Market-based Credit Research Articles

Does managerial pay disparity influence BHC default risk?

This study investigates the relationship between managerial pay disparity (i.e., pay inequality of the CEO with other top executives and other employees) and default risk (measured using an innovative market-based credit default swap spread). The research relies on panel data for 1992 to 2018 from 198 U.S. bank holding companies (BHCs). We find that managerial pay disparity is negatively related to BHC default risk, suggesting greater pay disparity does not necessarily contribute to excessive risk-taking and instability in the banking sector. However, additional analysis reveals that managerial pay disparity is associated with higher default risk among BHCs with assets of less than USD 50 billion. We also find that greater managerial pay disparity is detrimental to BHC stability in the presence of weaker board monitoring (in the form of less gender-diverse boards and higher board co-option). Overall, these findings suggest that BHC size and board monitoring mechanisms are important factors in understanding the influence of managerial pay disparity on BHC stability.

Interaction mechanism between dual-credit pricing and automobile manufacturers’ electrification decisions

The newly released dual-credit policy (DCP) in 2017 established a market-based credit trading scheme in China to facilitate the electrification transition of automobile manufacturers. However, it has not yet served its intended purpose perfectly. This study concerns the interaction between credit pricing and manufacturers’ electrification and develops a mathematical model of optimal investment timing and capacity utilization rate to investigate the traction mechanism and optimization strategy of the DCP. The results suggest that tightening the policy positively impacts electrification but does not necessarily lead to immediate investment by all manufacturers. Interestingly, while electrification leads firms to generate more credits to meet policy constraints, it promotes higher capacity utilization rates, resulting in equilibrium credit prices and greenhouse gas (GHG) emissions potentially rising rather than falling. Furthermore, a novel government target indicator that includes economic and environmental aspects is introduced to help revise the DCP and advise automobile manufacturers on electrification decisions.

Thinking about Financialization and Industrialization in Ghana: Is there Evidence of Long-run Equilibrium?

Ghana recently decided to embark on a massive industrialization agenda, because the decision makers in the country believe that industrialization is the way to create sustainable employment and achieve sustained long run economic growth. However, there are threats to this agenda that need to be examined. In this paper, we show that financing industrialization via typical domestic sources or foreign aid do not support the growth of manufacturing in Ghana. We argue that financialization threatens the success of industrialization in Ghana, because typical domestic finance and foreign aid focus on short-term returns. Using time series data from 1980 - 2019, we model the relationship between domestic finance, foreign aid and manufacturing growth in Ghana. The results support our concerns about threats of financialization. We recommend that Ghanaian policy makers consider using industrial finance as was done in Japan in the 1950s and 1960s to achieve long-term sustainability for industrialization in Ghana instead of using typical market-based credit or debt.

A core–periphery framework for understanding the place of Latin America in the global architecture of finance

Abstract This paper contributes to the understanding of subordinate financialisation in emerging and developing economies by setting out a novel core–periphery framework that elucidates the place of Latin America in the global architecture of finance. This framework builds on the centre–periphery financial model of uneven regional credit and economic growth, originally proposed by Victoria Chick and Sheila Dow in 1988. In the era of deregulated financial flows and market-based credit, the core–periphery relationship has become a three-level hierarchical system, in which Latin American nations occupy a subordinate place. The key drivers of this structural shift within these nations have been the liberalisation of cross-border financial flows and investment, the deregulation of banking and the adoption of private pension systems. These drivers’ adoption can be traced to both push and pull factors: specifically, recurrent financial crises requiring external intervention (especially by the International Monetary Fund (IMF)), and the possibility of engaging with the financial instruments and megabanks driving the globalisation of finance. Participating in this hierarchical system has required importing elements of the financial architecture that evolved in the 1980s in advanced economies and has also arguably deepened this region’s financial dependency and vulnerability.

The liquidity mechanics of dealer banks in the market-based credit system

Are US government bonds (Treasuries) as good as cash? Conventional wisdom in academia and industry says that their safety and liquidity make Treasuries a cash-substitute. This paper shows that Treasuries stop being as good as cash when dealer banks face excessive liquidity risk. Using data from US money markets from July 2001–Feb 2018, I use regression analyses to examine how the liquidity risk in Treasuries and in money and bond markets more generally depends on the health of market-makers, specifically, dealer banks. I find that market-making exposes dealer banks themselves to liquidity risk, which depends on the quality of collateral in dealers' short-term credit operations. Dealer banks’ own liquidity risk is an important driver of liquidity risk in Treasuries and more broadly in money and bond markets. As a rationale for the results, I develop a mechanism how dealers manufacture liquidity in the market-based credit system.

