than anything else affected the two “pillars” of the savings and cooperative banks. The article describes the most important changes in Germany, Austria, France, Italy and Spain and characterizes the former and the current roles of savings banks and cooperative banks in these countries. A particular focus is placed on the German case, which is almost unique in so far as the German savings banks and cooperative banks have maintained most of their traditional features. The article concludes with a plea for diversity of institutional forms of banks and argues that it is important to safeguard the strengths of those types of banks that do not conform to the model of a large shareholder-oriented commercial bank.
There is a prevalent view outside Greece that promotion of competitiveness is tantamount with price reductions for Greek goods and services. Massive horizontal salary cuts appear, at first, to promote competitiveness by reducing unit labor costs and to reduce fiscal deficits by reducing the wage bill of the public sector. Upon closer look, however, horizontal salary cuts have been much greater than needed for Greek competitiveness, providing an alibi vis a vis the Troika for reforms that are still to be implemented, but at the same time undermining both competitiveness and the potential to reduce public debt through sustainable development.
This paper employs stochastic simulations of the New Area-Wide Model—a microfounded open-economy model developed at the ECB—to investigate the consequences of the zero lower bound on nominal interest rates for the evolution of risks to price stability in the euro area during the recent financial crisis. Using a formal measure of the balance of risks, which is derived from policy-makers’ preferences about inflation outcomes, we first show that downside risks to price stability were considerably greater than upside risks during the first half of 2009, followed by a gradual rebalancing of these risks until mid-2011 and a renewed deterioration thereafter. We find that the lower bound has induced a noticeable downward bias in the risk balance throughout our evaluation period because of the implied amplification of deflation risks. We then illustrate that, with nominal interest rates close to zero, forward guidance in the form of a time-based conditional commitment to keep interest rates low for longer can be successful in mitigating downside risks to price stability. However, we find that the provision of time-based forward guidance may give rise to upside risks over the medium term if extended too far into the future. By contrast, time-based forward guidance complemented with a threshold condition concerning tolerable future inflation can provide insurance against the materialisation of such upside risks.
This paper summarizes the key proposals of the report by the Liikanen Commission. It starts with an explanation of a crisis narrative underlying the Report and its proposals. The proposals aim for a revitalization of market discipline in financial markets. The two main structural proposals of the Liikanen Report are: first, for large banks, the separation of the trading business from other parts of the banking business (the "Separation Proposal"), and the mandatory issuing of subordinated bank debt thought to be liable (the strict "Bail-in Proposal"). The credibility of this commitment to private liability is achieved by strict holding restrictions. The anticipated consequences of the introduction of these structural regulations for the financial industry and markets are addressed in a concluding part.
Can be a world order shaped by equivalents in the framework of the supranational model of Europe with the same legitimacy and with the same effectiveness? In this study was argued that Civilizing World Order (CWO) by Transnational Norm-Building Networks (TNNs) should have the legitimacy and effectiveness of the European Union supranational order. In this context, the concept of decentration (supra: centralization and infra: decentralization) which includes the nexus of voice (democratic participation) and entitlement (legal-social rights and duties) was examined. In this study as methodology published secondary data, online resources were used in order to reinforce the hypothesis.
This study investigates the transition from being a listed company with a dispersed ownership structure to being a privately held company with a concentrated ownership structure. We consider a sample of private equity backed portfolio companies to evaluate the consequences of the corporate governance changes on operational performance. Our analysis shows significant positive abnormal growth in several performance ratios for the private period of our sample companies relative to comparable public companies. These performance differences come from the increase in ownership concentration after the leveraged buyout transaction.
This paper compares two classes of models that allow for additional channels of correlation between asset returns: regime switching models with jumps and models with contagious jumps. Both classes of models involve a hidden Markov chain that captures good and bad economic states. The distinctive feature of a model with contagious jumps is that large negative returns and unobservable transitions of the economy into a bad state can occur simultaneously. We show that in this framework the filtered loss intensities have dynamics similar to self-exciting processes. Besides, we study the impact of unobservable contagious jumps on optimal portfolio strategies and filtering.
Pursuant to art. 45 of the Solvency II Framework Directive, all insurance undertakings will be obliged to conduct an “Own Risk and Solvency Assessment” (ORSA). ORSA’s relevance is not limited only to the second pillar of Solvency II, where mainly qualitative requirements are to be found. ORSA rather exhibits strong interlinks with the first pillar and its quantitative requirements and may also serve as a trigger for transparency duties which form Solvency II’s third pillar. ORSA may thus be described in some respects as the glue that binds together all three pillars of Solvency II. ORSA is one of the most obvious examples of the supervisory shift from a rules-based to a principles-based approach. As such, ORSA has hitherto been only very roughly defined. Since it is for the undertaking to determine its own specific risk profile and to evaluate whether this risk profile deviates significantly from the assumptions underlying the standard formula, it seems only natural that the supervisor must specify in greater detail what these underlying assumptions are. The most practicable way to do so would be for EIOPA to establish a “standard insurer”, which implies a translation of the assumptions concerning the underlying probability distributions into directly observable characteristics. The creation of the standard insurer would be an important step towards relaxing the insurers’ fear of what ORSA might bring about.
We study whether prices of traded options contain information about future extreme market events. Our option-implied conditional expectation of market loss due to tail events, or tail loss measure, predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-specific tail loss measure predicts individual expected returns and magnitude of realized stock-specific crashes in the cross-section of stocks. An investor that cares about the left tail of her wealth distribution benefits from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index.
