Transcript Layout Bologna

CDS: Liquidity Shortage or Structural
Insolvency?
Francesco Giuliani
Sumy, 24-25 May 2012
Outline
 Introduction
 Research gap, purpose and question
 Literature review: Meaning of Liquidity and
implications for the event of default.
 Model describing banks ALM
 Empirical analysis of Financial CDS
 Data and sample
 Novelty of the research and implication of the
expected results
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Introduction
• The current crisis has demonstrated that the functioning of the
banking system may be questioned by market: some variables
are currently under scrutiny:
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Liquidity
Leverage
Distribution of Debt and imminent refinancing needs.
Trust in the financial system
Adequate capitalization
• Central Bank and Sovereign State : concerned on
• Smooth functioning of the economy
• Controlled evolution of Money
Both objectives are subordinate to the proper functioning of the baking system
• Central bank and government:
•
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role in the Crisis and degree of intervention: Global consolidation
Independence of central banks and importance of flexible FX rates.
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Research Gap
• Standard literature on monetary policy sees the banking system
as a transmission tool for monetary input.
• CDS levels and interest rates seem to belong to different asset
classes: a risk free world versus credit risk variables. Can we
fill the gap?
• Accommodative monetary policy: an environment with low
rates?
• Capital and liquidity: are they really microeconomic variables?
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Purpose of the paper
• Research questions:
– Liquidity and deleverage: can banks contemplate both
variables?
– Interbank deposit and financial senior market: what if these
markets stop functioning?
– Can liquidity explain the solvency of the banking sector?
– The dilemma of a central bank: bias the input to save the
transmission mechanism?
– Global consolidation: how do we measure the resilience of
the banking system? Should we include the Government and
the Central Bank when we face periods of distress?
– Solvency: is it a microeconomic problem?
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Purpose of the paper (2)
• To answer these questions:
– We no longer consider a framework of Maximization of return on Equity
and focus on the constraint to roll debt due for redemption
– We analyze the distribution of debt maturities and Assets maturities:
both are legacy from the past. We adopt a framework where the
balance sheet of the bank is a backward looking sequence of
investments and issuance activity.
– We obtain that profitability is derived as a backward looking average of
the credit spread paid on the liabilities and received on the assets.
– When profitability drops and the capability to redeem debts is under
dispute, then debt market no longer clears: default is then the event
that a bank is no longer capable to roll debt: it then taps into central
bank facilities posting “Elegible Collateral”
– The transmission mechanism is out of control: the focus is the liability
side of the balance sheet and the credit origination is structurally
reduced: the deleverage wave is then stronger and transmitted to the
real economy
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Implications and themes
• What can we derive from such framework?
– Deleverage and Capital: the relevance of an adequate capital
structure to face a deleverage program
– The relevance of the consequences for real economy: the Sovereign
State intervenes and participates to the reshaping of the capital
structure of the banking sector
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–
–
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Government guaranteed Issuance
Subscription of Hybrid Capital
Subscription of Equity
Nationalization of some banks.
– The central bank loses control on M3 aggregate: the difficulties in the
banking sector are ultimately a lack of control on the transmission
mechanism of monetary policy.
– Financial CDS: do they reflect a liquidity shortage or a structural
insolvency?
– Are we not facing a structural need of more liquidity for the proper
functioning of banks’ balance sheet throughout the deleverage mode
in the banking industry?
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Literature Review
Plenty of topics mentioned in this paper are explored in depth by literature, namely
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Banks crisis and the link existing with governments financial health
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Are Banks too big to save or too big to fail? (Kunt and Huizinga)
Credit Spread Interdependencies of European States and Banks during the Financial Crisis
(Alter, Schuler)
The Janus-Headed Salvation. Sovereign and Bank Credit Risk Premia During 2008-09 (Ejsing,
Lemke)
CDS and evolution of bonds yields issued by the same reference entities: the base
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Sovereign Basis
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An analysis of Euro area sovereign CDS and their relation with government Bonds
(Fontana, Scheicher)
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Corporate Bond Pricing
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Liquidity and arbitrage in the Market of Credit Risk” (Nashikkar, Subrahmanyam, Mahanti)
“Monetary and Fiscal policy are being conducted in unchartered waters, without any
intellectual map to guide them. Policy makers are flying blind”
(Alistair Milne, in “Liquidity, bank credit and money”).
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Literature Review (2)
What common denominator can we find across these topics?