Assessment of Credit Ratings and Credit Risk Models on Public Bonds

The authors investigate the performance of two different credit risk models, the credit ratings of S&amp;P and the market-based credit risk models of Bloomberg, using 12,679 new corporate bonds issued by 933 firms through public offerings in the United States over the 1999–2015 period. In particular, they divide their sample into bonds issued by financial firms and those issued by non-financial firms and find that (1) even though both the S&amp;P ratings and the Bloomberg models affect the yield spreads significantly, the former has more statistical power in determining the yield spreads; (2) bond ratings of financial firms are higher than those of non-financials, but financial firms pay a higher cost of debt than non-financial firms; (3) S&amp;P credit ratings are superior to Bloomberg models in predicting actual default of the bonds; and (4) financial firms are less likely to default than non-financial firms. <b>TOPICS:</b>Credit risk management, information providers/credit ratings, fixed income and structured finance, performance measurement <b>Key Findings</b> ▪ S&amp;P’s ratings are better than Bloomberg models in determining the yield spreads. ▪ S&amp;P’s ratings are superior to Bloomberg models in predicting the actual default of bonds. ▪ Financial firms are less likely to default than non-financial firms.

A better criterion for forced selling in bond markets: Credit ratings versus credit spreads

During the global financial crisis, a bond portfolio manager using only credit ratings suffered from significant losses due to their lagging properties, and now focuses on market-based criteria as another credit risk measure for forced selling. In this study, we verify whether a market-based criterion outperforms in running the forced selling strategy for bond portfolios. In contrast to the market expectation, our empirical results show that the forced selling strategy with only market measures is inferior to the rating-based strategy in terms of risk-adjusted returns, although market measures precede changes in bond ratings. This result stems from the high volatility of market-based credit measures, which results in too frequent or too early sale of a bond with credit deterioration. The improvement of risk-return trade-off observed only when market measures are jointly considered with bond ratings. This implies that market-based credit measures have complementary benefits for detecting credit risk changes. In addition, these results are robust, even for credit-stressed bond portfolios, and for credit-stressed market conditions.

Corporate Loan Spreads and Economic Activity

We use secondary corporate loan market prices to construct a novel loan market-based credit spread. This measure has additional predictive power across macroeconomic outcomes beyond existing bond credit spreads as well as other commonly used predictors in both the U.S. and Europe. Consistent with theoretical predictions, our evidence highlights the joint role of financial intermediary and borrower balance sheet frictions. In particular, loan market borrowers are compositionally different from bond market borrowers, which helps explain the differential predictive power of loan over bond spreads. Exploiting industry specific loan spreads and alternative weighting schemes further improves our business cycle forecasts.

Institutional Dynamics in EU Financial Systems

This paper argues that the traditional dichotomous and static conceptualisations of financial systems fail explain how financial systems have changed as a result of transformative events (the 2007-2008 financial crisis in particular) and trends in recent decades. To shed light on developments in contemporary financial systems in the EU, this paper presents and analyses an index that seeks to capture the extent to which funding structures in non-financial companies subject them to financial pressures. The index reveals that the EU as a whole is distinctly “bank-based”, in the sense of private equity and bank credit matter more for funding of non-financial companies than listed equity or market-based credit. However, the EU and its Member States have become more market-based over the last decade. While this trend generally holds true, there is also increasing divergence between European financial systems. Developments in individual countries appears to be determined by competitive advantage specialization as well as how strong the country was hit by the 2007-2008 financial crisis. The paper thereby contributes to the comparative political economy literature on comparative financial systems, as well as the much neglected questions if, how and why institutional transformation in financial systems occur. It also contributes to the literature on how different national financial systems respond to economic shocks.

Assessment of Credit Risk Models on Rule 144A Corporate Bonds

Accurate assessment of credit risk can improve the performance of bond portfolio managers. Using credit ratings and market-based credit risk models from S&amp;P and Bloomberg, we investigate the performance of four credit risk models in the Rule 144A corporate bond markets in the United States over the 1990–2015 period. The authors divide their sample into straight bonds and convertible bonds and find that (1) when it comes to straight bonds, discrete models such as S&amp;P’s credit ratings and Bloomberg ratings determine yields more accurately than the continuous market-based models of S&amp;P and Bloomberg; (2) with regard to convertible bonds, a convertible option has a stronger effect than credit ratings in determining yields, and only Bloomberg default risk ratings, not S&amp;P credit ratings, determine the yields; (3) for convertible bonds, the continuous market-based models of S&amp;P and Bloomberg affect yields more significantly than discrete models; and (4) when it comes to predicting actual defaults, Bloomberg models are superior to S&amp;P’s models, and the Bloomberg discrete model has more power than its continuous counterpart.