We examine whether the robustifying nature of Taylor rule cross-checking under model uncertainty carries over to the case of parameter uncertainty. Adjusting monetary policy based on this kind of cross-checking can improve the outcome for the monetary authority. This, however, crucially depends on the relative welfare weight that is attached to the output gap and also the degree of monetary policy commitment. We find that Taylor rule cross-checking is on average able to improve losses when the monetary authority only moderately cares about output stabilization and when policy is set in a discretionary way.
We propose a new classification of consumption goods into nondurable goods, durable goods and a new class which we call “memorable” goods. A good is memorable if a consumer can draw current utility from its past consumption experience through memory. We construct a novel consumption-savings model in which a consumer has a well-defined preference ordering over both nondurable goods and memorable goods. Memorable goods consumption differs from nondurable goods consumption in that current memorable goods consumption may also impact future utility through the accumulation process of the stock of memory. In our model, households optimally choose a lumpy profile of memorable goods consumption even in a frictionless world. Using Consumer Expenditure Survey data, we then document levels and volatilities of different groups of consumption goods expenditures, as well as their expenditure patterns, and show that the expenditure patterns on memorable goods indeed differ significantly from those on nondurable and durable goods. Finally, we empirically evaluate our model’s predictions with respect to the welfare cost of consumption fluctuations and conduct an excess-sensitivity test of the consumption response to predictable income changes. We find that (i) the welfare cost of household-level consumption fluctuations may be overstated by 1.7 percentage points (11.9% points as opposed to 13.6% points of permanent consumption) if memorable goods are not appropriately accounted for; (ii) the finding of excess sensitivity of consumption documented in important papers of the literature might be entirely due to the presence of memorable goods.
Motivated by our experience in analyzing properties of translations between programming languages with observational semantics, this paper clarifies the notions, the relevant questions, and the methods, constructs a general framework, and provides several tools for proving various correctness properties of translations like adequacy and full abstractness. The presented framework can directly be applied to the observational equivalences derived from the operational semantics of programming calculi, and also to other situations, and thus has a wide range of applications.
We assess the effects of monetary policy on bank risk to verify the existence of a risk-taking channel - monetary expansions inducing banks to assume more risk. We first present VAR evidence confirming that this channel exists and tends to concentrate on the bank funding side. Then, to rationalize this evidence we build a macro model where banks subject to runs endogenously choose their funding structure (deposits vs. capital) and risk level. A monetary expansion increases bank leverage and risk. In turn, higher bank risk in steady state increases asset price volatility and reduces equilibrium output.
Mindfully Resisting the Bandwagon – IT Implementation and Its Consequences in the Financial Crisis
(2013)
Although the ”financial meltdown” between 2007 and 2009 can be substantially attributed to herding behaviour in the subprime market for credit default swaps, a “mindless” IT implementation of participating financial services providers played a major role in the facilitation of the underlying bandwagon. The problem was a discrepancy between two core complementary capabilities: (1.) the (economic-rationalistic) ability to execute financial transactions (to comply with the herd) in milliseconds and (2.) the required contextualized mindfulness capabilities to comprehend the implications of the transactions being executed and the associated IT innovation decisions that enabled these transactions.
The paper focuses on the problems of a juridical classification and evaluation of Ancient Near Eastern treaties with regard to the question if there existed an Ancient Near Eastern International Law or not. Alternatively treaties and their content are looked at uncommitted as mechanisms of conflict and dispute resolution. Main aspects are preliminary and prophylactic conflict resolution in treaties and the procedural context and efficiency of treaties.
This paper takes a novel approach to estimating bankruptcy costs by inference from market prices of equity and put options using a dynamic structural model of capital structure. This approach avoids the selection bias of looking at firms in or near default and therefore permits theories of ex ante capital structure determination to be tested. We identify significant cross sectional variation in bankruptcy costs across industries and relate these to specific firm characteristics. We find that asset volatility and growth options have significant positive impacts, while tangibility and size have negative impacts. Our bankruptcy cost variable estimate significantly negatively impacts leverage ratios. This negative impact is in addition to that of other firm characteristics such as asset intangibility and asset volatility. The results provide strong support for the tradeoff theory of capital structure.
Prior research suggests that those who rely on intuition rather than effortful reasoning when making decisions are less averse to risk and ambiguity. The evidence is largely correlational, however, leaving open the question of the direction of causality. In this paper, we present experimental evidence of causation running from reliance on intuition to risk and ambiguity preferences. We directly manipulate participants’ predilection to rely on intuition and find that enhancing reliance on intuition lowers the probability of being ambiguity averse by 30 percentage points and increases risk tolerance by about 30 percent in the experimental sub-population where we would a priori expect the manipulation to be successful(males).
Between the 12th and 16th centuries the Hanseatic merchants obtained extremely important privileges from the rulers of the countries with whom they traded. These secured their commercial and legal status and the autonomy of their staples in Flanders, England, Norway, Denmark and Russia. Within these privileges no other subject receives so extensive a treatment as court procedure. Here, the single most important concern of the Hanseatic merchants was their position in front of alien courts. The article analyses the great attention given to court procedure in the twenty main Hanseatic privileges: What did the merchants require? Which procedural rules were necessary to encourage them to submit their disputes to alien public court instead of taking the matter into their own hands and turning to extra-judicial methods to resolve matters, e.g. cancellation of business relations, boycotts or even trade wars? This analysis suggests that the two most important concerns reflected in the procedural rules were to avoid delay to the next trading trip and to ensure a rational law of proof. The former was addressed by pressing for short-term scheduling and swift judgment and by the dispensation from appearing before the court in person. The latter included avoidance of duels and other ordeals and the attempt to obtain parity by appointing half of the jurors from Hanseatic cities.
