Post on 27-Jan-2021
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Systemic Risk, Financial Market Developments and Market and Regulatory Performance:
What is Known from Finance Research, and What Remains to be Learnt
A benchmarking report prepared by
Terry S. Walter1
for
The Centre for International Finance and Regulation
August 2012
1 Terry Walter is a Visiting Fellow in the Finance Discipline Group at the University of Technology, Sydney, an
Adjunct Professor in the UWA Business School, The University of Western Australia and Chief Research Officer, Sirca Limited.
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Abstract and summary
This report has been commissioned by the Centre for International Finance and Regulation (CIFR). It
provides a high level literature review of finance research in research areas of key interest to CIFR,
broadly Systemic Risk, Financial Market Developments and Market and Regulatory Performance. It
seeks to answer the question “What do we know from prior studies about these key research
areas?” In conducting this analysis an objective is to identify gaps in knowledge, and thus provide a
list of potential projects for possible CIFR funding. It thus poses a second question “What do we not
know from prior studies about these key research areas?” While the papers surveyed are not based
entirely on evidence from U.S. financial markets, these feature prominently in most survey papers,
and some use U.S. data exclusively. The report identifies major opportunities for additional research
in the following areas:
Systemic risk
There is currently considerable ongoing theoretical and empirical research and there is a lively
debate between academics, policy makers, regulators and practitioners on how to regulate systemic
risk. Better access to banking data would enable additional insights via empirical analysis.
Asset price bubbles
Potential research topics include (i) whether short sale restrictions be liberalised, (ii) whether the
asymmetric protection of limited liability should be reconsidered, (iii) whether governments should
intervene in markets when “warning bells start ringing”, and (iv) whether financial education might
play a role in reducing investor irrationality.
Financial Crises
More research is required to allow us to gain a better understanding of the market failures that lead
to financial crises. This work is needed in order to design policies to prevent such crises and
ameliorate their effects. The three main market failures that warrant additional research are (i)
provision of liquidity, (ii) limits to arbitrage and the mispricing of assets and (iii) contagion.
Additional macroeconomic research is also warranted to give a better understanding of the
relationship between monetary policy, credit and asset prices.
Measuring systemic risk
Existing research uses U.S. data to investigate statistical patterns in monthly index returns for hedge
funds, banks, brokers and insurance companies in order to develop various measures of systemic
risk. It is apparent that similar analysis in other nations would be desirable. Further, the analysis
could be extended to measures other than returns, in particular higher moments of the return
distributions, as well as volumes of trading, spreads and informed trading measures. It would also be
worth investigating individual firm returns, rather than index returns.
Risk management
In spite of several quantitative advances, risk management is still largely an art form. Risk
architecture needs to consider the costs and timeliness of risk signals relative to the benefits. There
is considerable scope for both theoretical development and model calibration. Empirical
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investigation would be greatly enhanced by more granular databases becoming available, though
commercial-in-confidence issues abound.
Modelling financial crises and sovereign risks
Several new directions for future research are identified in the report in order to improve
measurement, analysis and management of financial and sovereign risks, and to reduce the severity
of financial crises. A key to such analysis is that comprehensive risk exposure data must be collected.
Mortgage-backed securities
Despite the considerable effort devoted to valuation models by academics and practitioners,
“development of better models is undoubtedly an area ripe for research”. Again, empirical
investigations would be facilitated by having reliable past data. Much of the work in MBS has
stemmed from the U.S. creating the opportunity for innovative research in nations where the
mortgage lending arrangements differ from those in the U.S. Australia is a case in point.
Managing financial risk
There is wide disparity in the extent to which corporations hedge their risks, but questions as to why
a firm hedges and what instruments should be employed remain unresolved, prompting a call for
further research. There has been scant research effort associated with a firm pre-committing to
hedging strategies. Firm characteristics that are associated with hedging have received some
attention, but there are substantial areas where further research is necessary. There is considerable
scope for research on implementation of risk management strategies.
Securitisation
Securitisation is “largely unregulated and it is not well understood”. There has been little research on
the issue. Basic questions remain unresolved. Why did securitisation arise? Was there innovation?
What are the sources of value? How and why does innovation occur? Will securitisation regain its
pre-financial crisis prominence in capital markets? How does securitisation affect incentives to
monitor borrower behaviour? These are quite fundamental questions and illustrate that relatively
little empirical research has been undertaken on this topic. It is also clear that answering many of
these questions will require much more data collection than has happened to date. The data to
address these questions are not currently obtainable at low cost.
Financial innovation – counterfactual research
There are several research areas, such as (i) counterfactual analysis of major financial innovations
that to date have not been investigated other than in the U.S., where differing institutional
arrangements might shed light on the U.S. findings (ii) the analysis of settings where there are
constraints or barriers to financial innovation – a specific example being Islamic finance, (iii) the
greater use of experimental techniques and (iv) the use of structural estimation models, albeit with
the caveat of an inability to assess externalities.
Volatility derivatives
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There are several issues that need further theoretical exposition and development. No doubt there
will be some CIFR researchers who are interested in the mathematical finance aspects of volatility
derivatives and who wish to take up such development. There is ample scope for empirical
application to investigate which (how, why) firms use volatility derivatives and the impacts of these
instruments on firm value.
Credit risk models
Additional model development is required in relation to (i) implementation of realistic contagion
models (ii) stochastic recovery rates, and (iii) the inclusion of liquidity risk in credit risk models.
Credit default swaps
There is considerable scope for further research in CDSs, however such endeavour is hampered by a
lack of a comprehensive and reliable set of data.
Mutual funds
Relatively little finance research has been conducted on the marketing activities of mutual funds.
U.S. evidence shows that a member of a family that performs well results in a spill-over effect of
flows into the other funds within the family. While the empirical evidence shows that fund
performance declines as a particular fund in a family gets larger, performance increases with the size
of the rest of the family, consistent with economies of scale. Similar research outside the U.S. is
warranted.
Life-cycle finance and pension funds
It is noted that future research will be enhanced by access to more granular data on individual
portfolio holdings. Current empirical research, which relies almost exclusively on linear regression
analysis, is unable to identify the nonlinearities that are embedded in horizon effects, wealth effects,
cohort effects, and behavioural distortions in preferences.
Performance of mutual funds
Additional research in several areas is warranted. In particular (i) a more balanced treatment of fund
costs, (ii) the resolution of theoretical ambiguities associated with the interpretation of alpha, and
(iii) the development of client-specific performance measures. More granular data on fund trading
activities would open up a huge range of possible topics, including, but by no means limited to,
optimal strategies for fund trading activities to reduce market impact costs, investigation of the
investment skill of fund analysts, investigation of buy verses sell recommendation performance
asymmetries, and the way in which fund performance changes as a result of algorithmic trading.
Collateralised debt obligations
The problem facing future research is not that appropriate mathematical models have been
developed, but rather, not having appropriate data for back-testing of those models.
Mutual funds
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Research of the macroeconomic predictive model has shown great promise in the hedge fund
universe, and it would be interesting to see future research on other asset classes, such as bond
funds, private equity funds, and emerging market funds. Further, one glaring omission from the
literature is an estimate of the trading costs of individual funds. Securities lending is a sideline
business that is profitable for many managed funds. It would be of great interest to study the
interface between the holdings of managed funds, securities lending activity, and the effects of short
selling on markets. Further research advances should be made for non-U.S. asset managers. Finally,
the recently passed Dodd-Frank Act might provide further data for researchers, which could benefit
the public in many ways.
Corporate governance and the board of directors
Although there is a growing empirical literature of the role of boards in setting strategy this is an
area in which much work remains to be done. We still lack a good understanding of committee
structure and the relation between committees and the full board. Progress would be enabled by a
dataset containing all committees. Open questions are numerous and frequently quite fundamental.
Researchers should look for natural experiments, in particular, changes in regulation as a potential
way of dealing with joint-endogeneity issues. Clearly, a database containing changes in global
regulations would be of great value to researchers and regulators alike. Several specific topics seen
as profitable for future research are: How are potential outside directors identified? How are inside
directors identified? What is the role of social networks in director selection? Are busy directors bad
for the firm? How and why does director expertise matter? Typically, the board is modelled as a
single decision maker, but what are the dynamics within boards? Committees need further research.
