Journal of Financial Economics
Decomposing systemic risk: the roles of contagion and common exposures
Abstract
- Abstract
We evaluate the effects of contagion and common exposure on banks? capital through
a regression design inspired by the structural VAR literature and derived from the balance
sheet identity. - Contagion can occur through direct exposures, fire sales, and market-based
sentiment, while common exposures result from portfolio overlaps. - First, we document that contagion varies in time, with the highest levels
around the Great Financial Crisis and lowest levels during the pandemic. - Our new framework complements
traditional stress-tests focused on single institutions by providing a holistic view of systemic risk. - While existing literature presents various contagion narratives, empirical findings on
distress propagation - a precursor to defaults - remain scarce. - We decompose systemic risk into three elements: contagion, common exposures, and idiosyncratic risk, all derived from banks? balance sheet identities.
- The contagion factor encompasses both sentiment- and contractual-based elements, common exposures consider systemic
aspects, while idiosyncratic risk encapsulates unique bank-specific risk sources. - Our empirical analysis of the Canadian banking system reveals the dynamic nature of contagion, with elevated levels observed during the Global Financial Crisis.
- In conclusion, our model offers a comprehensive lens for policy intervention analysis and
scenario evaluations on contagion and systemic risk in banking. - This
notion of systemic risk implies two key components: first, systematic risks (e.g., risks related
to common exposures) and second, contagion (i.e., an initially idiosyncratic problem becoming
more widespread throughout the financial system) (see Caruana, 2010). - In this paper, we decompose systemic risk into three components: contagion, common exposures, and idiosyncratic risk.
- First, we include contagion in three forms: sentiment-based contagion, contractual-based
contagion, and price-mediated contagion. - In this context,
portfolio overlaps create common exposures, implying that bigger overlaps make systematic
shocks more systemic. - With the COVID-19 pandemic starting
in 2020, contagion drops to all time lows, potentially related to strong fiscal and monetary
supports. - That is, our
structural model provides a framework for analyzing the impact of policy interventions and
scenarios on different levels of contagion and systemic risk in the banking system. - This provides a complementary approach to
seminal papers that took a structural approach to contagion, such as DebtRank Battiston et al. - More generally, the literature on networks and systemic risk started with Allen and Gale
(2001) and Eisenberg and Noe (2001). - The matrix is structured as follows:
1In our model, we do not distinguish between interbank liabilities and other types of liabilities.
- In other words, we can and aim to estimate different degrees
of contagion per asset class, i.e., potentially distinct parameters ?Ga . - For that, we build three major
metrics to check: average contagion, average common exposure, and average idiosyncratic risk. - N i j
et ,
Further, we define the (N ?K) common exposure matrix as Commt = [A(20)
et ]diag (?C
?Lsuch that average common exposure reads,
average common exposure =1 XX
Commik,t . - N i j
(22)
20
? c ),
The three metrics?average contagion, average common exposure, and average idiosyncratic risk?provide a comprehensive framework for understanding banking dynamics.
- Figure 4 depicts the average level of risks per systemic risk channel: contagion risk, common exposure, and idiosyncratic risk.
- Figure 4: Average levels of contagion (Equation (20)), common exposure (Equation (21)), and idiosyncratic risk
(Equation (22)). - The market-based contagion is the contagion due to
investors? sentiment, and the network is an estimate FEVD on volatility data. - For most of
the sample, we find that contagion had a bigger impact on the variance than common exposures.
Central bank asset purchases and auction cycles revisited: new evidence from the euro area
Working Paper Series
- Working Paper Series
Federico Maria FerraraCentral bank asset purchases
and auction cycles revisited:
new evidence from the euro areaNo 2927
Disclaimer: This paper should not be reported as representing the views of the European Central Bank
(ECB). - Abstract
This study provides new evidence on the relationship between unconventional monetary
policy and auction cycles in the euro area. - The findings indicate that Eurosystem?s asset purchase flows mitigate
yield cycles during auction periods and counteract the amplification impact of market volatility. - The dampening effect of central bank asset purchases on auction cycles is more sizeable and
precisely estimated for purchases of securities with medium-term maturities and in jurisdictions
with relatively lower credit ratings. - On the other hand, central banks may influence price dynamics in these markets, most notably
through their asset purchase programmes. - If so, do central bank asset purchases
affect bond yield movements around auction dates? - Auction cycles are present when secondary market yields rise in
anticipation of a debt auction and fall thereafter, generating an inverted V-shaped pattern around auction
dates. - ECB Working Paper Series No 2927
3
1
Introduction
The impact of central bank asset purchases on government bond markets is a focal point of economic and
financial research. - If so,
do central bank asset purchases shape yield sensitivity around auction dates? - The paper provides new evidence on the effects of Eurosystem?s asset purchases on secondary market
yields around public debt auction dates. - The analysis builds on previous research based on aggregate data
on central bank asset purchases and a shorter analysis period (van Spronsen and Beetsma 2022). - Using
granular data on Eurosystem?s asset purchases offers an opportunity to shed light on the mechanisms linking
unconventional monetary policy and auction cycles. - Given this legal constraint, the study
hypothesises that the effect of asset purchases on 10-year auction cycles is mostly indirect, and goes via price
spillovers generated by purchases of securities outside the 10-year maturity space. - Taken together, these results provide new evidence about auction cycles in Europe and contribute to a
larger literature on the flow effects of central bank asset purchases on bond markets. - Section 4 offers descriptive evidence about auction cycles in the euro area.