The German corporate governance code includes a recommendation as to diversity on corporate boards. Two draft bills on gender quotas are currently under way in legislative proceedings. However, the ruling coalition rejects those, advocating a “flexible quota”. The present study provides an overview on legislative proposals currently presented and on academic scholarship on the issue. Legal obstacles to the introduction of a “fix” quota under German law are discussed and the “soft” version of “flexible” quotas is advocated.
Following the experience of the global financial crisis, central banks have been asked to undertake unprecedented responsibilities. Governments and the public appear to have high expectations that monetary policy can provide solutions to problems that do not necessarily fit in the realm of traditional monetary policy. This paper examines three broad public policy goals that may overburden monetary policy: full employment; fiscal sustainability; and financial stability. While central banks have a crucial position in public policy, the appropriate policy mix also involves other institutions, and overreliance on monetary policy to achieve these goals is bound to disappoint. Central Bank policies that facilitate postponement of needed policy actions by governments may also have longer-term adverse consequences that could outweigh more immediate benefits. Overburdening monetary policy may eventually diminish and compromise the independence and credibility of the central bank, thereby reducing its effectiveness to preserve price stability and contribute to crisis management.
The German Capital Markets Model Case Act (KapMuG) and its amendment of 2012 highlight some fundamentals of collective redress in civil law countries at the example of model case procedures in the field of investor protection. That is why a survey of the ongoing activities of the European Union in the area of collective redress and of its repercussions on the member state level forms a suitable basis for the following analysis of the 2012 amendment of the KapMuG. It clearly brings into focus a shift from sector-specific regulation with an emphasis on the cross-border aspect of protecting consumers towards a “coherent approach” strengthening the enforcement of EU law. As a result, regulatory policy and collective redress are two sides of the same coin today. With respect to the KapMuG such a development brings about some tension between its aim to aggregate small individual claims as efficiently as possible and the dominant role of individual procedural rights in German civil procedure. This conflict can be illustrated by some specific rules of the KapMuG: its scope of application, the three-tier procedure of a model case procedure, the newly introduced notification of claims and the new opt-out settlement under the amended §§ 17-19.
Model case procedures have some fundamentals in common with collective redress in civil law countries. This is particularly true in the field of investor protection which is highly regulated and marked by resulting enforcement failures, which led the German legislator to the enactment of the KapMuG and its recent amendment which highlight exemplary elements of model case procedure. A survey of the ongoing activities of the European Union in the area of collective redress and of its repercussions on the member state level therefore forms a suitable basis for the following analysis of the 2012 amendment of the KapMuG. It clearly brings into focus a shift from sector-specific regulation with an emphasis on the cross-border aspect of protecting consumers towards a “coherent approach” strengthening the enforcement of EU law. As a result, regulatory policy and collective redress are two sides of the same coin today. With respect to the KapMuG such a development brings about some tension between its aim to aggregate small individual claims as efficiently as possible and the dominant role of individual procedural rights in German civil procedure. This conflict can be illustrated by some specific rules of the KapMuG: its scope of application, the three-tier procedure of a model case procedure, the newly introduced notification of claims and the new opt-out settlement under the amended §§ 17-19.
Investment in financial literacy, social security and portfolio choice : [version may 21, 2013]
(2013)
We present an intertemporal portfolio choice model where individuals invest in financial literacy, save, allocate their wealth between a safe and a risky asset, and receive a pension when they retire. Financial literacy affects the excess return and the cost of stock market participation. Since literacy depreciates over time and has a cost related to current consumption, investors simultaneously choose how much to save, the portfolio allocation, and the optimal investment in literacy. This last depends on households' resources, its preference parameters and on how much financial literacy affects the returns on risky assets and the stock market participation cost, and the returns on social security wealth. The model implies one should observe a positive correlation between stock market participation (and risky asset share, conditional on participation) and financial literacy, and a negative correlation between the generosity of the social security system and financial literacy. The model also implies that the stock of financial literacy accumulated early in life is positively correlated with the individual's wealth and portfolio allocations later in life. Using microeconomic cross-country data, we find support for these predictions.
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.
Although intellectual property law is a distinctively Western, modern, and relatively young body of law, it has spread all over the world, now encompassing all but a very few outsiders such as Afghanistan, Somalia, and Vanuatu. This article presents three legal transfers that contributed to this development: first, from real property in land and movables to intellectual property in the late 18th century in Western Europe; second, from Western Europe, in particular from the United Kingdom and France to the rest of the world during the colonial era in the 19th and early 20th century; third, from the protection of new knowledge to the protection of traditional knowledge, held by indigenous communities in developing countries, on 5 August 1963. This story illuminates how legal transfers in a broad sense – including, but not limited to legal transplants - drive the evolution of law.
We are able to shed light on the black box of restructuring tools private equity investors use to improve the operational performance of their portfolio companies. By building on previous work considering performance evaluation of PE backed companies, we analyze whether private equity improves operating efficiency and which of the typical restructuring tools are the main performance drivers. Using a set of over 300 international leveraged buyout transactions of 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 influence while financial leverage has no influence on operational performance.
The analyses of intersectoral linkages of Leontief (1941) and Hirschman (1958) provide a natural way to study the transmission of risk among interconnected banks and to measure their systemic importance. In this paper we show how classic input-output analysis can be applied to banking and how to derive six indicators that capture different aspects of systemic importance, using a simple numerical example for illustration. We also discuss the relationship with other approaches, most notably network centrality measures, both formally and by means of a simulated network.
