Implications For Systemic Risk Research Articles

Are fund managers rewarded for taking cyclical risks?

The investment fund sector has expanded dramatically since 2008, increasing the capacity for its risk-taking to generate negative spillovers. This paper provides empirical evidence for the existence of wide-spread risk-taking incentives in the investment fund sector, with a particular focus on incentives for synchronized, cyclical risk-taking which could have systemic risk implications. Incentives arise from the positive response of investors to returns achieved through cyclical risk-taking and non-linearities in the relationship between fund returns and fund flows. The fact that market discipline may not be sufficient to ensure prudent behavior among managers creates a clear case for macroprudential regulatory intervention.

Decoding the systemic risk implications of corporate innovation: Evidence from a three‐period game model and a panel data regression

AbstractHow to understand the implications of corporate innovation in integrating economic development and financial stability is of great importance to the academia and the authority. Based on data from Chinese A‐share listed firms during 2007–2021, this study constructs a three‐period game model and a two‐way fixed effects panel regression model to examine the impact of corporate innovation on systemic risk theoretically and empirically. It is found that innovation measured by quantity and investment significantly pushes up corporate systemic risk, and such an effect is stronger in firms facing a more severe principal‐agent issue and in firms with weaker internal governance and external supervision. The effect pertains to the fact that innovation features high innovation risk and low innovation information robustness. Nevertheless, innovation quality manifested by R&D capitalization has a significant depressing effect on firm systemic risk. Additional tests show that inventive innovation strategies have a significant pushing‐up effect on firm systemic risk. Contrarily, non‐inventive innovation strategies are not necessarily related to a lower failure risk and higher innovation information robustness, and impact firm systemic importance and systemic vulnerability inconsistently, causing an undefined effect on firm systemic risk. The study highlights that the authority should scientifically guide enterprises to innovate and focus on improving innovation quality for structuring a balanced system of stabilizing growth and resolving risks.

Procyclical variation margins in central clearing

This study analyzes the effect of asset prices on the daily exchange of profit and loss from derivatives contracts in central clearing, called variation margin (VM). It provides empirical evidence that the VM exhibits a high volatility and a significant relation to changes in market prices. The magnitude of VM procyclicality has significant implications for systemic risk. This study analytically shows that an internal loan facility can reduce liquidity hoarding and external funding during stress periods and thus contribute to contain systemic risk. In addition, this study proposes a new scheme called the posting of variation margin in securities (PVMS) clause as an example of internal loan facility between the contract counterparties. The PVMS can replace cash VM payments with collateral posting in times of market stress.

CREDIT DEFAULT SWAPS AND BANK SAFETY

In this analysis we find evidence that credit default swap (CDS) purchasesincrease bank safety. Specifically, we show banks which were net buyers ofCDS had smaller increases in loan loss reserves in response to the COVID-19crisis. Previous research had speculated that bank CDS purchases causedincreased risk-taking by banks which offset the effect of the hedge. This anal-ysis contributes to this literature on the effect of hedging on bank risk takingand capital structure. Moreover, since our results are consistent with CDSbeing effectively used to hedge, our results have implications for systemicrisk.

The Effects of Securitization for Managing Banking Risk Using Alternative Tranching Schemes

Diversification practices by banks affect their own risk of failing and the risk of the banking system as a whole (systemic risk). A seminal theoretical work has shown that linear diversification can reduce the risk of a bank failing, but at the cost of increasing systemic risk. Later, a follow-up study showed that a particular strategy of securitization with tranches can help avoid this trade-off. We extend the theoretical work on securitization by considering all possible strategies for securitization with two tranches, by finding their corresponding optimal diversification solutions, and by discussing their implications for individual and systemic risk. We show that securitization that involves exchanging a portion of both tranches brings back the dark side of diversification. In addition, we also show how different strategies of securitization can have risk amplification effects among banks when confidence shocks occur.

Russia–Ukraine war and systemic risk: Who is taking the heat?