Much of the literature is on Anglo-American firms, yet there are potential insights and lessons to be
learned from understanding how others deal with corporate governance. Finally, behavioural
corporate finance identifies several human decision-making biases. Do boards suffer from these?
Market microstructure
This is one area where data abounds. Some possible future research issues include:
optimal trading strategies for typical trading problems;
how information is impounded into prices;
how we might enhance the information aggregation process;
how we avoid market failures;
what sorts of trading mechanisms maximise efficiency;
what the trade-off is between fairness and efficiency;
how market structure is related to the valuation of securities;
what market / trading data can tell us about the informational environment of the firm;
what market / trading data can tell us about long-term risk; and
how fair are capital markets. Much has been done on efficiency, but fairness has received
relatively little attention.
Finance and inequality
Future research would benefit enormously from constructing more precise measures of financial
development, access to financial services, and inequality on a global basis. There is a shortage of
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theoretical and empirical research on the potentially enormous impact of formal financial sector
policies, such as bank regulations and securities law, on persistent inequality. Furthermore, we lack a
conceptual framework for considering the joint and endogenous evolution of finance, inequality,
and economic growth.
Learning in financial markets
This is a fascinating research area with many potential topics. In most existing learning models,
agents learn by observing cash flows or asset returns, but they could also learn from the prices of
derivative securities. Another promising direction is to separate systematic and idiosyncratic
uncertainty. Future work can also analyse strategic information generation. More generally, we need
more dynamic learning models in corporate finance.
Particular challenges in conducting this research
Academics invest heavily in developing their research skills to gain expertise and reputation in
particular areas. These skills are not always easily transferred to other research topics; consequently
many academics maintain whole-of-career associations with particular topics where they have
sound knowledge of the literature and research methods. The CIFR key research issues are in areas
that are not necessarily those in which academics have developed their expertise, hence creating the
incentives for researchers to take on new areas of investigation is a vexing issue. CIFR wants
researchers to break out of their comfort zones and take on new (and thus seen as risky) projects.
A recurring theme in this report is that the availability of reliable datasets is a precursor to empirical
research. Accordingly, to the extent that CIFR’s key research interests require data that are currently
not available, a challenge for CIFR is to invest (or co-invest) in providing such data. When CIFR
receives research proposals that involve the creation of datasets that will both address key CIFR
research questions, and facilitate research for subsequent investigations, it seems that such
proposals warrant special consideration.
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Introduction
This report has been commissioned by the Centre for International Finance and Regulation (CIFR). It
provides a high level (i.e., it is based on a reading of survey papers rather than the original research
contributions) literature review of finance research in research areas of key interest to CIFR, broadly
Systemic Risk, Financial Market Developments and Market and Regulatory Performance (see below
for further sub-category details). It answers the question “What do we know from prior studies
about these key research areas?” In conducting this analysis, an objective is to identify gaps in
knowledge, and thus provide a list of potential projects for possible CIFR funding. It thus answers the
second question “What do we not know from prior studies about these key research areas?”
What we know about finance and what remains to be learned is the subject of the final chapter of
Brealey, Myers and Allen (2011), one of the most widely used textbooks in corporate finance. This
chapter contains a list of seven things that we know about finance, as well as 10 unsolved problems
in finance. The seven most important ideas in finance are:
1. Net Present Value. This rule, which states that firms should accept projects with positive net
present values, allows managers of firms to make decisions that shareholders will agree
with, irrespective of their wealth and attitude to risk.
2. The Capital Asset Pricing Model (CAPM). This model, which was developed from Markowitz’s
Portfolio Theory, gives firms a manageable way of estimating the required rate of return on
a risky investment. The model has proved empirically intractable, however the practical
implication that the risk of an asset should be thought about in terms of its non-diversifiable
(alternatively called systematic, market or beta risk) component is of monumental
significance.
3. Efficient Capital Markets (ECM). This idea states that security prices accurately and rapidly
reflect available information. Were this not true then the use of market signals (price,
volume, volatility, order book depth, spread etc.) in empirical research would cause invalid
conclusions.
4. Value Additivity and the Law of the Conservation of Value. This rule states that the value of
the whole (say firm) is equal to the summation of the individual investments that the firm
has made.
5. Capital Structure Theory. If the Law of Conservation of Value works for adding project cash
flows, it must also work when you subtract cash flows, i.e., for financing decisions. This is the
Modigliani and Miller (MM) perfect capital market proposition that “the total size of a pie
does not depend on how it is sliced”. Proof of the MM capital structure irrelevance
propositions was developed through the exploitation of arbitrage opportunities that would
arise if, in perfect capital markets, levered and unlevered firms were valued differently.
Some would argue that arbitrage, rather than capital structure, is the key lesson from this
analysis.
6. Option Theory. The relevant attributes to price an option, i.e., the exercise price, the
exercise date, the spot price, the volatility of the underlying asset and the risk-free rate of
interest, are known as a result of the work done by Fisher Black and Myron Scholes.
7. Agency Theory. Participants in firms have incentives to act in their own interest, and this
creates conflicts of interest. These conflicts need to be monitored and managed.
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The ten unsolved problems in finance, according to Brealey et al. (2011), are:
1. How can a financial manager assess a project beta?
2. What is missing from the CAPM, i.e., are factors other than beta priced?
3. How important are the exceptions to ECM?
4. Why do closed-end funds sell at a discount?
5. Why has there been such a huge proliferation in financial markets and instruments?
6. What is the optimal payout policy for a firm?
7. What risks should a firm hedge?
8. What is the value of liquidity?
9. How can we explain merger waves?
10. Why are financial systems seemingly so prone to crisis and what factors cause these crises?
Brealey, Myers and Allen (2011, p. 875) state “Understanding financial crises will occupy
economists and financial regulators for many years to come. Let’s hope they figure out the
last one before the next one knocks on the door”. CIFR would no doubt concur.
In developing the papers that are analysed below I adopted the following approach. I used library,
SSRN and web searches to identify major finance survey papers that had been published in the last
four years. The principal sources for these papers were the electronic journal “Annual Review of
Financial Economics”, Eckbo ed. (2008) and SSRN. This search discovered 66 survey papers. The
Abstract for each survey paper was then read and used to classify the paper as being of high,
moderate or low relevance to CIFR’s key research agenda. This resulted in 23 finance papers being
classified as high relevance. This list and the identified papers were then sent to CIFR for comment,
and this resulted in a further four finance papers being added to the high relevance category. Thus
this review is a summary of 27 recent finance survey papers (which refer to a total of 2,873 original
published articles, books and working papers) that the author and CIFR have jointly agreed to be
highly relevant to the future key research focus of the Centre.
Each of the 27 reviewed papers follows a consistent format and is set out in three sections. First, the
abstract from each paper is quoted verbatim. Second, a summary of the references used in the
paper is provided so the reader can understand the breadth and quality of the papers used in the
survey. Third, a discussion of the key messages from the paper and the areas where future research
is warranted, is provided.
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CIFR Key Areas of Interest
(A) Systemic Risk
Understanding and managing systemic risk
Specific systemic risks
Transmission of systemic risk through the global financial system.
Reviewed papers
Paper 1
Michiel Bijlsma, Jeroen Klomp and Sijmen Duineveld, 2010, “Systemic risk in the financial sector: A
review and synthesis”, CPB Netherland Bureau for Economic Policy Analysis Paper 210.
Abstract – quoted directly from Bijlsma et al. (2010)
“The financial crisis has put systemic risk firmly on the policy agenda. In such a crisis, an initial shock
gets amplified while it propagates to other financial intermediaries, ultimately disrupting the
financial sector. We review the literature on such amplification mechanisms, which create
externalities from risk taking. We distinguish between two classes of mechanisms: contagion within
the financial sector and pro-cyclical connection between the financial sector and the real economy.