Household decisions are profoundly shaped by a complex set of financial options due to Social Security rules determining retirement, spousal, and survivor benefits, along with benefit adjustments that vary with the age at which these are claimed. These rules influence optimal household asset allocation, insurance, and work decisions, given life cycle demographic shocks such as marriage, divorce, and children. Our model generates a wealth profile and a low and stable equity fraction consistent with empirical evidence. We also confirm predictions that wives will claim retirement benefits earlier than husbands, while life insurance is mainly purchased by younger men. Our policy simulations imply that eliminating survivor benefits would sharply reduce claiming differences by sex while dramatically increasing men’s life insurance purchases.
This paper analyzes the equilibrium pricing implications of contagion risk in a Lucas-tree economy with recursive preferences and jumps. We introduce a new economic channel allowing for the possibility that endowment shocks simultaneously trigger a regime shift to a bad economic state. We document that these contagious jumps have far-reaching asset pricing implications. The risk premium for such shocks is superadditive, i.e. it is 2.5\% larger than the sum of the risk premia for pure endowment shocks and regime switches. Moreover, contagion risk reduces the risk-free rate by around 0.5\%. We also derive semiclosed-form solutions for the wealth-consumption ratio and the price-dividend ratios in an economy with two Lucas trees and analyze cross-sectional effects of contagion risk qualitatively. We find that heterogeneity among the assets with respect to contagion risk can increase risk premia disproportionately. In particular, big assets with a large exposure to contagious shocks carry significantly higher risk premia.
This paper tests whether an increase in insured deposits causes banks to become more risky. We use variation introduced by the U.S. Emergency Economic Stabilization Act in October 2008, which increased the deposit insurance coverage from $100,000 to $250,000 per depositor and bank. For some banks, the amount of insured deposits increased significantly; for others, it was a minor change. Our analysis shows that the more affected banks increase their investments in risky commercial real estate loans and become more risky relative to unaffected banks following the change. This effect is most distinct for affected banks that are low capitalized.
Debt-induced crises, including the subprime, are usually attributed exclusively to supply-side factors. We uncover an additional factor contributing to debt culture, namely social influences emanating from the perceived average income of peers. Using unique information from a representative household survey of the Dutch population that circumvents the need to define the social circle, we consider collateralized, consumer, and informal loans. We find robust social effects on borrowing – especially among those who consider themselves poorer than their peers – and on indebtedness, suggesting a link to financial distress. We check the robustness of our results using several approaches to rule out spurious associations and handle correlated effects.
We show that the presence of high frequency trading (HFT) has significantly mitigated the frequency and severity of end-of-day price dislocation, counter to recent concerns expressed in the media. The effect of HFT is more pronounced on days when end of day price dislocation is more likely to be the result of market manipulation on days of option expiry dates and end of month. Moreover, the effect of HFT is more pronounced than the role of trading rules, surveillance, enforcement and legal conditions in curtailing the frequency and severity of end-of-day price dislocation. We show our findings are robust to different proxies of the start of HFT by trade size, cancellation of orders, and co-location.
We consider an economy where individuals privately choose effort and trade competitively priced securities that pay off with effort-determined probability. We show that if insurance against a negative shock is sufficiently incomplete, then standard functional form restrictions ensure that individual objective functions are optimized by an effort and insurance combination that is unique and satisfies first- and second-order conditions. Modeling insurance incompleteness in terms of costly production of private insurance services, we characterize the constrained inefficiency arising in general equilibrium from competitive pricing of nonexclusive financial contracts.
This paper empirically examines the role of soft information in the competitive interaction between relationship and transaction banks. Soft information can be interpreted as a private signal about the quality of a firm that is observable to a relationship bank, but not to a transaction bank. We show that borrowers self-select to relationship banks depending on whether their privately observed soft information is positive or negative. Competition affects the investment in learning the private signal from firms by relationship banks and transaction banks asymmetrically. Relationship banks invest more; transaction banks invest less in soft information, exacerbating the selection effect. Finally, we show that firms where soft information was important in the lending decision were no more likely to default compared to firms where only financial information was used.
This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. However, the significance mainly comes from R&D firms, which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we also document that only idiosyncratic volatility (ivol) has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting according to the size of idiosyncratic volatility, we only find a significant ivol anomaly for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To simultaneously control for several explanatory variables, we also run panel regressions of portfolio alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses.
We study to what extent firms spread out their debt maturity dates across time, which we call "granularity of corporate debt." We consider the role of debt granularity using a simple model in which a firm's inability to roll over expiring debt causes inefficiencies, such as costly asset sales or underinvestment. Since multiple small asset sales are less costly than a single large one, firms may diversify debt rollovers across maturity dates. We construct granularity measures using data on corporate bond issuers for the 1991-2011 period and establish a number of novel findings. First, there is substantial variation in granularity in that many firms have either very concentrated or highly dispersed maturity structures. Second, our model's predictions are consistent with observed variation in granularity. Corporate debt maturities are more dispersed for larger and more mature firms, for firms with better investment opportunities, with higher leverage ratios, and with lower levels of current cash flows. We also show that during the recent financial crisis especially firms with valuable investment opportunities implemented more dispersed maturity structures. Finally, granularity plays an important role for bond issuances, because we document that newly issued corporate bond maturities complement pre-existing bond maturity profiles.
Monetary theorists have advanced an intriguing notion: we exchange money to make up for a lack of enforcement, when it is difficult to monitor and sanction opportunistic behaviors. We demonstrate that, in fact, monetary equilibrium cannot generally be sustained when monitoring and punishment limitations preclude enforcement — external or not. Simply put, monetary systems cannot operate independently of institutions — formal or informal — designed to monitor behaviors and sanction undesirable ones. This fundamental result is derived by integrating monetary theory with the theory of repeated games, studying monetary equilibrium as the outcome of a matching game with private monitoring.