The Russia–Ukraine conflict has increased systemic vulnerabilities of the global financial system. We develop a database of news events and investigate the systemic risk implications of the conflict on Russia, Ukraine, France, Germany, Italy, the UK, the USA, and China. Results show that systemic instability costs of the conflict go beyond Russia and Ukraine. Sanctions cause systemic risk spillovers to European countries and the USA. Study findings caution against the accumulation of systemic risk as sanctions may adversely affect the rest of the world aside from the main target - Russia.

Sex Differences in Lipid Metabolism: Implications for Systemic Lupus Erythematosus and Cardiovascular Disease Risk.

It is known that healthy women during childbearing years have a lower risk of cardiovascular disease (CVD) and coronary heart disease compared to age matched men. Various traditional risk factors have been shown to confer differential CVD susceptibilities by sex. Atherosclerosis is a major cause of CVD and mortality and sex differences in CVD risk could be due to reduced atherogenic low and very low-density lipoproteins (LDL and VLDL) and increased atheroprotective high density lipoproteins (HDLs) in women. In contrast, patients with systemic lupus erythematosus (SLE), a chronic inflammatory disease that predominately affects women, have an increased atherosclerotic and CVD risk. This increased CVD risk is largely associated with dyslipidaemia, the imbalance of atherogenic and atheroprotective lipoproteins, a conventional CVD risk factor. In many women with SLE, dyslipidaemia is characterised by elevated LDL and reduced HDL, eradicating the sex-specific CVD protection observed in healthy women compared to men. This review will explore this paradox, reporting what is known regarding sex differences in lipid metabolism and CVD risk in the healthy population and transgender individuals undergoing cross-sex hormone therapy, and provide evidence for how these differences may be compromised in an autoimmune inflammatory disease setting. This could lead to better understanding of mechanistic changes in lipid metabolism driving the increased CVD risk by sex and in autoimmunity and highlight potential therapeutic targets to help reduce this risk.

Sustainability and Systemic Risk - A Conference Report

On 15 June 2020, Eva Micheler (LSE Law), Jon Danielsson (LSE Finance) and Jean-Pierre Zigrand (LSE Finance) organised a conference at the Systemic Risk Centre at the London School of Economics entitled 'Sustainability and Systemic Risk'. The concept of sustainability discourages companies from focusing only on short-term gains and encourages them to integrate the long-term environmental, social and human impact into their decision making. The hope is that business can generate profit while also benefitting or, at the very least, not harming planet and people. The conference explored how sustainability has been incorporated into corporate law and regulation. In the area of corporate law, the concept of stewardship now integrates ecological and social factors. There is also a new focus on corporate purpose. Climate change and other environmental risks have become recognised as factors that can have implications for systemic risk. Sustainability has thus been added into macro- and micro-prudential regulation as well as monetary policy. With investors displaying a greater interest in sustainable financial products, the problem of green-washing has emerged. Financial regulators are currently attempting to address this issue. Corporate law and regulation have come a long way from focusing entirely on financial return to now integrating wider aims into their remit. Sustainability has truly arrived. We cannot however say at this point how much this integration of sustainability into business decisions will achieve for the wider aims it is designed to serve. For example, measuring non-financial impact can cause substantial problems for the social enterprises and charities. Time will tell to what extent profit can be aligned with planet and people. The sections below contain a summary of the contributions made at the conference.

Optimal risk-sharing across a network of insurance companies

Risk transfer is a key risk and capital management tool for insurance companies. Transferring risk between insurers is used to mitigate risk and manage capital requirements. We investigate risk transfer in the context of a network environment of insurers and consider capital costs and capital constraints at the level of individual insurance companies. We demonstrate that the optimisation of profitability across the network can be achieved through risk transfer. Considering only individual insurance companies, there is no unique optimal solution and, a priori, it is not clear which solutions are fair. However, from a network perspective, we derive a unique fair solution in the sense of cooperative game theory. Implications for systemic risk are briefly discussed.