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Systemic risk
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Capital structure
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Banks regulation, Credit ratings and Systemic Risk (Iannotta, Pennacchi)
European Systemic Risk in Post-LTRO World (Calamaro)
Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the
Financial Crisis (Dieckmann, Plank)
Risk management and balance sheet volatility during turbulent times (Giuliani, Forthcoming)
Contingent Capital: The Case of COERCs (Pennacchi, Vermaelen, Wolff)
Capital regulation and Monetary Policy with Fragile Banks (Angeloni, Faia)
Optimal Capital Structure of a Bank: the role of asymmetry of information and Equityzation of
Debt (Giuliani)
Liquidity, mainly explored as a microeconomic variable within banks. Yet this paper
points at emphasizing this concept under a Macro approach
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Bank Liquidity Risk Management: which lesson from recent market turmoil (Vento, La Ganga)
Funding Liquidity risk in a quantitative model of systemic stability (Aikman and others).
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Assets and Liabilities: modelling a BS
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Asset side of the balance sheet
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Redemption of assets , new investments and impairments describe the evolution of
the assets from one year to another.
(t)
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New investments : An(
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Redemptions: a(t)
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Depreciation/ impairment of assets: d(t)
* A(t-1)
* A(t-1)
Hence assets evolve according to:
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Liability side of the balance sheet
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The liability side of a banks’ balance sheet requires a distinction between various
instruments:
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Deposits: D(t)
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Bonds outstanding at time t: B(t)
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Liabilities against the central bank at time t: CB(t)
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Capital at time t: S(t)
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Stock of assets at time t
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Stock of Bonds at time t
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Cost of the liabilities and revenues from
assets
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Profitability of the core banking activity is only partially determined by
current market variables: stock of assets and liabilities depend on the
past and so do the average yield on assets and the average cost of
liabilities.
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Average spread paid on outstanding bonds depends on the turnover of the stock of
issued debt: it will depend on the number of years that have contributed to the
composition of the outstanding bonds. We will denote such number as yb((t)
Average credit spread on the stock of assets depends on the turnover of assets: it will
depend on the number of years that have contributed to the composition of current
assets. We will denote such number as ya((t)
Hence we derive that the profitability of the bank derives, among other factors, from
the difference between
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Modelling Liabilities: assumptions
•
We do not aim at modelling the capital structure evolution, a topic explored in a
previous work by the same author : “Optimal Capital Structure of a bank: the
role of asymmetry of information and Equityzation of debt”
•
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Leverage is endogenous and depends primarily on the evolution of Credit Market
Capital structure is endogenous and a strong deterioration of credit market make the value of CDS
dependent from volatility
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We do not aim at embedding within the model an analysis including panic
induced reduction of deposits: deposits are assumed constant. We also
assume constant the amount of issued equity. In essence we keep the
“extremes” of the capital structure constant and we model the evolution of debt
and liability versus the central bank as the most important tools during the
financial crisis.
•
Deposits and rights issuance are actually respectively decreasing and
increasing as the crisis is unfolding: is this model then irrealistic?
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A run to the counter is a tail event which cannot be managed: the survival of the bank under such
event is left mainly to the interventions of financial authorities.
Equity is not the adequate instrument to address liquidity requirement, hence the analysis benefits
from a reduced amount of variables.
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Liabilities Rolling
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The general constraint is
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Under the assumption that Deposits and Equity will not change from
one period to another
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Hence the minimum debt amount to be issued is
Such constraint in the ALM management of the bank is so central
during crisis times that we can define the event of default as the event
not to be capable to roll liabilities (net of redeeming assets)
We are not analyzing the microeconomic stress of a single financial
institution, whose lack of liquid assets can be addressed by the orderly
functioning of financial markets. We are instead looking at major
disfunctional events when Bonds issuance and interbank deposit
markets can handle too few transactions compared to the need of
market players to roll liabilities and extend debt maturity.
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The relevance of maturities distribution
•
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At a certain time t the market looks at the redemptions due in the next s
years, both on the liability side and the asset side.
i.
Liabilities due for redemption between time t and time t+s:
ii.
Assets due for redemption between time t and time t+s:
iii.
The bank will also grant credit and make new investments: An((t,t+s)
iv.
Therefore the bank will have to satisfy the constraint that the minimum issuance
required is
Event of default is, in this framework, that such minimum issuance is higher
than market demand: hence the amount issued is such scenario is lower
then required
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No clearing price for Debt
•
Standard microeconomics of supply and demand does not apply to
financial debt.
i.