The U.S. Energy Information Administration (EIA) regularly publishes monthly and quarterly forecasts of the price of crude oil for horizons up to two years, which are widely used by practitioners. Traditionally, such out-of-sample forecasts have been largely judgmental, making them difficult to replicate and justify. An alternative is the use of real-time econometric oil price forecasting models. We investigate the merits of constructing combinations of six such models. Forecast combinations have received little attention in the oil price forecasting literature to date. We demonstrate that over the last 20 years suitably constructed real-time forecast combinations would have been systematically more accurate than the no-change forecast at horizons up to 6 quarters or 18 months. MSPE reduction may be as high as 12% and directional accuracy as high as 72%. The gains in accuracy are robust over time. In contrast, the EIA oil price forecasts not only tend to be less accurate than no-change forecasts, but are much less accurate than our preferred forecast combination. Moreover, including EIA forecasts in the forecast combination systematically lowers the accuracy of the combination forecast. We conclude that suitably constructed forecast combinations should replace traditional judgmental forecasts of the price of oil.
We use responses to survey questions in the 2010 Italian Survey of Household Income and Wealth that ask consumers how much of an unexpected transitory income change they would consume. We find that the marginal propensity to consume (MPC) is 48 percent on average, and that there is substantial heterogeneity in the distribution. We find that households with low cash-on-hand exhibit a much higher MPC than affluent households, which is in agreement with models with precautionary savings where income risk plays an important role. The results have important implications for the evaluation of fiscal policy, and for predicting household responses to tax reforms and redistributive policies. In particular, we find that a debt-financed increase in transfers of 1 percent of national disposable income targeted to the bottom decile of the cash-on-hand distribution would increase aggregate consumption by 0.82 percent. Furthermore, we find that redistributing 1% of national disposable income from the top to the bottom decile of the income distribution would boost aggregate consumption by 0.33%.
Recently, we evaluated a fiscal consolidation strategy for the United States that would bring the government budget into balance by gradually reducing government spending relative to GDP to the ratio that prevailed prior to the crisis (Cogan et al, JEDC 2013). Specifically, we published an analysis of the macroeconomic consequences of the 2013 Budget Resolution that was passed by the U.S. House of Representatives in March 2012. In this note, we provide an update of our research that evaluates this year’s budget reform proposal that is to be discussed and voted on in the House of Representative in March 2013. Contrary to the views voiced by critics of fiscal consolidation, we show that such a reduction in government purchases and transfer payments can increase GDP immediately and permanently relative to a policy without spending restraint. Our research makes use of a modern structural model of the economy that incorporates the long-standing essential features of economics: opportunity costs, efficiency, foresight and incentives. GDP rises because households take into account that spending restraint helps avoid future increases in tax rates. Lower taxes imply less distorted incentives for work, investment and production relative to a scenario without fiscal consolidation and lead to higher growth.
In this paper we provide new evidence that corporate financing decisions are associated with managerial incentives to report high equity earnings. Managers rely most heavily on debt to finance their asset growth when their future earnings prospects are poor, when they are under pressure due to past declines in earnings, negative past stock returns, and excessively optimistic analyst earnings forecasts, and when the earnings yield is high relative to bond yields so that from an accounting perspective equity is ‘expensive’. Managers of high debt issuing firms are more likely to be newly appointed and also more likely to be replaced in subsequent years. Abnormal returns on portfolios formed on the basis of asset growth and debt issuance are strongly positively associated with the contemporaneous changes in returns on assets and on equity as well as with earnings surprises. This may account for the finding that debt issuance forecasts negative abnormal returns, since debt issuance also forecasts negative changes in returns on assets and on equity and negative earnings surprises. Different mechanisms appear to be at work for firms that retire debt.
The financial services industry worldwide has undergone major transformation since the late 1970s. Technological advancements in information processing and communication facilitated financial innovation and narrowed traditional distinctions in financial products and services, allowing them to become close substitutes for one another. The deregulation process in many major economies prior to the recent financial crisis blurred the traditional lines of demarcation between the distinct types of financial institutions, exposing those firms to new competitors in their traditional business areas, while the increasing globalization of financial markets fostered the provision of financial services across national borders. Against this backdrop, a trend toward consolidation across financial sectors as well as across national borders increasingly manifested itself since the 1990s. The developments in the financial markets ever more intensified competition in the financial services industry and induced financial institutions to redefine their business strategies in search of higher profitability and growth opportunities. Consolidation across distinct financial sectors, i.e. financial conglomeration, in particular became a popular business strategy in light of the potential operational synergies and diversification benefits it can offer. This trend spurred the growth of diversified financial groups, the so-called financial conglomerates, which commingle banking, securities, and insurance activities under one corporate umbrella.5 Still today, large, complex financial conglomerates are represented among major players in the financial markets worldwide, whose activities not only sway across traditional boundaries of banking, securities, and insurance sectors but also across national borders.
Notwithstanding the economic benefits that conglomeration may produce as a business strategy, the emergence of financial conglomerates also exacerbated existing and created new prudential risks in the financial system. 6 The mixing of a variety of financial products and services under one corporate roof and the generally large and complex group structure of financial conglomerates expose such organizations to specific group risks such as contagion and arbitrage risk as well as systemic risk. When realized, these risks may not only cause the failure of an entire financial group but threaten the stability of the financial system as a whole, as evidenced by the events during recent financial crisis of 2007-2009...