Regulation can diminish systemic risk by reducing these externalities. However, regulation of
systemic risk faces several problems. First, systemic risk and its costs are difficult to quantify.
Second, banks have strong incentives to evade regulation meant to reduce systemic risk. Third,
regulators are prone to forbearance. Finally, the inability of governments to commit not to bail out
systemic institutions creates moral hazard and reduces the market’s incentive to price systemic risk.
Strengthening market discipline can play an important role in addressing these problems, because it
reduces the scope for regulatory forbearance, does not rely on complex information requirements,
and is difficult to manipulate.”
Reference Count – Overall ratio of A* and A journals to total references 0.418
Journal Count
Journal of Finance 10
Econometrica 1
American Economic Review 11
Journal of Financial Economics 1
Review of Financial Studies 3
Other A-ranked journals 70
Other references 134
Total 230
Discussion
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This 98 page report, containing 230 references, is Paper 210 issued by the CBP Netherlands Bureau
for Economic Policy Analysis. The three authors of this report are policy analysts within the Bureau
for Economic Policy Analysis. The paper would perhaps fit better into a banking benchmark review,
rather than a finance review.
Systemic risk – definition and costs of systemic crises
Definition
The report notes that there is disagreement about the definition of systemic risk. The authors define
systemic risk as “the probability that a systemic crisis arises” and the essence of this lies in the
“negative effects that one bank’s problems have on other banks”. The report also notes that the
“mechanisms that lie behind these effects … are ill understood, empirically as well as theoretically”.2
Cost of systemic crises
Empirical evidence shows that the cost of providing government support to bail out a weak banking
system (via a recapitalisation which occurs in 85 per cent of the global banking crises or a
nationalisation which occurs in 57 per cent of global banking crises) is “about 14 per cent of GPD the
first five years after the start of the crisis”. Output is also disrupted, with empirical estimates of the
permanent output loss due to a crisis in the range of 4 to 16 per cent of GDP. When a crisis involves
both a credit crunch and a house price bust the median loss is 6.7 per cent of GDP. According to the
International Monetary Fund (IMF) governments spent about 30 per cent of global GDP on rescue
operations following the recent global financial crisis.
There are three elements to a financial crisis. First, there is an initial shock. Second, this shock is
propagated and amplified. Third, the financial system is disrupted. Systemic risk can be reduced by
reducing the probability of a shock, by damping the amplification or by isolating crucial parts of the
financial system. The report focuses on the propagation and amplification mechanisms which can
occur through two different channels, namely (i) contagion within the financial sector and (ii) pro-
cyclical connection between the financial sector and the real economy. Each of these channels is
analysed in detail in a major chapter in the report. A discussion of the various approaches to the
regulation of systemic risk also occupies a major chapter.
Contagion
Contagion is defined as “the propagation of shocks experienced by one bank to other banks through
mechanisms within the financial sector”. The literature identifies three ways in which this
propagation can occur, namely (i) through direct and indirect interconnections between the banks
created by an intricate web of financial contracts (i.e., direct exposures are due to credit lines,
derivative counter-party exposures, loans in the inter-bank market, while indirect exposures arise
due to a common exposure to borrowers or lenders) (ii) one bank’s problems might negatively affect
the ability of other banks to obtain funding in the face of unexpected liquidity needs (resulting in fire
sales of assets, liquidity hoarding and adverse selection) and (iii) information spill-overs (causing
bank runs). While these propagation mechanisms are understood conceptually, and have been
2 Clearly if researchers had access to better data from the banks and the central bank these transmission
mechanisms could be investigated.
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subject to extensive economic modelling, a precise understanding of the relative contribution of
each propagation mechanism remains both controversial and elusive. Researchers have turned to
empirical investigations, but these frequently suffer from an inability to access sufficient detail on
the complex financial contracting between banks, necessitating the use of assumptions that might
be invalid. Both micro-level and market data studies have been conducted. Micro-level studies
typically employ simulation of balance sheet connections or payment system connections. These
studies generally conclude that the likelihood of large scale banking defaults being caused by
contagion is relatively small. However there are several methodological problems in these empirical
investigations. Another group of studies employ market data such as share prices and credit-default
swap spreads, though there is considerable difference in the way they define a systemic risk. Most
market data studies find some evidence of contagion, but again experimental design problems
abound.
Clearly there is ample opportunity for additional empirical research, particularly if richer datasets
become available.
Pro-cyclicality
Pro-cyclicality refers to the feedback loop between the financial sector and the real economy. If the
literature to date on contagion, as discussed above, does not find strong support for contagion as a
dominant factor in the propagation of systemic risk, then it follows that pro-cyclicality (assuming
other propagation mechanisms do not exist) is likely to play a strong role. Pro-cyclicality is induced in
a financial system in several ways. First, regulation of bank capital adequacy ratios can play a role.
Regulation requires banks to have higher capital adequacy in downturns (reflecting the increased
potential credit losses in their portfolios) than in periods of economic expansion and banks might
respond by restricting credit, leading to a reduction in investment and consumption. Second, the use
of Fair Value Accounting (FVA) might require banks to write down their assets in periods when
economic activity is slowing. This writing down reduces banks’ capital, resulting in a curtailment of
their lending activities. Third, pro-cyclicality can be caused by financial acceleration, a macro-
economic literature term that is developed around the idea that financial market imperfections can
amplify the business cycle through the availability of bank credit. Fourth, behavioural biases, herding
and bubbles might be at play.
The discussion in the paper on pro-cyclicality is almost entirely conceptual. The discussion points out
that, empirically, loan loss provisions are higher when GDP growth is lower, that the quality of loans
is positively associated with the business cycle, and that there has been some empirical work in
relation to FVA, while herding and asset price bubbles have been more extensively researched.
Regulation
The benefits of creating systemic risk accrue privately, but the costs are imposed across the whole
society. This disparity is argued to make regulation of the financial system necessary. Three broad
policy measures that are intended to reduce systemic risk are incentive regulation (with elements of
taxation, capital requirements, insurance and market discipline), structural regulation (with
elements of quantity regulation, portfolio restrictions, transparency and standardisation, fair value
accounting and credit rating agencies) and ex post crisis intervention (with elements of lender of the
last resort, deposit insurance, Prompt Corrective Action, living will and bank-specific bankruptcy
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law). The paper proposes that regulation has a role to play in r educing systemic risk, but that there
are four generic problems. These are summarised in the Abstract above. It should however be noted
that it is both impossible and undesirable to fully eliminate systemic risk via regulation.
Clearly there is currently considerable ongoing theoretical and empirical research and a lively debate
between academics, policy makers, regulators and practitioners on how to regulate systemic risk.
Better access to banking data would enable additional insights via empirical analysis. Current
research is somewhat limited by the inability of researchers to access detailed banking records that
would allow a deeper understanding through access to detailed global banking records.
Paper 2
Anna Scherbina and Bernd Schlusche (2011), “Asset Price Bubbles: A Survey”
Abstract - quoted directly from Scherbina and Schlusche (2011)
“Why do asset price bubbles continue to appear in various markets? What types of events give rise
to bubbles and why do arbitrage forces fail to quickly burst them? Do bubbles have real economic
consequences and should policy makers do more to prevent them? This paper provides an overview
of recent literature on bubbles, with significant attention given to behavioural models and rational
models with frictions. The latest U.S. real estate bubble is described in the context of this literature.”
Reference Count – Overall ratio of A* and A journals to total references 0.671
Journal Count
Journal of Finance 12
Econometrica 3
American Economic Review 9
Journal of Financial Economics 8
Review of Financial Studies 2
Other A-ranked journals 23
Other references 28
Total 85
Discussion
A straightforward definition of a bubble is “a (persistent) deviation of the market price from the
asset’s fundamental value”. Because trading against an overvalued asset involves additional costs of
maintaining a short position, it can be expected that persistent overvaluation is more common than
persistent undervaluation. The paper focuses on positive price bubbles. The paper provides a
chronological overview of famous bubbles, including the 1634 – 1637 tulip price bubble, the South
Sea Company market price bubble of 1720, the Mississippi Company bubble of 1719 – 1721, and the
collapse of both stock and real estate prices in the U.S. in October 1929 leading to the Great
Depression. In the 1980s Japanese real estate and equity prices increased dramatically, but fell
dramatically in the early 1990s. The dot-com bubble began in 1995 and began to deflate in March
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2000, reaching a low in August 2002. These and the many other examples3 provided in the paper
indicate that bubbles can sometimes explode, and they can sometimes deflate rather more
gradually. However, the time it takes asset prices to deflate is generally shorter than the time to
inflate. Bubbles are, in short, reasonably common.