- Auction cycles are defined by the presence of an inverted V-shaped pattern in secondary market yields
around primary auctions. - That is, government bond yields rise in the run-up to the date of the auction and
fall back to their original level after the auction. - Their limited risk-bearing capacities and inventory management operations are
seen as key mechanisms driving auction cycles (Beetsma et al. - ECB Working Paper Series No 2927
7
Second, central bank asset purchases can alleviate the cycle by (partly) absorbing the additional supply
of substitutable instruments in the secondary market (van Spronsen and Beetsma 2022). - This expectation is
supported by several analyses on the price effects of central bank bond purchases (D?Amico and King 2013;
Arrata and Nguyen 2017; De Santis and Holm-Hadulla 2020). - Empirically, previous research has provided evidence of auction cycles taking place across different jurisdictions.
- (2016) detect auction cycles for government debt in Italy, but not in Germany, during the European
sovereign debt crisis. - Research on the impact of central bank asset purchases on yield cycles around auctions is still limited.
- Their paper provides evidence
that Eurosystem?s asset purchases reduce the presence of auction cycles for euro area government debt. - Nonetheless, several questions remain open about auction cycles and unconventional monetary policy
in the euro area. - Therefore, they
provide only a partial picture of auction cycles and central bank asset purchases in Europe. - The use of granular data on central bank asset purchases is especially important in light of the modalities
of monetary policy implementation of the Eurosystem. - Altogether, these elements motivate further investigation of the relationship between central bank asset
purchases and auction cycles in the euro area. - Taken together, these results confirm that Eurosystem?s asset purchases mitigate yield cycles during auction periods and counteract the amplification impact of market volatility.
- The findings confirm that the flow
effects of central bank purchases on yield movements around auction dates are driven by lower-rated countries. - Additional analyses provide evidence for an indirect effect of purchases on auction cycles and highlight
the presence of substantial heterogeneity across jurisdictions and purchase programmes. - Flow Effects of Central Bank Asset Purchases on Sovereign Bond
Prices: Evidence from a Natural Experiment. - Federico Maria Ferrara
European Central Bank, Frankfurt am Main, Germany; email: [email protected]? European Central Bank, 2024
Postal address 60640 Frankfurt am Main, Germany
Telephone
+49 69 1344 0
Website
www.ecb.europa.eu
All rights reserved.
Monetary asmmetries without (and with) price stickiness
Is home bias biased? New evidence from the investment fund sector
Isabel Schnabel: R(ising) star?
This box investigates how households have responded to the 2021-23 inflationary episode using evidence from the ECB’s Consumer Expectations Survey.
- This box investigates how households have responded to the 2021-23 inflationary episode using evidence from the ECB’s Consumer Expectations Survey.
- The findings suggest that households have primarily adjusted their consumption spending to cope with higher inflation.
US monetary policy is more powerful in low economic growth regimes
The impact of regulatory changes on rating behaviour
Abstract
- Abstract
We examine rating behaviour after the introduction of new regulations regarding Credit Rating
Agencies (CRAs) in the European securitisation market. - There is empirical evidence of rating catering in the securitisation market in the pre-GFC period (He et al.,
2012; Efing and Hau, 2015). - Competition among
CRAs could diminish ratings quality (Golan, Parlour, and Rajan, 2011) and promotes rating shopping by
issuers resulting in rating inflation (Bolton et al., 2012). - This paper investigates the impact of the post-GFC regulatory changes in the European
securitisation market. - In 2011, in addition to the creation of
European Securities and Markets Authority (ESMA), a regulatory and supervisory body for CRAs was
introduced. - We examine how rating behaviours have changed in the European securitisation market after the
introduction of these new regulations. - We utilise the existence of multiple ratings and rating agreements between
CRAs to identify the existence of rating shopping and rating catering, respectively (Griffin et al., 2013; He
et al., 2012; 2016). - We find that the regulatory changes have been effective in tackling conflicts of interest between issuers
and CRAs in the structured finance market. - Rating catering, which is a direct consequence of issuer and
CRA collusion, seems to have disappeared after the introduction of these regulations. - There is empirical evidence of rating catering in the securitisation market in
the pre-GFC period (He et al., 2012; Efing and Hau, 2015). - Competition among CRAs could diminish ratings quality (Golan, Parlour,
and Rajan, 2011) and promotes rating shopping by issuers resulting in rating inflation (Bolton et
al., 2012). - This paper investigates the impact of the post-GFC regulatory changes in the European
securitisation market. - In 2011, in addition
to the creation of European Securities and Markets Authority (ESMA), a regulatory and
supervisory body for CRAs was introduced. - We find that the regulatory changes have been effective in tackling conflicts of interest
between issuers and CRAs in the structured finance market. - Rating catering, which is a direct