We propose the realized systemic risk beta as a measure for financial companies’ contribution to systemic risk given network interdependence between firms’ tail risk exposures. Conditional on statistically pre-identified network spillover effects and market as well as balance sheet information, we define the realized systemic risk beta as the total time-varying marginal effect of a firm’s Value-at-risk (VaR) on the system’s VaR. Statistical inference reveals a multitude of relevant risk spillover channels and determines companies’ systemic importance in the U.S. financial system. Our approach can be used to monitor companies’ systemic importance allowing for a transparent macroprudential supervision.
Our motivation is the question whether the lazy lambda calculus, a pure lambda calculus with the leftmost outermost rewriting strategy, considered under observational semantics, or extensions thereof, are an adequate model for semantic equivalences in real-world purely functional programming languages, in particular for a pure core language of Haskell. We explore several extensions of the lazy lambda calculus: addition of a seq-operator, addition of data constructors and case-expressions, and their combination, focusing on conservativity of these extensions. In addition to untyped calculi, we study their monomorphically and polymorphically typed versions. For most of the extensions we obtain non-conservativity which we prove by providing counterexamples. However, we prove conservativity of the extension by data constructors and case in the monomorphically typed scenario.
Our motivation is the question whether the lazy lambda calculus, a pure lambda calculus with the leftmost outermost rewriting strategy, considered under observational semantics, or extensions thereof, are an adequate model for semantic equivalences in real-world purely functional programming languages, in particular for a pure core language of Haskell. We explore several extensions of the lazy lambda calculus: addition of a seq-operator, addition of data constructors and case-expressions, and their combination, focusing on conservativity of these extensions. In addition to untyped calculi, we study their monomorphically and polymorphically typed versions. For most of the extensions we obtain non-conservativity which we prove by providing counterexamples. However, we prove conservativity of the extension by data constructors and case in the monomorphically typed scenario.
We examine the impact of stock exchange trading rules and surveillance on the frequency and severity of suspected insider trading cases in 22 stock exchanges around the world over the period January 2003 through June 2011. Using new indices for market manipulation, insider trading, and broker-agency conflict based on the specific provisions of the trading rules of each stock exchange, along with surveillance to detect non-compliance with such rules, we show that more detailed exchange trading rules and surveillance over time and across markets significantly reduce the number of cases, but increase the profits per case.
The paper uses fiscal reaction functions for a panel of euro-area countries to investigate whether euro membership has reduced the responsiveness of countries to shocks 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, such as an exclusion of Greece from the panel. This suggests that the current debt problems may result to a large extent from preexisting 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.
On July 4, 2013 the ECB Governing Council provided more specific forward guidance than in the past by stating that it expects ECB interest rates to remain at present or lower levels for an extended period of time. As explained by ECB President Mario Draghi this expectation is based on the Council’s medium-term outlook for inflation conditional on economic activity and money and credit. Draghi also stressed that there is no precise deadline for this extended period of time, but that a reasonable period can be estimated by extracting a reaction function. In this note, we use such a reaction function, namely the interest rate rule from Orphanides and Wieland (2013) that matches past ECB interest rate decisions quite well, to project the rate path consistent with inflation and growth forecasts from the survey of professional forecasters published by the ECB on August 8, 2013. This evaluation suggests an increase in ECB interest rates by May 2014 at the latest. We also use the Eurosystem staff projection from June 6, 2013 for comparison. While it would imply a longer period of low rates, it does not match past ECB decisions as well as the reaction function with SPF forecasts.
We develop a dynamic network model whose links are governed by banks' optmizing decisions and by an endogenous tâtonnement market adjustment. Banks in our model can default and engage in firesales: risk is transmitted through direct and cascading counterparty defaults as well as through indirect pecuniary externalities triggered by firesales. We use the model to assess the evolution of the network configuration under various prudential policy regimes, to measure banks' contribution to systemic risk (through Shapley values) in response to shocks and to analyze the effects of systemic risk charges. We complement the analysis by introducing the possibility of central bank liquidity provision.
We use unique data from financial advisers’ professional exam scores and combine it with other variables to create an index of financial sophistication. Using this index to explain long-term stock return expectations, we find that more sophisticated financial advisers tend to have lower return expectations. A one standard deviation increase in the sophistication index reduces expected returns by 1.1 percentage points. The effect is stronger for emerging market stocks (2.3 percentage points). The sophistication effect contributes 60% to the model fit, while employer fixed effects combined contribute less than 30%. These results help understand the formation of potentially excessively optimistic expectations.
Does it pay to invest in art? A selection-corrected returns perspective : [draft october 15, 2013]
(2013)
This paper shows the importance of correcting for sample selection when investing in illiquid assets with endogenous trading. Using a large sample of 20,538 paintings that were sold repeatedly at auction between 1972 and 2010, we find that paintings with higher price appreciation are more likely to trade. This strongly biases estimates of returns. The selection-corrected average annual index return is 6.5 percent, down from 10 percent for traditional uncorrected repeat sales regressions, and Sharpe Ratios drop from 0.24 to 0.04. From a pure financial perspective, passive index investing in paintings is not a viable investment strategy once selection bias is accounted for. Our results have important implications for other illiquid asset classes that trade endogenously.
U.S. retail food price increases in recent years may seem large in nominal terms, but after adjusting for inflation have been quite modest even after the change in U.S. biofuel policies in 2006. In contrast, increases in the real prices of corn, soybeans, wheat and rice received by U.S. farmers have been more substantial and can be linked in part to increases in the real price of oil. That link, however, appears largely driven by common macroeconomic determinants of the prices of oil and agricultural commodities rather than the pass-through from higher oil prices. We show that there is no evidence that corn ethanol mandates have created a tight link between oil and agricultural markets. Rather increases in food commodity prices not associated with changes in global real activity appear to reflect a wide range of idiosyncratic shocks ranging from changes in biofuel policies to poor harvests. Increases in agricultural commodity prices in turn contribute little to U.S. retail food price increases, because of the small cost share of agricultural products in food prices. There is no evidence that oil price shocks have caused more than a negligible increase in retail food prices in recent years. Nor is there evidence for the prevailing wisdom that oil-price driven increases in the cost of food processing, packaging, transportation and distribution are responsible for higher retail food prices. Finally, there is no evidence that oil-market specific events or for that matter U.S. biofuel policies help explain the evolution of the real price of rice, which is perhaps the single most important food commodity for many developing countries.