Rethinking the Philippine Financial Market Regulatory Model for Market-Based Credit Intermediation

The Philippines was one of the first countries in Asia to embark on a series of reforms which targeted capital market development and financial liberalization in the 1980s. It was very much on its way towards international financial integration when the 1997 Asian Financial Crisis (AFC) tempered this development. As a consequence, commercial banking assets still account for a majority of the total financial assets in the Philippines and traditional bank lending remains the primary mode of financing. However, change is coming. Estimation reveals that the country needs approximately US$110 billion to cover its infrastructure needs between 2013 and 2020. While the public sector can still be counted on to provide a lion’s share of this funding need, a tight fiscal space prevents it from solely fulfilling the investment target. As stricter banking regulations have raised the cost of borrowing and shrunk availability of capital in some cases due to borrower limits, the urgency brought by this infrastructure financing gap has given rise to calls to shift towards market-based credit intermediation. However, as local banks move into this space as a result of government reforms, new risks could possibly arise which the present framework of the institutional separation between banks and securities regulation might be ill-equipped to deal with. The purpose of this paper is to assess the capacity of Philippine financial regulators to cope with new risks as the country shifts from bank-based credit intermediation to a market-based one. Specifically, this paper shall attempt to answer whether the traditional separation between banking and securities regulation will still work under a changing financial landscape or whether there will be a need to shift towards a goal-oriented or functional model of financial regulation? This problem is not only relevant in the Philippine context but is also important for other developing countries which are attempting similar reforms.

Financial Structure Changes and the Central Bank Policy

:In a response to the financial collapse of 2007–2009, central banks overstepped their narrow role of lender of last resort (LLR) and acted as dealers or market-makers of last resort (MMLR). Such an evolution of the central bank policy stems from the endogenous process of growing securities markets, financial innovations, and market-based credit intermediation. This article examines how changes in the structure of the banking and financial system transforms the central bank policy in financial stability. It considers the separation or integration of the LLR and MMLR functions, revisits the debate opposing lend-to-market and lend-to-institution theses, and discusses the LLR standard rule and its transposition to the MMLR rule. Inasmuch as private securities markets and financial innovations determine the structure of the credit system, central banks endogenously adopt the integrated approach, so that the extensive LLR policy prevails.

Credit risk interconnectedness: What does the market really know?

We analyze the relation between market-based credit risk interconnectedness among banks during the crisis and the associated balance sheet linkages via funding and securities holdings. For identification, we use a proprietary dataset that has the funding positions of banks at the bank-to-bank level for 2006–2013 in conjunction with investments of banks at the security level and the credit register from Germany. We find asymmetries both cross-sectionally and over time: when banks face difficulties to raise funding, the interbank lending affects market-based bank interconnectedness. Moreover, banks with investments in securities related to troubled classes have a higher credit risk interconnectedness. Overall, our results suggest that market-based measures of interdependence can serve well as risk monitoring tools in the absence of disaggregated high-frequency bank fundamental data.

Developing an advanced biofuels industry in California: The alternative and renewable fuel and vehicle technology program

Developing an advanced biofuels industry in California: The alternative and renewable fuel and vehicle technology program

Credit Risk Interconnectedness: What Does the Market Really Know?

We analyze the relation between market-based credit risk interconnectedness among banks during the crisis and the associated balance sheet linkages via funding and securities holdings. For identification, we use a proprietary dataset that has the funding positions of banks at the bank-to-bank level for 2006-13 in conjunction with investments of banks at the security level and the credit register from Germany. We find asymmetries both cross-sectionally and over time: when banks face difficulties to raise funding, the interbank lending affects market-based bank interconnectedness. Moreover, banks with investments in securities related to troubled classes have a higher credit risk interconnectedness. Overall, our results suggest that market-based measures of interdependence can serve well as risk monitoring tools in the absence of disaggregated high-frequency bank fundamental data.

Credit Risk Interconnectedness: What Does the Market Really Know?