Lack of appetite cannot be addressed by price
ii.
A price is converted into yield: is it sustainable? What is the yield of the assets and
how does it compare to liabilities? What is the implied profitability of the bank if debt
converges towards the price for issuance just realized?
iii.
When a price is not sustainable the primary market not only does not clear, but it
shows disaffection to debt and no new subscriptions take place
•
If primary market is shut the reaction of the banking system is by selecting
no new investments: the deleverage mechanism accelerates and central
banks may intervene on the relaxation of financing parameters, by
selecting a new refinancing percentage of assets,ρ̃.
•
The event of default is then (when the debt market is not clearing)
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Assets vs Liabilities: where is profitability
heading?
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Banking System: no longer a liquidity
generator
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A stable function of liquidity generation (managing assets and liabilities
with different liquidity and maturity) has made the banking system of
public relevance for
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A role of monetary policy transmission
A role of Credit multiplication by simultaneous generation of liabilities and
assets
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The key variable to manage this delicate public role is micro-economic,
yet subject to public scrutiny: Capital Structure.
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Questioning the functioning of debt market is equivalent to
acknowledgement that the economy requires a lower leverage; the
entire banking system is called to a deleverage of the balance sheet:
this is the main theme of the financial crisis.
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In the deleverage mode, the banking system is absorbing liquidity and
there is only one liquidity generator: the central bank.
Debt: a variable difficult to handle.
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Financial debt issuance was the key tool for liquidity adjustments. Yet
recent years have witnessed
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First a reduction of appetite and demand for short tenor debt only, with the consequence of
clustering the refinancing needs in the short term
More recently, a collapse in demand for almost any financial debt, with no distinction relating to
maturity
The shortening of the tenor of the liabilities implies a cost for debt more
reactive to higher level of CDS, and, in general , to deteriorating
market conditions. Shortening of the average maturity also increases
the maturity transformation between assets and liabilities.
Shortening of the average maturity concentrates redemptions and
refinancing needs in the immediate future: will supply of issued bonds
find demand for similar size?
Maturities cluster in very few years, hence a liquidity shock opens a
strong refinancing risk: liquidity is no longer a microeconomic variable
and can no longer be managed via a statistical approach where long
positions finance short positions in the financial market.
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Debt reduction
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Why are markets imposing a debt reduction?
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Profits are not growing in saturated economies with a speed consistent with debt interests
A suboptimal point in the capital structure may erode equity: such a scenario increases correlation
across different debtors. Debt bears then a systemic risk and no longer an idiosyncratic credit risk
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Financial markets are running ahead of regulators: they are imposing a
deleverage which ultimately means that the global stock of debt is to
be reduced, be it in the format of public debt, private debt or Financial
senior debt.
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Are Basel III and its more stringent capital requirements simply
imposing a market requirement?
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Tools for Debt Reduction
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We are facing a structural change in the leverage of the economy
where a micro-economic management of liabilities relies on
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Liabilities rolling, even for short term horizon, where possible (maturities clustering
have exacerbated the importance of liquidity around the months of peaks in
redemptions)
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Usage of existing liquidity for payments coming due (actual deleverage)
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Reduction of real value of liabilities, via inflation or FX rate
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Selective defaults (painful but ultimately a way to reduce debt).
Default rates of SME are increasing and they reduce further the
profitability and solvency of the banking sector: the market scrutinizes
the capital and the resilience of the banking sector .
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What is Global Consolidation?
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The intuition is mainly empirical: the correlation we experience across
Banks debt and public debt seems to suggest a consolidation of the
balance sheets of these debtors. This facilitates the understanding of the
resilience of the banking sector.
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A banking system under stress is a concern for the smooth functioning of
the economy: the public sector intervenes to reduce financial stress and
markets quote a strong correlation between public and banks’ debt.
•
Kunt and Huizinga analyze the theme well beyond the mere intuition and
analyze the difference between banks too big to fail or too big to save. The
relevance of the public sector is econometrically derived when data show
that
i.
ii.
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CDS levels are related negatively to a country’s fiscal balance
Valuations of systemically large banks are lower when located in countries with
weaker public finances.
Central bank: another institution to consolidate when the transmission of
monetary policy is at risk due to an aggressive deleverage?
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Consequences of Global Consolidation
•
Not clearing markets of public debt is simultaneous with not clearing
markets of financial debt (within the same region).