The substantial variation in the real price of oil since 2003 has renewed interest in the question of how to forecast monthly and quarterly oil prices. There also has been increased interest in the link between financial markets and oil markets, including the question of whether financial market information helps forecast the real price of oil in physical markets. An obvious advantage of financial data in forecasting oil prices is their availability in real time on a daily or weekly basis. We investigate whether mixed-frequency models may be used to take advantage of these rich data sets. We show that, among a range of alternative high-frequency predictors, especially changes in U.S. crude oil inventories produce substantial and statistically significant real-time improvements in forecast accuracy. The preferred MIDAS model reduces the MSPE by as much as 16 percent compared with the no-change forecast and has statistically significant directional accuracy as high as 82 percent. This MIDAS forecast also is more accurate than a mixed-frequency realtime VAR forecast, but not systematically more accurate than the corresponding forecast based on monthly inventories. We conclude that typically not much is lost by ignoring high-frequency financial data in forecasting the monthly real price of oil.
This note proposes a new set-up for the fund backing the Single Resolution Mechanism (SRM). The proposed fund is a Multi-Tier Resolution Fund (MTRF), restricting the joint and several supranational liability to a limited range of losses, bounded by national liability at the upper and the lower end. The layers are, in ascending order: a national fund (first losses), a European fund (second losses), the national budget (third losses), the ESM (fourth losses, as a backup for sovereigns). The system works like a reinsurance scheme, providing clear limits to European-level joint liability, and therefore confining moral hazard. At the same time, it allows for some degree of risk sharing, which is important for financial stability if shocks to the financial system are exogenous (e.g., of a supranational macroeconomic nature). The text has four parts. Section A describes the operation of the Multi-Tier Resolution Fund, assuming the fund capital to be fully paid-in (“Steady State“). Section B deals with the build-up phase of the fund capital (“Build up“). Section C discusses how the proposal deals with the apparent incentive conflicts. The final Section D summarizes open questions which need further thought (“Open Questions“).
In this note, a new concept for a European deposit guarantee scheme is proposed, which takes account of the strong political reservations against a mutualization of the liability for bank deposits. The three-stage model for deposit insurance outlined in the text builds on existing national deposit guarantee schemes, offering loss compensation on a European level and at the same time preventing excessive risk and moral hazard taking by individual banks.
How does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. While the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap.
This paper examines a practice that is nearly imperceptible to historians because the bulk of evidence for it is to be found in the interstices of the beaten paths of legal and social history and because it mixes economic and religious matters in a strikingly unfamiliar manner. From the thirteenth to the sixteenth century, excommunication for debt offered ordinary people an economical, efficacious enforcement mechanism for small-scale, daily, unwritten credit. At the same time, the practice offered holders of ecclesiastical jurisdiction an important opportunity to round out their incomes, particularly in the difficult fifteenth century. This transitional practice reveals a level of credit below that of the letters of change, annuities secured on real property, or written obligations beloved of economic historians and historians of banking. Studying the practice casts light on the transition from the face-to-face, local economies of the high Middle Ages to the regional economies of the early modern period, on how the Reformation shaped early modern regimes of credit, and on how the disappearance of ecclesiastical civil justice facilitated the emergence of early modern juridically sovereign territories.
A concurrent implementation of software transactional memory in Concurrent Haskell using a call-by-need functional language with processes and futures is given. The description of the small-step operational semantics is precise and explicit, and employs an early abort of conflicting transactions. A proof of correctness of the implementation is given for a contextual semantics with may- and should-convergence. This implies that our implementation is a correct evaluator for an abstract specification equipped with a big-step semantics.
We introduce a copula-based dynamic model for multivariate processes of (non-negative) high-frequency trading variables revealing time-varying conditional variances and correlations. Modeling the variables’ conditional mean processes using a multiplicative error model we map the resulting residuals into a Gaussian domain using a Gaussian copula. Based on high-frequency volatility, cumulative trading volumes, trade counts and market depth of various stocks traded at the NYSE, we show that the proposed copula-based transformation is supported by the data and allows capturing (multivariate) dynamics in higher order moments. The latter are modeled using a DCC-GARCH specification. We suggest estimating the model by composite maximum likelihood which is sufficiently flexible to be applicable in high dimensions. Strong empirical evidence for time-varying conditional (co-)variances in trading processes supports the usefulness of the approach. Taking these higher-order dynamics explicitly into account significantly improves the goodness-of-fit of the multiplicative error model and allows capturing time-varying liquidity risks.
The amino acid content (alanine/arginine, glutamine, proline, taurine) of five different lichen species (Evernia prunastri, Hypogymnia physodes, Parmelia sulcata, Physcia adscendens, Xanthoria parietina) from different parts of Germany and NW France with different atmospheric nitrogen depositions was determined.
The study revealed that the so called nitrophytic lichen species (Physcia adscendens, Xanthoria parietina) had no higher amino acid contents as compared with the other species. The amino acid contents of five different lichen species from the same tree varied without regard to the nitrophily of the species. The contents of amino acids of the lichen species studied from Bonn is four to twelve times higher as in the same species in the Vosges Mountains, France. The amount of amino acids in nitrophytic species (Xanthoria parietina, Physcia adscendens) from a region with high load of atmospheric nitrogen (35 kg/y/ha) is in average 5 times higher than in the same species from a region with low nitrogen immission (16 kg/y/ha).