The paper (Section 3) then reviews the theoretical and empirical work on rational models of bubbles,
i.e., bubbles that arise when all agents are perfectly rational. The models reviewed in this section
help explain the seemingly puzzling empirical facts that stock prices are more volatile than dividends
and that stock prices overreact to dividend changes.
Section 4 reviews behavioural models, where agents are not necessarily perfectly rational. These
models generally draw on evidence of human behaviour from the psychology literature. Several
behavioural categories exist, namely (i) models based on asymmetric information in the presence of
short sale constraints, (ii) feedback trading leading to price paths for assets akin to a Ponzi scheme,
(iii) models where agents take more notice of signals that confirm their beliefs than signals that
contradict their priors, and (iv) models based on the representativeness heuristic where agents put
too much weight on recent observations relative to more distant outcomes.
Historically, most bubbles have a somewhat sensible explanation, i.e., the dot-com bubble fed on
the way new technology would improve productivity, and real estate bubbles can arise because land
supply is fixed but population expands, particularly if securitisation allowed risk mitigation. Bubbles
are frequently associated with abnormally high trading volumes. The literature points to a number of
reasons why bubbles are not arbitraged away, including the risk to a short-seller that prices will
continue to rise and that the cost of trading is higher when information asymmetries are greater
(which is typical of conditions in a bubble). During the dot-com bubble, hedge funds rode the bubble
(i.e., maintained long positions) rather than attack it via sale and short-sale strategies.
Newer generation bubble models are based on (i) herding of agents – here the role of the media in
herding has not been analysed, (ii) limited liability which can offer downside protection, (iii)
(sometimes) perverse incentives of important market participants including analysts, rating agencies
and auditors.
Bubbles have been shown to develop in a large number of experimental settings. Experimental
market bubbles retain many of the features of bubbles in actual markets, namely high transaction
volumes, large swings in price relative to fundamentals and sustained trading at prices different
from the fundamental value.
The deflation of some bubbles has dramatic effects on the economy (subprime mortgage collapse of
2007), while deflation of others has a minimal effect (e.g. the dot-com bubble). The literature
regards real estate price bubble collapses as especially likely to be rapidly transmitted to, and
disruptive of, the financial system and the wider economy. Some argue that central banks should
aim to deflate bubbles. However the authors do not agree because (i) bubbles are not easily
identifiable, (ii) intervention to pierce a bubble will harm those with a long position in the asset, (iii)
3 Perhaps the best example of an Australian bubble is the shares of Poseidon NL’s announcement of a
promising nickel discovery in September 1969. In early September of 1969 Poseidon’s share price was around 80 cents; the price peaked at $280 per share in intraday trading on 5 February 1970, and then fell steadily to around $50 per share by November 1970 as the bubble deflated.
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a bubble might be positive for the economy for extended periods, (iv) some bubbles might result
from inefficiencies in the market, and regulation to improve market quality might be more
productive, and (v) central banks might not have tools that produce net economic gains to the
economy.
The origins of the subprime mortgage bubble are traced to the low-interest-rate environment that
was introduced to help the U.S. economy recover from the dot-com bubble’s collapse. Further, a
number of financial innovations (securitisation of MBSs and credit default swaps that were
incorrectly priced due to AAA ratings being given to CCC portfolios of mortgages) and policies that
made housing investment seem attractive relative to other asset classes. The U.S. Financial Crisis
Inquiry Commission (2011) recently determined that the crisis could have been avoided if the
government had paid more attention to the warning signs. It is unlikely that an explosion in
subprime lending, rapid home price increases, unscrupulous lending, and steep increases in
homeowners’ leverage will be allowed to continue unabated in the future. In short, closer
monitoring of economic activity will prevail. Potential research topics include (i) whether short sale
restrictions should be liberalised, (ii) whether the asymmetric protection of limited liability should be
reconsidered, (iii) whether governments should intervene in markets when “warning bells start
ringing”, and (iv) what role can financial education better play in reducing investor irrationality.
Paper 3
Franklin Allen, Ana Babus, and Elena Carletti, 2009, “Financial Crises: Theory and Evidence”
Abstract – quoted directly from Allen et al. (2009)
“Financial crises have occurred for many centuries. They are often preceded by a credit boom and a
rise in real estate and other asset prices, as in the current crisis. They are also often associated with
severe disruption in the real economy. This paper surveys the theoretical and empirical literature on
crises. The first explanation of banking crises is that they are a panic. The second is that they are part
of the business cycle. Modelling crises as a global game allows the two to be unified. With all the
liquidity problems in interbank markets that have occurred during the current crisis, there is a
growing literature on this topic. Perhaps the most serious market failure associated with crises is
contagion, and there are many papers on this important topic. The relationship between asset price
bubbles, particularly in real estate, and crises is discussed at length.”
Reference Count – Overall ratio of A* and A journals to total references 0.542
Journal Count
Journal of Finance 5
Econometrica 5
American Economic Review 10
Journal of Financial Economics 3
Review of Financial Studies 4
Other A-ranked journals 38
Other references 55
Total 120
15
Discussion
Financial crises result, on average, in severe economic effects. For example, real housing prices fall
35 per cent over six years, equity prices fall 55 per cent in 3.5 years, output falls nine per cent in two
years, unemployment rises seven per cent in four years and central government debt is typically 86
per cent higher than its pre-crisis level.
The paper gives a brief overview of theoretical models of (a) banking crises (the literature is divided
into two sections; one set of models is built on bank runs being caused by random deposit
withdrawals that are unrelated to changes in the real economy, while the second set describes
banking crises as a natural outgrowth of the business cycle), (b) liquidity and interbank markets, (c)
contagion (where models examine either direct linkages or indirect balance-sheet linkages), and (d)
bubbles and crises. The discussion in these four sections is almost entirely a non-technical
description of the main theoretical models. Some empirical studies are discussed in relation to
indirect interbank balance-sheet linkages and asset bubbles.
The final section of the papers provides directions for future research. While the current crisis has
spurned a large literature, Allen et al. (2009) call for more research that will allow us to gain a better
understanding of the market failures that lead to financial crises. Such work is needed in order to
design policies to prevent such crises and ameliorate their effects. The three main market failures
that warrant additional research are (i) provision of liquidity, (ii) limits to arbitrage and the
mispricing of assets, and (iii) contagion. The paper also calls for additional macroeconomic research
to give a better understanding of the relationship between monetary policy, credit and asset prices.
Allen et al. (2009) state (p.112) that the “financial services industry is perhaps the most regulated
(industry) in the world”. Yet this regulation did not prevent the crisis. “The failure … indicates that a
complete overhaul is needed.” (p. 112) In particular they argue that the Basel arrangements are not
based on a coherent intellectual framework. Current policies of supporting failed institutions create
bad incentives for large institutions if they start to rely on being saved in future crises. The best form
of intervention is not understood, and perhaps temporary nationalisation and subsequent orderly
privatisation would be preferred.
Paper 4
Monica Billio, Mila Getmansky, Andrew W. Lo, and Loriana Pelizzon, 2010, “Measuring Systemic Risk in the Finance and Insurance Sectors”
Abstract – quoted directly from Billio et al. (2010)
“A significant contributing factor to the Financial Crisis of 2007–2009 was the apparent
interconnectedness among hedge funds, banks, brokers, and insurance companies, which amplified
shocks into systemic events. In this paper, we propose five measures of systemic risk based on
statistical relations among the market returns of these four types of financial institutions. Using
correlations, cross-autocorrelations, principal components analysis, regime-switching models, and
Granger causality tests, we find that all four sectors have become highly interrelated and less liquid
over the past decade, increasing the level of systemic risk in the finance and insurance industries.