We analyze the relation between market-based credit risk interconnectedness among banks during the crisis and the associated balance sheet linkages via funding and securities holdings. For identification, we use a proprietary dataset that has the funding positions of banks at the bank-to-bank level for 2006-13 in conjunction with investments of banks at the security level and the credit register from Germany. We find asymmetries both cross-sectionally and over time: when banks face difficulties to raise funding, the interbank lending affects market-based bank interconnectedness. Moreover, banks with investments in securities related to troubled classes have a higher credit risk interconnectedness. Overall, our results suggest that market-based measures of interdependence can serve well as risk monitoring tools in the absence of disaggregated high-frequency bank fundamental data.

Comparative credit risk in Islamic and conventional bank

In this paper, we consider the levels of credit risk in Islamic and conventional banks. One problem with existing studies is the use of accounting information alone to assess credit risk, and this could be especially misleading with Islamic banking. Using a market-based credit risk measure, Merton's distance-to-default (DD) model, we evaluate the credit risk of 156 conventional banks and 37 Islamic banks across 13 countries between 2000 and 2012. We also calculate the accounting information-based Z-score and nonperforming loan (NPL) ratio for the purpose of comparison. Our results show that Islamic banks have significantly lower credit risk than conventional banks as based on DD. In contrast, and as expected, Islamic banks display much higher credit risk using the Z-score and NPL ratio. These findings suggest that the measure chosen plays a significant role in assessing the actual credit risk of Islamic banks.

Comparative Credit Risk in Islamic and Conventional Banks

This study considers whether Islamic banks and conventional banks have different levels of credit risk. One problem with existing research in this area is the dominance of accounting information to assess credit risk, and this could be especially misleading in the case of Islamic banking. Using Merton’s distance-to-default (DD) model, a market-based credit risk measure, we evaluate the credit risk of 156 conventional banks and 37 Islamic banks across 13 countries between 2000 and 2012. We also calculate the accounting information-based Z-score and nonperforming loan (NPL) ratio for the purpose of comparison. Our results show that Islamic banks have significantly lower credit risk than conventional banks when measuring credit risk with the DD. In contrast, and as expected, Islamic banks exhibit much higher credit risk using the Z-score and NPL ratio. Overall, the findings suggest that the methodology used plays a significant role in assessing the apparent credit risk of Islamic banks.

Shadow Banking: The Money View

This paper presents an accounting framework for measuring the sources and uses of short-term funding in the global financial ecosystem. We introduce a dynamic map of global funding flows to show how dealer banks emerged as intermediaries between two types of asset managers: cash pools searching for safety via collateralized cash investments and levered portfolio managers searching for yield via funded securities portfolios and derivatives. We argue that the monetary aggregates (M0, M1, M2, etc.) and the Financial Accounts of the United States (formerly the Flow of Funds) do not adequately reflect the institutional realities of the modern financial ecosystem, and should be updated to allow policymakers to better analyze and monitor the shadow banking system and its potential contributions to financial instability. The monetary aggregates, used mainly to inform the aggregate demand management aspects of monetary policy, do not include the instruments that asset managers use as money, particularly repos. Asset managers’ money demand is not driven by transaction needs in the real economy but in the financial economy: in this sense, repo-based money dealing activities in the shadow banking system are about the provision of working capital for asset managers, much like real bills provided working capital for merchants and manufacturers in Bagehot’s world over 150 years ago. These developments should be systematically captured in a new set of Flow of Collateral, Flow of Risk and Flow of Eurodollar satellite accounts to supplement the Financial Accounts. The accounting framework presented with this paper also explains how the Federal Reserve’s reverse repo facility helps reduce interconnections within the financial system and how they could evolve into minimum liquidity requirements for shadow banks and a tool to control market-based credit cycles. The global macro drivers behind the secular rise of cash pools and leveraged portfolio managers in the asset management complex are identical with the real economy drivers behind the idea of secular stagnation. As such, one way to interpret shadow banking is as the financial economy reflection of real economy imbalances caused by excess global savings, slowing potential growth, and the rising share of corporate profits relative to wages in national income.

Market-Based Credit Ratings

We present a methodology for rating in real-time the creditworthiness of public companies in the U.S. from the prices of traded assets. Our approach uses asset pricing data to impute a term structure of risk neutral survival functions or default probabilities. Firms are then clustered into ratings categories based on their survival functions using a functional clustering algorithm. This allows all public firms whose assets are traded to be directly rated by market participants. For firms whose assets are not traded, we show how they can be indirectly rated by matching them to firms that are traded based on observable characteristics. We also show how the resulting ratings can be used to construct loss distributions for portfolios of bonds. Finally, we compare our ratings to Standard & Poors and find that, over the period 2005 to 2011, our ratings lead theirs for firms that ultimately default.