It can be concluded that the amino acid contents of lichens reflects the atmospheric nitrogen load and that the amino acid content of so called nitrophytic lichen species is not higher as in other species, that lichens are passive sampler and take up the available nitrogen but make no use of it but store it as amino acids. On the other hand, the conductivity of the cell liquid (as a measure of the osmotic pressure) of nitrophytic lichen species is higher as compared with non-nitrophytic species. Thus the “nitrophily” of these species is presumably not based upon the facility to higher nitrogen uptake but osmotic tolerance against the salt effects of nitrogen compounds. Within nitrophytic species, the osmotic values of Phaeophyscia orbicularis are double as high as those from Physcia adscendens, which is explained by the higher tolerance of Phaeophyscia against dry deposition. The higher osmotic values of nitrophilous lichen species lead to the conclusion that they are also drought resistant species and occur in regions with low humidity where they are more competitive than other lichen species.
We show that the optimal consumption of an individual over the life cycle can have the hump shape (inverted U-shape) observed empirically if the preferences of the individual exhibit internal habit formation. In the absence of habit formation, an impatient individual would prefer a decreasing consumption path over life. However, because of habit formation, a high initial consumption would lead to high required consumption in the future. To cover the future required consumption, wealth is set aside, but the necessary amount decreases with age which allows consumption to increase in the early part of life. At some age, the impatience outweighs the habit concerns so that consumption starts to decrease. We derive the optimal consumption strategy in closed form, deduce sufficient conditions for the presence of a consumption hump, and characterize the age at which the hump occurs. Numerical examples illustrate our findings. We show that our model calibrates well to U.S. consumption data from the Consumer Expenditure Survey.
Advances in technology and several regulatory initiatives have led to the emergence of a competitive but fragmented equity trading landscape in the US and Europe. While these changes have brought about several benefits like reduced transaction costs, regulators and market participants have also raised concerns about the potential adverse effects associated with increased execution complexity and the impact on market quality of new types of venues like dark pools. In this article we review the theoretical and empirical literature examining the economic arguments and motivations underlying market fragmentation, as well as the resulting implications for investors' welfare. We start with the literature that views exchanges as natural monopolies due to presence of network externalities, and then examine studies which challenge this view by focusing on trader heterogeneity and other aspects of the microstructure of equity markets.
The European Commission recently put forward a proposal for a regulation to amend and strengthen the 2009 version of the EU's rules on the regulation of credit rating agencies ("CRA3"). Among other things, Art. 35a of the draft proposal introduces strict liability for rating agencies. This liability proposal is at odds with the aim to strengthen competition in the rating sector and could have a chilling effect on capital markets. The paper analyses existing rules on civil liability of rating agencies under different legal systems. Subsequently, the provision under Art. 35a of the Draft Proposal is examinded more closely. Suggestions on possible improvemts of the proposal are made.
The financial crisis which started in 2007 has caused a tremendous challenge for monetary policy. The simple concept of inflation targeting has lost its position as state of the art. There is a debate on whether the mandate of a central bank should not be widened. And, indeed, monetary policy has been very accommodative in the last couple of years and central banks have modified their communication strategies by introducing forward guidance as a new policy tool. This paper addresses the consequences of these developments for the credibility, the reputation and the independence of central banks. It also comments on the recent debate among economists concerning the question whether the ECB's OMT program is compatible with its mandate.
The IMFS Interdisciplinary Study 2/2013 contains speeches of Michael Burda (Humboldt University ), Benoît Coeuré (European Central Bank), Stefan Gerlach (Bank of Ireland and former IMFS Professor), Patrick Honohan (Bank of Ireland), Sabine Lautenschläger (Deutsche Bundesbank), Athanasios Orphanides (MIT) and Helmut Siekmann as well as Volker Wieland.
Basel III and CEO compensation in banks: pay structures as a regulatory signal : [March 6, 2013]
(2013)
This paper proposes a new regulatory approach that implements capital requirements contingent on managerial compensation. We argue that excessive risk taking in the financial sector originates from the shareholder moral hazard created by government guarantees rather than from corporate governance failures within banks. The idea of the proposed regulation is to utilize the compensation scheme to drive a wedge between the interests of top management and shareholders to counteract shareholder risk-shifting incentives. The decisive advantage of this approach compared to existing regulation is that the regulator does not need to be able to properly measure the bank investment risk, which has been shown to be a difficult task during the 2008-2009 financial crisis.
We show that market discipline, defined as the extent to which firm specific risk characteristics are reflected in market prices, eroded during the recent financial crisis in 2008. We design a novel test of changes in market discipline based on the relation between firm specific risk characteristics and debt-to-equity hedge ratios. We find that market discipline already weakened after the rescue of Bear Stearns before disappearing almost entirely after the failure of Lehman Brothers. The effect is stronger for investment banks and large financial institutions, while there is no comparable effect for non-financial firms.
Euro area data show a positive connection between sovereign and bank risk, which increases with banks’ and sovereign long run fragility. We build a macro model with banks subject to incentive problems and liquidity risk (in the form of liquidity based banks’ runs) which provides a link between endogenous bank capital and macro and policy risk. Our banks also invest in risky government bonds used as capital buffer to self-insure against liquidity risk. The model can replicate the positive connection between sovereign and bank risk observed in the data. Central bank liquidity policy, through full allotment policy, is successful in stabilizing the spiraling feedback loops between bank and sovereign risk.