These measures can also identify and quantify financial crisis periods. Our results suggest that while
16
hedge funds can provide early indications of market dislocation, their contributions to systemic risk
may not be as significant as those of banks, insurance companies, and brokers who take on risks
more appropriate for hedge funds.”
Reference Count – Overall ratio of A* and A journals to total references 0.512
Journal Count
Journal of Finance 13
Econometrica 1
American Economic Review 2
Journal of Financial Economics 6
Review of Financial Studies 10
Other A-ranked journals 33
Other references 62
Total 127
Discussion
This paper uses the statistical patterns in monthly index returns for hedge funds, banks, brokers and
insurance companies to develop various measures of systemic risk. These measures capture the
liquidity, leverage, linkages and losses of the four types of financial institutions. As the abstract
states, the paper uses correlations, cross-autocorrelations, principal components analysis, regime-
switching models, and Granger causality tests as alternative ways of empirically estimating the level
of systemic risk in the U.S. economy. Data for the 180 months of January 1994 to December 2008
are used. It is immediately apparent that similar analysis in other nations would be desirable.
Further, the analysis could be extended to measures other than returns, in particular higher
moments of the return distributions, as well as volumes of trading, spreads, and informed trading
measures. It would also be worth investigating individual firm returns, rather than index returns.
The data reveal a number of interesting findings, which are summarised in four sections below.
1. Findings – Illiquidity and Correlation
The correlations vary considerably over time. All types of financial institutions have high
illiquidity during the recent crisis. The evidence suggests that hedge funds suffer from,
rather than cause, contagion from other financial institutions.
2. Findings – Principal Components Analysis
The findings suggest that banks, brokers and insurance companies are heavily exposed to
the first and second principal components in returns, while hedge funds have high exposure
to the third and fourth components. Hedge funds seem to be quite independent of other
financial institutions. Hedge funds have, however, become more interconnected with each
other over time, thus increasing systemic risk.
3. Findings – Regime Switching Models
17
Volatility in the high-volatility regime is typically twice as large as it is in the low-volatility
regime. A natural measure would be to classify periods when all four types of financial
institutions are in high-volatility regimes as being a period of systemic risk. An alternative
measure would be to calculate the average probability of being in a high-volatility regime for
the four institutions. Both measures allow periods when systemic risk is on the rise to be
identified, and to assess the influence of each industry.
4. Findings – Granger Causality Tests
During the first part of the sample (1994-2000), banks, brokers and insurers uni-directionally
affected hedge funds. However, shocks to hedge funds did not propagate to other financial
institutions. In the second part of the sample all financial institutions became highly linked.
Banks are found to be the most contagious of the four types, i.e., their shocks propagate to
the others while shocks to the others do not affect banks.4
Over the recent period, the empirical results suggest that the banking sector is a more important
source of systemic risk than other financial sectors. The best method of avoiding some of the most
disruptive consequences of crises is to develop methods for measuring, monitoring and anticipating
such events.
Paper 5
Philippe Jorion, 2010, “Risk Management” Abstract – quoted directly from Jorion (2010) “Modern risk management systems were developed in the early 1990s to provide centralized risk
measures at the top level of financial institutions. These are based on a century of theoretical
developments in risk measures. In particular, value at risk (VAR) has become widely used as a
statistical measure of market risk based on current positions. This methodology has been extended
to credit risk and operational risk. This article reviews the benefits and limitations of these models.
In spite of all these advances, risk methods are poorly adapted to measure liquidity risk and systemic
risk.”
Reference Count – Overall ratio of A* and A journals to total references 0.640
Journal Count
Journal of Finance 4
Econometrica 2
American Economic Review -
Journal of Financial Economics 1
Review of Financial Studies -
4 It is important to note that the empirical tests are based on index returns, and what is true for the index is
not necessarily true for the individual firms that are part of the index.
18
Other A-ranked journals 9
Other references 9
Total 25
Discussion
A time-series of the main developments in risk management is provided in Table 1 of Jorion (2010, p.
348), and this is reproduced below.
This chronology introduces risk concepts of duration (1938), stock beta (1963), and option “Greeks”
(especially option delta and vega) (1973). Markowitz shows that the risk of the portfolio of
exposures / assets that a firm holds depends, not on the individual risks of the exposures / assets
(which can be eliminated in a diversified portfolio), but on the way the individual elements
contribute to the risk of the whole. This is a covariance risk, not a variance risk.5 However, if the
assets in a portfolio are highly correlated, as they were in the case of Long-Term Capital
Management, and as they are in the case of the highly levered portfolios of banks, particularly in
periods of stress, then portfolio risk does not benefit from diversification. Following Sharpe’s single
factor asset pricing theory,6 multi-factor versions emerged (1966). Developments in derivative
instruments such as complex options, forwards, futures and swaps most frequently occurred among
participants in financial markets and institutions, rather than as a result of academic research.
Global derivatives markets have experienced dramatic growth7, as illustrated in Table 2 from Jorion
(2010, p. 353) reproduced below:
5 A stock’s beta is its covariance with the market return scaled by the variance of the market return.
6 Several versions of the CAPM were developed, including those by James Tobin, Jack Treynor, John Lintner
and Jan Mossin, but William Sharpe was “singled-out” by being jointly-awarded the 1990 Noble Prize in Economics. 7 To put these numbers in context it is noted that the global equity market capitalisation for listed securities
stood at approximately $US50 trillion in 2008, approximately the same value as outstanding currency swaps. Interest rate swaps are larger that global equity market capitalisation by a factor of eight. It is clear that if a major link in this chain of counterparty exposures in interest rate swaps were to fail, the repercussions are
19
As a result of some spectacular losses (for example Barings lost $1.3 billion from unauthorised
speculation in stock index futures), the financial industry devised more comprehensive measures of
risk. Value at Risk (VaR) was introduced in 1993 at J.P. Morgan and led to the creation of its
RiskMetrics in 1994.8 VaR has several limitations. It ignores losses in a portfolio that are outside a
pre-determined confidence interval, it assumes orderly liquidation of assets, and it views a financial
institution as a price-taker and thus ignores market impact costs. Recognition of these led to the
development of Conditional VaR (CVaR), which has some theoretical advantages to VaR, but still
ignores market impact costs. Finally, it needs to be noted that in any risk management system the
use of historical data as inputs for models poses problems. The past does not necessarily repeat and
structural breaks may not be present in past data. Methods to model time variation in risk (ARCH)
were developed in 1982 by Robert Engle.9 Hence risk management requires specific modelling of
regime switches and the use of long periods of historical data in model calibration.
VaR methods and their subsequent refinements were introduced to measure market risk. These
approaches have been extended to consider credit risk (counterparty risk) and operational risk.
Credit risk models, which build on the Merton model and the Jarrow and Turnbull model, were
developed in the late 1990s. These allowed financial institutions to measure their total credit risk for
the first time – and this spurned the development of credit default swaps. As is the case with market
risk measures, credit risk models also have limitations. In particular, it is difficult to incorporate
counterparty risk, because this depends on the counterparties that the counterparty has, and
financial contracting is a complex web. Operational risk models (risk of losses arising from
inadequate or failed internal processes, from people and systems or from external events) have also
been developed, but data to estimate these are scarce and the methods remain controversial.
potentially dramatic. Hence the famous “too big to fail” quote popularised by U.S. Congressman Stewart McKinney in a 1984 Congressional hearing, discussing the Federal Deposit Insurance Corporation's intervention with Continental Illinois. Alan Greenspan, who served as Chairman of the Federal Reserve of the United States from 1987 to 2006, believes that such large organisations should be deliberately broken up: “If they’re too big to fail, they’re too big.” 8 J.P. Morgan made RiskMetrics freely available on the internet.