Bank-based versus market-based financing: Implications for systemic risk

Abstract Against the background of the great financial crisis, this paper assesses the merits of bank-based versus market-based financing by exploring the relationship between financial structure and systemic risk. The findings indicate that bank-based financial structures are associated with higher systemic risk than market-based financial structures. In relatively bank-based financial structures, bank financing is found to increase systemic risk while market financing decreases systemic risk. By contrast, in relatively market-based financial structures, bank and market financing do not impact systemic risk. Together, the results signal that market-based financial structures are more resilient to systemic risk.

CLIMAFIN Handbook: Pricing Forward-Looking Climate Risks Under Uncertainty

Aligning finance to sustainability requires methodologies to price forward-looking climate risks and opportunities in financial contracts and in investors' portfolios. Traditional approaches to financial pricing models cannot incorporate the nature of climate risk (i.e. deep uncertainty, non-linearity and endogeneity), and of financial risks (interconnectedness and complexity). To fill this gap, we developed a transparent, science-based framework to assess and price climate financial risks under uncertainty, the CLIMAFIN tool. It embeds climate scenarios adjusted financial pricing models (for equity holdings, sovereign and corporate bonds), climate scenarios conditioned risk metrics (such as the Climate Spread and the Climate Value-at-Risk). These allow us to introduce forward-looking climate risk scenarios in the valuation of counterparty risk, in the probability of default and largest losses on investors' portfolios. This handbook is intended to support investors in the assessment of forward-looking climate risks in their portfolios and in the identification of portfolios' risk management strategies, and financial supervisors in the analysis of risk exposures that could have implications for systemic risk and in the design of prudential measures to mitigate such risk.

Monetary policy and systemic risk-taking in the euro area banking sector

Available empirical evidence on the significance of the (micro) risk-taking channel of monetary policy is not enough to indicate a threat to financial stability. Evidence of risk-taking with systemic risk implications is necessary. Statistical measures that capture systemic risk in all its forms within a structural factor-augmented vector autoregressive model suggest that conventional and unconventional monetary policies have resulted in systemic risk-taking in the euro area banking sector. Systemic risk has taken the form of an increase in the banking sector’s vulnerability via contagion and interconnectedness. Banks’ balance sheets, however, do not account for the full transmission from (micro) risk taking to systemic risk-taking. The main policy implication is that a persistently accommodative monetary policy may drive a monetary authority with a price stability mandate to consider a possible trade-off with financial stability. At a minimum, coordination between monetary and macro-prudential policies requires serious consideration.

Default contagion and systemic risk in loan guarantee networks

AbstractThis paper studies systemic risk in the Chinese debt market stemming from inter‐corporate loan guarantees using field data from Zhejiang Province. We apply a weighted and directed network model to analyse the implications for default contagion and systemic risk under different stress testing scenarios. The empirical results indicate that the topology of the loan guarantee network is close to a ‘scale‐free’ structure, which is known to be robust against accidental failures but vulnerable to coordinated attacks. Hence, the network is able to cope with idiosyncratic shocks resulting from single company failures, but can easily suffer from more widespread contagion if a group of systemically important companies are hit by a targeted shock. We further demonstrate that within our sample of small and medium‐sized enterprise (SME) companies, increasing leverage reduces network stability and exacerbates the effects of contagion. More lenient bank lending policies increase the survival rate of sample companies and thereby reduce the losses from default contagion.

The Systemic Risk Implications of Using Credit Ratings Versus Quantitative Measures to Limit Bond Portfolio Risk

Despite intense criticism, agency credit ratings are still widely used in regulation and risk management. One possible alternative is to replace them with quantitative default risk measures. For US data, I find that systemically relevant losses from corporate defaults are mostly smaller if risk-taking in portfolios is limited with the help of default probability estimates from the Credit Research Initiative rather than through Moody’s ratings. The results continue to hold when investors follow a regulatory arbitrage strategy that tilts portfolios toward issuers with high systematic risk. I further show that combining information from both measures can lead to a systemic risk profile that is more favorable than can be achieved by using only one.