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The banking sector is highly interconnected: even banks structurally
different and operating in different areas within the same monetary region
are affected by each other balance sheet soundness
•
Government under financial stress affect not only the banks of their own
country; via an econometric analysis we will analyze the evolution of a
basket of European CDS: its daily evolutions can be explained, among
other factors, via the daily evolution of CDS levels of Sovereigns affected
by a debt crisis.
•
Such explanatory power on a European basket of financial CDS via CDS
levels of certain Sovereigns is a feature shown by a time series with
inception well before the sovereign crisis.
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Literature focuses on correlation and interdependencies within regions.
Here instead we insist on a macroeconomic global interconnection across
the entire European Banking Sector.
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Consequences of Global Consolidation (2)
•
If probabilities of default are explained by means of macroeconomic
variables, can solvency and liquidity be addressed at a microeconomic
level?
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Default of a bank may no longer be considered a microeconomic event
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Market assigns a probability of default by quoting CDS levels: a deleverage
mode exacerbated by reluctance to subscribe financial debt creates a
unique link between liquidity conditions and probability of default
•
Liquidity is the variable explaining the transmission mechanism in the
banking sector.
•
Hence the title of my work posing the question if levels (and variations) of
financial CDS are to be explained, in the last 4 years, by
a) Liquidity Shortage
b) Structural insolvency
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Inference on liquidity.
Selection of variables (with a bias towards EUR area).
• Euribor -Eonia
•
•
Euribor and Eonia are two indices that are
considered respectively proxies for the
unsecured interbank deposit rate (e.g. 3month EURIBOR) and the secured interbank
deposit rate (i.e. Deposits which are secured
against collateral)
We consider the evolution of such
parameters considering the swap rate for
each floating parameter, with maturity 2
years.
• Sovereign CDS – Bond par spread
•
•
CDS is an unfunded transaction, hence
market players are not affected by the
availability of liquidity
The investment in securities issued by the
sovereign does require to satisfy a liquidity
constraint.
• Cross Currency Swap Eur/Usd
•
A higher cross currency spread quoted by
the market is the signal that there is a higher
demand for Dollars versus Euros at time
zero, possibly due to the difficulty to roll the
USD denominated liabilities.
Lenza, Pill, Reichlin also consider crucial
this variable in “Monetary Policy in
Exceptional Times”
Fontana and Sheiker analyze such basis
(Sovereign CDS – Yield of the bond), but
they investigate the evolution with a much
shorter time series, with weekly data and
before the government bond crisis. They
also see such difference as explained,
among other regressors, by the log value of
the Itraxx Financial Senior. Here insteead
we propose the basis as one of the
regressors to explain the daily variations of
the Itraxx Financial Senior Index
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Monetary Policy in exceptional times
(European Central Bank, working paper series)
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Explaining CDS levels via Liquidity
•
To exclude for cointegration, we analyze daily differences.
•
We will explain the daily evolution of the index Itraxx Financial Senior by the
adoption of the variables above. Such basket of CDS is composed by banks
and insurances which are not restricted to a particular region of Europe.
•
Not only we deduce the central role of Liquidity in the last 3.5 years of Crisis, but
data encourage to view the banking sector as a whole, without restriction to
regional samples or different phases of this crisis ( as per approach of Alter and
Schuler)
•
CDS will be regressed on variables typically monitored by central bank: when
CDS reflect such a high percentage of systemic risk, should they be considered
a crucial variable for monetary policy?
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Regression Results
Range: 09-Dec-2009--21-May-2012 (Days: 583)
Adjusted
R_squared:
49.4%
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Regression Results
Range: 04-Nov-2008--21-May-2012 (Days: 871)
Adjusted
R_squared:
37.8%
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Regression Results
Range: 04-Nov-2008--21-May-2012 (Days: 871)
Adjusted
R_squared:
57.9%
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Conclusions
•
We have analyzed the evolution of a basket of European CDS in terms of
regressors which ultimately map into the liquidity concept
•
We believe that Liquidity, Debt, Capital and Deleverage are not issues that
can be addressed from a microeconomic point of view.
•
Dealing with risk implies then the diversification theories will fail: the concept
of indipendent variable is difficult to apply and risk management is
challenged in the reduction of risk. Risk management and capital
management need to address Balance Sheet volatility and Capital Structure
to cope with these turbulent times.
•
Monetary policy is now relying on a very unstable transmission mechanism:
a sharp deleverage may mean a collapse in M3 which in the short term can
be addressed only via Monetary Base.
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