9 Engle was awarded the 2003 Nobel Prize in Economics.
http://en.wikipedia.org/wiki/U.S._Congresshttp://en.wikipedia.org/wiki/Stewart_McKinney_%28politician%29http://en.wikipedia.org/wiki/Stewart_McKinney_%28politician%29http://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporationhttp://en.wikipedia.org/wiki/Continental_Illinoishttp://en.wikipedia.org/wiki/Alan_Greenspanhttp://en.wikipedia.org/wiki/Chairman_of_the_Federal_Reserve
20
In spite of several quantitative advances, risk management is still largely an art form. Risk
architecture needs to consider the costs and timeliness of risk signals relative to the benefits. And, of
course, if all risks are managed, the prediction from theory is that the firm will earn the T-bill rate.
“No model can fully account for systemic risk … Systemic risk should be handled by the central bank,
which is effectively becoming the risk manager of last resort.” (p. 364)
Paper 6
Dale F. Gray, 2009, “Modeling Financial Crises and Sovereign Risks”
Abstract – quoted directly from Gray (2009)
“The complex interactions, spillovers, and feedbacks of the global crisis that began in 2007 remind us
of how important it is to improve our analysis and modeling of financial crises and sovereign risk.
This review provides a broad framework to examine how vulnerabilities can build up and suddenly
erupt in a financial crisis, with potentially disastrous feedback effects for sovereign debt and
economic growth. Traditional macroeconomic analyses overlook the importance of risk, which
makes them ill-suited to examine interconnectedness, risk transmission mechanisms, and contagion.
After presenting an overview of the key features of the global 2007-2009 crisis, this review discusses
new directions for research on modeling financial crises and sovereign risk, including the need for
integrating risk into macroeconomic policy models and enhancing early warning system and financial
contagion models through a more comprehensive view of economy-wide risks. Also, new tools to
mitigate and control macro risk need to be developed, along with new approaches to regulate
financial sector risk-taking and monitor and manage the interactions between private sector and
sovereign risk.”
Reference Count – Overall ratio of A* and A journals to total references 0.304
Journal Count
Journal of Finance 1
Econometrica -
American Economic Review 3
Journal of Financial Economics -
Review of Financial Studies -
Other A-ranked journals 20
Other references 55
Total 79
Discussion
The first section of this paper provides a succinct yet comprehensive summary of the events that led
to the GFC. It ends with a quote from a paper written by Martin Wolfe and published in the Financial
Times. This is reproduced in full below from Gray (2009, p. 126):
http://www.annualreviews.org.ezproxy.lib.uts.edu.au/doi/abs/10.1146/annurev.financial.050808.114316
21
“We need to ask ourselves whether we could have done a better job of understanding the processes at work. The difficulty we had was that we all look at one bit of the clichéd elephant in the room. Monetary economists looked at the monetary policy. Financial economists looked at risk management. International macroeconomists looked at global imbalances. Central bankers focused on inflation. Regulators looked at Basel capital ratios and then only inside the banking system. Politicians enjoyed the good times and did not ask too many questions ... One big lesson of this experience is that economics is too compartmentalized and so … are official institutions. To get a full sense of the risks we need to combine the worst scenarios of each set of experts. Only then would we have had some sense of how the global imbalances, inflation targeting, the impact of China, asset price bubbles, financial innovation, deregulation and risk management systems might interact.”
The very clear message that emerges is that information from several different perspectives needs
to be analysed simultaneously to get a clear picture of systemic risk. Wolf identifies monetary
economists, financial economists, international macroeconomists, central bankers, regulators and
politicians as having a role.
Gray (2009) then argues that what was missing were inputs from macro financial risk experts (who
work for central banks, ministries of finance, regulatory bodies and international institutions) who
can provide timely assessments of
(i) Risk exposures and risk-adjusted balance sheets aggregated for the financial sector
and sovereign level, including off-balance sheet risks,
(ii) The integration of financial sector risks with monetary policy, and
(iii) Financial contagion and interconnections.
Conventional models and tools used by central banks and governments are ill-suited for analysing
risk exposures (because macroeconomic risk assessment is almost entirely flow- or balance sheet-
based, because default risk is ignored in macroeconomic models, and because of not adequately
incorporating the off-balance sheet exposures to obscure credit derivatives). So what can be done?
Gray suggests (p. 121) the “development of a sovereign contingent claims option theoretic model
through the application of modern finance theory (and in particular the lessons from the Merton
model where equity is priced as a call option with an exercise price equal to the value of the debt)
and risk-adjusted balance sheets, using contingent claims analysis (CCA), to all the key sectors of the
economy. These finance and balance sheet models are then integrated with macroeconomic
monetary policy models, dynamic stochastic general equilibrium models, and other macro models.”
Gray (2009) identifies six new directions for future research to improve measurement, analysis and
management of financial and sovereign risk, and to reduce the severity of financial crises. These are
as follows:
1. Developing a unified macrofinance framework aggregated across the
household and corporate sectors incorporating financial stability policies,
monetary policies and fiscal and debt policies, as well as global market claims;
2. Integrating financial sector and sovereign risk into monetary policy models;
3. Developing new models of early warning, financial contagion and
interconnectedness;
4. Developing new tools and techniques to mitigate control and transfer risk;
22
5. Introducing new approaches to the regulation of financial sector risk taking.
This involves several aspects including fully understanding linkages, rethinking
capital adequacy, cross-border banking regulation, and understanding the
unintended consequences of inappropriate regulations. As a result of the GFC
the U.S. banking system is far more concentrated, and the top 15 institutions
now control more than half the nonfinancial debt. These are “really too big to
fail and may be too big to rescue”. Institutions that are adjudged to be
contributing substantially to systemic risk should be required to purchase
insurance or pay a surcharge. Comprehensive risk exposure data must be
collected. (bold emphasis added)
6. Monitoring and managing sovereign risk through the application of CCA and
VaR analysis at the sovereign level.
23
(B) Financial Market Developments
Market quality measures
Market innovation, complexity and integrity (products, services, technologies,
market payment systems, counterparty risk, outsourcing)
International capital markets (risks and benefits in flows, diversification and
different regulatory frameworks)
Financial Market Integration
Reviewed papers
Paper 7
John J. McConnell and Stephen A. Buser, 2011, “The Origins and Evolution of the Market for
Mortgage-Backed Securities”
Abstract – quoted directly from McConnell and Buser (2011)
“The first mortgage-backed security (MBS) was issued in 1968. Thereafter, the MBS market grew
rapidly with outstanding issuances exceeding $9 trillion by 2010. The growth in the MBS market was
accompanied by numerous innovations such as collateralized mortgage obligations (CMOs) and the
emergence of private label alternatives to MBS issued by government-sponsored entities. We trace
the evolution of the MBS market and we review debates surrounding such questions as whether the
MBS market has reduced the cost of housing finance, whether the MBS market is a market for
lemons, and what role, if any, MBS played in the run-up and subsequent decline of home prices
during the decade of the 2000s. We also detail the evolution of models for MBS valuation as
developed by academics and practitioners.”
Reference Count – Overall ratio of A* and A journals to total references 0.781
Journal Count
Journal of Finance 6
Econometrica 3
American Economic Review 1
Journal of Financial Economics 1
Review of Financial Studies 5
Other A-ranked journals 41
Other references 16
Total 73
Discussion
http://www.annualreviews.org.ezproxy.lib.uts.edu.au/doi/abs/10.1146/annurev-financial-102710-144901http://www.annualreviews.org.ezproxy.lib.uts.edu.au/doi/abs/10.1146/annurev-financial-102710-144901
24
This paper describes the evolution of the U.S. market for mortgage-backed-securities (MBS) and
investigates whether these developments have lowered the cost of housing finance, and whether
they have expanded the pool of funds available for house finance. The paper also investigates the
role that MBS and collateralised mortgage obligations (CMO) played in the GFC, and describes the
evolution of models developed to price these complex assets.10
Government-Sponsored Mortgage Enterprises (GSE); Agency and Non-Agency (Private) MBS
The MBS market in the U.S. can be divided into two sectors, agency and non-agency (i.e., private)
MBS. Loans must meet certain criteria to be acceptable for inclusion in the agency market. Such
loans are called conforming loans. All other loans are a part of the non-agency market (subprime and
nonprime loans, i.e., nonconforming loans). The agency market covers government-sponsored
mortgage enterprises (GSE) which had their genesis in 1933 and 1944 when the U.S. government
established mortgage insurance programs11 to provide guarantees for mortgage investors, thereby
making house finance more readily available following the Great Depression and the Second World
War, respectively. In 1938 the Federal National Mortgage Association (FNMA) was established, and
this was privatised in 1968. When this privatisation took place, the U.S. government established the
Government National Mortgage Association (GNMA) which, at its inception, was chartered to issue
MBS supported by FHA and VA mortgage loans.12 In 1996, total MBS issuances were less than $500
million, and private label offerings were only 10 per cent of this total. Total MBS reached an all-time
high of $3.2 trillion in 2003, and private label issuances peaked at $0.9 trillion in 2006. Private
issuances shrank to $45 million during 2008 (1/20th of the peak) and to $30 million in 2009 (1/30th of
the peak).