The Systemic Risk Implications of Using Credit Ratings Versus Quantitative Measures to Limit Bond Portfolio Risk

The Systemic Risk Implications of Using Credit Ratings Versus Quantitative Measures to Limit Bond Portfolio Risk

Sectoral Credit Cycles and Systemic Risk in the United States

This paper studies the properties and systemic risk implications of sectoral credit cycles for the United States over the period 1960Q1 – 2017Q3. The analysis shows that the credit cycle in the United States was indeed characterised by systemically relevant sector-specific boom/bust cycles during our sample period. Sectoral credit exuberance, with the exception of consumer credit, generally does not lead to broader credit exuberance within a period of one year. Taken together, these findings indicate that it may be useful to act upon sectoral credit cycles rather than on broad-based credit developments. Regarding the systemic relevance of sector-specific boom/bust cycles, the results indicate that CRE is the most systemic credit segment: exuberance in the sector-specific component of the CRE credit-to-GDP gap tends to be followed by a surge in financial stress and borrower delinquencies. Exuberance in the residential mortgage sector may also lead to financial stress and tends to be followed by a moderate rise in borrower delinquency rates. For sufficiently large shocks to C&I credit, there has been an increase in the aggregate credit risk at commercial banks in the United States, albeit not as strong as following sector-specific shocks to RRE and CRE mortgages. Finally, losses following a period of exuberance in sectoral credit developments are not necessarily limited to the exuberant credit segments. In particular, exuberance in CRE and RRE mortgage credit tends to raise delinquency rates in credit segments beyond real estate.

Optimal Risk-Sharing Across a Network of Insurance Companies

Risk transfer is a key risk and capital management tool for insurance companies. Transferring risk between insurers is used to mitigate risk and manage capital re- quirements. We investigate risk transfer in the context of a network environment of insurers and consider capital costs and capital constraints at the level of individual insurance companies. We demonstrate that the optimisation of profitability across the network can be achieved through risk transfer. Considering only individual in- surance companies, there is no unique optimal solution and, a priori, it is not clear which solutions are fair. However, from a network perspective, we derive a unique fair solution in the sense of cooperative game theory. Implications for systemic risk are briefly discussed.

The Post-Crisis Evolution of Banks and Markets: Introduction

This paper briefly reviews papers presented at a JFI-Washington University Conference on the post-crisis evolution of banks and financial markets that are appearing in a special issue of the JFI. The major themes represented by the papers in this issue have significantly advanced our understanding of the post-crisis blurring of boundaries between banks and markets and the risk implications of this phenomenon. They have highlighted the fact that to better grasp how risks in the financial system are evolving, we need to understand the unique aspects of banks’ funding model which relies heavily on customers who do not wish to be exposed to the bank’s credit risk, trends in both formal and informal financing and how they impact economic growth, the role of collateral and the systemic risk implications of how it is deployed in the economy (especially through mechanisms like rehypothecation), the trading of asset-backed securities emerging from the securitization of bank loans, and bank culture. These papers raise a host of interesting questions for future research.

Economies of scale and scope in financial market infrastructures

This article confirms the existence of substantial economies of scale in trading and post-trading financial market infrastructures (FMI), using the panel data of thirty stock exchanges, twenty-nine clearing houses, and twenty-three central securities depositories from thirty-six countries. We show that economies of scale are positively related to size and vertical and horizontal integration of FMI providers. Economies of scale are significantly higher in North America than in other regions. When analyzing economies of scope, we show that the efficiency of FMI providers increases with vertical (but not horizontal) integration and with a focus on a narrow range of asset classes. We also analyze implications for systemic risk.

Systemic risk and heterogeneous leverage in banking networks

Abstract This study probes systemic risk implications of leverage heterogeneity in banking networks. We show that the presence of heterogeneous leverages drastically changes the systemic effects of defaults and the nature of the contagion in interbank markets. Using financial leverage data from the US banking system, through simulations, we analyze the systemic significance of different types of borrowers, the evolution of the network, the consequences of interbank market size and the impact of market segmentation. Our study is related to the recent Basel III regulations on systemic risk and the treatment of the Global Systemically Important Banks (GSIBs). We also assess the extent to which the recent capital surcharges on GSIBs may curb financial fragility. We show the effectiveness of surcharge policy for the most-levered banks vis-a-vis uniform capital injection.