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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.”


Journal Count


Econometrica 3





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.”


Journal Count


Econometrica 5





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.”


Journal Count


Econometrica 1





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.”


Journal Count


Econometrica 2

American Economic Review -


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 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.”


Journal Count


Econometrica -


Journal of Financial Economics -

Review of Financial Studies -


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.”


Journal Count


Econometrica 3





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.”


Journal Count


Econometrica -



26



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.”


Journal Count


Econometrica 1





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.”


Journal Count


Econometrica 1





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

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