Collateralised Mortgage Obligations
The first multiclass MBSs (or CMOs) were issued in 1983 and 1985 by the Federal Home Loan
Mortgage Corporation (FHLMC) and FNMA respectively. Investors in MBS face two risks, interest rate
risk and credit risk. Because the earliest MBS was essentially government-guaranteed, credit risk
played a relatively small role in early research on the MBS market and the valuation of MBSs and
CMOs.
Cost of Mortgage Credit
The creation of GSEs and the establishment of their MBS programs had the national goal of assisting
individuals and families in buying homes. Did these programs cause borrowing rates to fall? While
the evidence is not unanimous, the several studies that have been conducted suggest the answer is
yes, with estimates of lower borrowing costs in the range of nine to 30 basis points. Did these
programs expand the pool of mortgage credit? Again the tentative answer is yes, but the main driver
of this expanded pool is attributed to the expansion of subprime MBS lending.
10
The U.S. market for house finance differs from the Australian market. U.S. mortgages are typically fixed-rate loans. A U.S. mortgagee has the option to repay a loan, without penalty, if interest rates fall. A U.S. mortgagee also has an option to walk away from a home if house price falls. Thus U.S. borrowers have both a call option and a put option. Whether the subprime defaults that occurred in the U.S. would have been as dramatic if lending followed Australian practice is an interesting issue. 11
The Federal Housing Administration (FHA) and Veterans Administration (VA) program, respectively. 12
The first ever financial futures contract, initiated in 1974, has as its underlying asset GNMA MBS.
25
Credit Rating Agencies (CRAs) and the GFC
The early MBS market had no role for CRAs because of implicit or explicit government guarantees.
But as the volume of private label CMOs expanded, CRAs were called upon to rate the credit quality
of CMO tranches. The empirical evidence suggests that the rating standards of the CRAs declined in
the lead-up to the GFC. But were investors duped? The evidence suggests not, because the yields on
lower quality tranches were higher, indicating that investors were able to discern and price this
greater credit risk. That aside, McConnell and Buser (2011, p. 175) suggest that “sorting out the
factors that led to the crash of the MBS market during 2006-2009 is likely to require further
investigation with an emphasis on policy implications”, in particular, what to do with the GSEs that
were taken back into government conservatorship in the bail-out mounted by the Federal Reserve.
Valuation models for MBS and CMO
MBSs are complex securities, and CMOs are even more so. Two approaches to the valuation of these
instruments exist in the literature. One approach is via structural models in which it is typically
assumed that borrowers optimize their loan decisions (i.e., they choose to make a monthly payment,
pay off the loan or default) resulting in a stream of cash flows to the MBS investors. Several
developments, primarily by academics, have occurred in the structural model approaches to valuing
MBSs. Reduced form models were, in contrast, primarily developed by Wall Street, because
structural models were not suited to the valuation of CMOs. Even so, reduced form models suffer
because they require significant time series data to estimate the cash flows to investors, and if the
economic conditions prevailing in the estimation period are structurally different to those in the
valuation period, considerable error can enter into the valuations. Despite the considerable effort
devoted to valuation models by academics and practitioners, McConnell and Buser (2011, p. 175)
state that “development of better models is undoubtedly an area ripe for research”.
Paper 8
Clifford W. Smith, “Managing Financial Risk”, Chapter 18 of Eckbo (2008)
Abstract – quoted directly from Smith (2008)
“Recent developments in corporate risk management include an expansion of the available
instruments, a material reduction in the costs of risk management products, and a more
sophisticated understanding of the benefits. This chapter examines the underlying theory of how risk
management increases firm value, and it summarises the evidence on the use of risk management
instruments.”
Reference Count – Overall ratio of A* and A journals to total references 0.875
Journal Count
Journal of Finance 6
Econometrica -
American Economic Review 1
Journal of Financial Economics 5
26
Review of Financial Studies 1
Other A-ranked journals 15
Other references 4
Total 32
Discussion
Cliff Smith is a highly regarded academic with an impressive publication record. This paper sets out a
series of conclusions drawn from a distillation of the conceptual and empirical literature on
corporate risk management. Many of these propositions are well understood and generally accepted
as theoretically valid, though the empirical evidence is frequently less consistent. The key messages
for the paper are:
Risk management has expanded substantially during the last 20 years.
Our understanding of the costs (which have dramatically decreased) and benefits of risk
management has improved.
Much of the literature on risk management focuses on the use of derivatives, especially
forwards, futures, swaps and options in hedging exposures to interest rates, foreign
exchange rates and commodity prices. However the available risk management instruments
are much broader than these derivatives.
There is disagreement about whether cash flow risk, earnings risk or firm value risk should
be the focus of risk management approaches, and thus additional research is warranted.
The literature identifies wide disparity in the extent to which corporations hedge their risks,
but the questions of why a firm hedges and what instruments should be employed remain
unresolved, again prompting a call for further research.
Some risks are firm specific and some are market-wide or systemic.
For a corporation held by investors who hold diversified portfolios, portfolio theory tells us
that the required rate of return depends on systematic risk, and not on total risk (i.e.,
systematic risk plus diversifiable or firm specific risk). Thus a hedging instrument that
reduces diversifiable risk for such a firm does not reduce the required rate of return for the
firm.
Even if risk management affects systematic risk, as long as the instrument is appropriately
priced, risk management will not affect firm value.
Risk management can, however, increase the value of a widely held firm by increasing the
firm’s expected net cash flows – not by reducing its required rate of return. This can occur
because risk management might affect investment decisions, taxes or contracting costs.
The impact of risk management cannot be confined to shareholders only. Other claimants on
the firm’s cash flows (i.e., bondholders, employees, managers, suppliers and customers)
have a vested interest in the firm’s success.
There has been scant research effort associated with a firm pre-committing to hedging
strategies.
The cost of risk management techniques like swaps has fallen dramatically since the 1980s
when spreads of 100 basis points were common; whereas many swap spreads by 2006 were
as low as two basis points. Swap markets are much more liquid, yet they remain relatively
27
un-researched. The costs of hedging are negatively related to the liquidity of the instrument,
and positively related to asset volatility and specificity.
Almost all firms use derivatives for hedging rather than speculation according to the survey
evidence. Additional research is warranted.
Firm characteristics that are associated with hedging have received some attention, but
there are substantial areas where further research is necessary.
Large firms tend to hedge less than small firms.
Closely held firms’ use of hedging remains largely unexplored.
While hedging involves four steps (exposure identification, instrument design, net benefit
assessment and strategy implementation), the academic literature has concentrated on the
first three steps, leaving considerable scope for research on implementation strategies. Yet
this “may be the single most important in terms of creating firm value”.
Paper 9
Gary Gorton and Andrew Metrick, 2011, “Securitization”
Abstract – quoted directly from Gorton and Metrick (2011)
“We survey the literature on securitization and lay out a research program for its open questions.
Securitization is the process by which loans, previously held to maturity on the balance sheets of
financial intermediaries, are sold in capital markets. Securitization has grown from a small amount
in 1990 to a pre-crisis issuance amount that makes it one of the largest capital markets. In 2005 the
amount of non-mortgage asset-backed securities issues in U.S. capital markets exceeded the amount
of U.S corporate debt issued, and these securitized bonds – even those unrelated to sub-prime
mortgages – were at the centre of the recent financial crisis. Nevertheless, despite the
transformative effect of securitization on financial intermediation, the literature is still relatively
small and many fundamental questions remain open.”
Reference Count – Overall ratio of A* and A journals to total references 0.331
Journal Count
Journal of Finance 8
Econometrica 1
American Economic Review 3
Journal of Financial Economics 4
Review of Financial Studies 4
Other A-ranked journals 27
Other references 95
Total 142
Discussion
28
Securitisation played a central role in the global financial crisis. Prior to the 2007-2008 financial
crisis, securitisation was a very large part of the U.S. capital markets.13 Yet securitisation is “largely
unregulated and it is not well understood”. There has been little research on the issue. The paper,
after providing institutional and descriptive statistics on securitisation, presents a simple model of
the securitisation decision. The origins of securitisation are then summarised. The theoretical
implications for the cost of capital are then discussed, and this is followed by the empirical evidence
on the effect of securitisation on the cost of capital. The question posed is whether securitised loans
have lower rates than loans held on the balance sheet. “Although the perfect experiment … is yet to
be run”, the evidence that does exist suggests that the cost of securitised loans is indeed lower by
around 10-17 basis points.
The final section of this paper is particularly relevant as it sets out a raft of unanswered questions.
These are summarised below.
Why did securitisation arise? Was there innovation? What are the sources of value? How
and why does innovation occur? Will securitisation regain its pre-financial crisis prominence
in capital markets? How does securitisation affect incentives to monitor borrower
behaviour? These are quite fundamental questions and illustrate that relatively little
empirical research has been undertaken on this topic.
The tranching of pools sold to special purpose vehicles (SPVs) remains a puzzle, as, too, does
the choice of loans to pool and sell to the SPV. Why, for example, has securitisation been
confined to specific pools of obligations rather than building portfolios of securitised assets
that combine, for example, credit card receivables, automobile loans, consumer loans,
mortgages and leases?
Explaining the structure of securitisation appears to have a long way to go.
The contractual nature of securitisation also needs more attention.
The structure of securitisation, that is, the internal workings of the SPV, has received little
attention.
Bankruptcy remoteness has received much more attention (particularly in the legal
literature) than liquidation-efficiency, that is, the living will aspect of the SPV. There are a
few examples where SPVs have been liquidated following the contractual rules, but there
are no studies of the contractual rules, or of their evolution.
The market pricing of asset-backed securities (ABS), both primary and secondary, are very
under-studied. As an important asset class, asset pricing of ABS is woefully lacking.
The role of rating agencies in the collapse of securitised loans is under-researched.
The legal form of the special purpose vehicle, typically a trust, has not been studied. Many
countries other than the U.S. had to pass special legislation to create tax neutral legal
vehicles. But, this international dimension has also not been studied.
Little is known about the international cross section of securitisation, other than that it has
grown. Whether there is important national variation is not known.
13
In 1990 straight corporate debt and securitisation in the U.S. both stood at around $100 billion. By 2005 securitisation had grown to $1,700 billion (compound growth of 20.8 per cent per annum) and corporate debt was $1,000 billion (growth rate 16.6 per cent). By 2010 the securitisation market had collapsed to around $120 billion, while corporate debt, after a fall to around $700 billion in 2007, recovered to around $1,080 by 2010.
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Nothing is known about servicers of securitised portfolios or about the contractual
arrangements with servicers.
Could securitisation evolve further?
An important asset class securitised in Europe is the “whole businesses” – whole business
securitisation. What are the limits of securitisation?
What are the implications of securitisation for monetary policy?
Asset-backed securities were at the core of the financial crisis. Their value as collateral was
questioned, causing runs on repo and asset-backed commercial paper (ABCP). What is the
social calculus as to costs and benefits of securitisation? Can a new regulatory design retain
the benefits while minimising the costs?
The paper concludes (p. 62) as follows: “Answering these questions will, in large part, require an
interdisciplinary approach involving scholars of accounting, finance, and law. The institutional and
legal details are very important. It is also clear that answering many of these questions will require
much more data collection than has happened to date. The data to address these questions is (sic)
not obtainable at low cost. It can’t simply be downloaded.”
Paper 10
Josh Lerner and Peter Tufano, 2011, “The Consequences of Financial Innovation: A Counterfactual
Research Agenda”
Abstract – quoted directly from Lerner and Tufano (2011)
“Financial innovation has been both praised as the engine of growth of society and castigated for
being the source of the weakness of the economy. In this article, we review the literature on
financial innovation and highlight the similarities and differences between financial innovation and
other forms of innovation. We also propose a research agenda to systematically address the social
welfare implications of financial innovation. To complement existing empirical and theoretical
methods, we propose that scholars examine case studies of systemic (widely adopted) innovations,
explicitly considering counterfactual histories had the innovations never been invented or adopted.
The significance of financial innovation has been widely touted. Many leading scholars, including
Miller (1986) and Merton (1992), highlight the importance of new products and services in the
financial arena, sometimes characterizing these innovations as an engine of economic growth.
But at the same time, claims of the beneficial impacts of financial innovations must be approached
with caution. One reason is that despite the acknowledged economic importance of financial
innovation, the sources of such innovation remain poorly understood, particularly empirically. In a
recent review, Frame & White (2004) are able to identify only 39 empirical studies of financial
innovation. Moreover, this literature concentrates largely on the back end of the innovation process,
focusing on the diffusion of these innovations, the characteristics of adopters, and the consequences
of innovation for firm profitability and social welfare. Frame & White identify only two papers on the
origins of innovation, namely, Ben-Horim & Silber (1977) and Lerner (2002).
http://www.annualreviews.org.ezproxy.lib.uts.edu.au/doi/abs/10.1146/annurev.financial.050808.114326http://www.annualreviews.org.ezproxy.lib.uts.edu.au/doi/abs/10.1146/annurev.financial.050808.114326javascript:void(0);javascript:void(0);javascript:void(0);javascript:void(0);javascript:void(0);
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There are many different research approaches to understanding financial innovation, including
empirical studies, theoretical models, and traditional historical descriptions. Each has advantages
and disadvantages, which we discuss below. In this review, our goal is to lay out a complementary
research agenda, which we hope will encourage subsequent scholars. After we review the definition
of financial innovation, we turn to three general observations about how financial innovation is
similar to and different from other forms of innovation—and which inform the limitations of
standard research methods. We then consider three case studies of particular innovations and
highlight what is both known and unknown about their consequences.”
Reference Count – Overall ratio of A* and A journals to total references 0.387
Journal Count
Journal of Finance 8
Econometrica 1
American Economic Review 3
Journal of Financial Economics 2
Review of Financial Studies 3
Other A-ranked journals 36
Other references 84
Total 137
Discussion
As noted above, Brealey et al. (2011) is one of the most widely used textbooks in corporate finance.
Much of this book is devoted to developing the net present value (NPV) model as the appropriate
investment decision-making approach. The NPV rule states that firms should accept projects with a
positive NPV. Brealey et al. (2011) argue that finding positive NPV projects for real assets (buying a
new machine, manufacturing a new product, starting a mining project etc.) is relatively easy, but
that investment in financial assets will be a zero NPV project if the asset is efficiently priced. Only if a
new financial product can be developed, for which there is an existing or potential unsatisfied
clientele, will the innovation have a positive NPV. The clear message to many thousands of corporate
finance students is “financial innovation can be a source of value creation”. The proliferation of
financial products over the last 20 years, especially products that are used in risk management,
shows that innovation in financial products is a growth industry.
A good understanding of the main arguments in the Lerner and Tufano (2011) paper can be gleaned
from the rather extensive abstract to their paper that is quoted above. Financial innovation is
controversial, with some papers arguing that it adds to the fragility