consequence of issuer and CRA collusion, seems to have disappeared after the introduction of
these regulations. - Investors who previously demanded higher spreads for rating agreements for a
multiple rated tranche, did not consider the effect of rating harmony as a risk in the post-GFC
period. - Regarding rating shopping, we find that the effectiveness of the changes has been limited,
potentially for two reasons. - Additionally, we also find that rating over-reliance might still be an issue, especially
Rating catering is a broad term and it can involve rating shopping. - They re-examine the rating shopping and rating
catering phenomena in the US market by looking at the post-crisis period between 2009 and 2013. - Using 622 CDO tranches, they also observe the existence of rating shopping and the diminishing
of the rating catering. - Firstly, our main focus is the EU?s CRA Regulation and its effectiveness in reducing
rating inflation and rating over-reliance. - To the best of our knowledge, this paper is the first to
examine the effectiveness of the EU?s CRA regulatory changes on the investors? perception of
rating inflation in the European ABS market. - Hence, the coverage and quality of our dataset constitutes significant addition
to the literature and allows us to test the rating shopping and rating catering more authoritatively. - The following section reviews the literature
on securitisation concerning CRAs and conflicts of interest, and outlines the regulatory changes
introduced in the post-GFC period. - Firstly, ratings became ever more important as the Securities and
Exchange Commission (SEC) 5 began heavily relying on CRA assessments for regulatory purposes
(i.e. - the investment mandates that highlight rating agencies as the main benchmark for investment
eligibility) (SEC, 2008; Kisgen and Strahan, 2010; Bolton et al., 2012). - issuers) as one of the main explanations for the rating inflation (He et al., 2011; 2012; Bolton
et al., 2012; Efing and Hau, 2015). - Bolton et al., (2012) demonstrate that competition
promotes rating shopping by issuers, leading to rating inflation. - The last phase, CRA III, was implemented in mid-2013 and involves an additional
set of measures on reducing transparency and rating over-reliance. - As mentioned above, rating inflation can be caused by rating shopping
In order to be eligible to use the STS classification, main parties (i.e. - The higher the difference in the number of ratings for a
given ABS tranche, the greater the risk of rating shopping. - Alternatively, the impact of the new
regulations could be limited when it comes to reducing rating shopping. - This is because, firstly,
the conflict of interest between securitisation parties is not necessarily the sole cause for the
occurrence of rating shopping. - L is a set of variables (Multiple ratings, CRA reported, Rating agreement) that
we utilise interchangeably to capture the rating shopping and rating catering behaviour. - Hence, issuers are incentivised to report the highest possible rating and
ensure each additional rating matches the desired level. - All in all, our results suggest that
the new stricter regulatory measures have been effective in tackling conflicts of interest and
reducing rating inflation caused by rating catering. - Self-selection might be a concern in analysing the impact of the
new measures and investors? response with regard to the rating inflation. - This
result is in line with the earlier findings suggesting that regulatory changes have reduced investors?
suspicion of rating inflation and increased trust of CRAs. - Conclusion
Several regulatory changes were introduced in Europe following the GFC aimed at tackling
conflicts of interest between issuers and CRAs in the ABS market. - Utilising a sample of 12,469
ABS issued between 1998 and 2018 in the European market, this paper examined whether these
changes have had any impact on rating inflations caused by rating shopping and rating catering
phenomena. - We find that the
effectiveness of the changes has been more limited on rating shopping potentially for two reasons. - Tranche Credit Rating is the rating reported for a tranche at launch.
Business as usual: bank climate commitments, lending, and engagement
Measuring market-based core inflation expectations
Abstract
- Abstract
We build a novel term structure model for pricing synthetic euro area core inflation-linked
swaps, a hypothetical swap contract indexed to core inflation. - The model provides estimates of market-based expectations for core inflation, as
well as core inflation risk premia, at daily frequency, whereas core inflation expectations from
surveys or macroeconomic projections are typically only available monthly or quarterly. - We
find that core inflation-linked swap rates are generally less volatile than headline inflationlinked swap rates and that market participants expected core inflation to be substantially
more persistent than headline inflation following the 2022 energy price spike. - In this paper, we aim to infer market-based core inflation expectations, which are otherwise
not directly observable because no financial asset directly tied to core inflation exists. - We deem this second assumption reasonable because HICP inflation itself is a linear combination
of core as well as energy and food inflation. - The level of 2 percent and relatively low volatility of
long-term inflation expectations suggests that inflation expectations are firmly anchored at the
ECB?s 2 percent inflation target. - This assumption appears reasonably uncontroversial,
as core inflation is a sub-component of headline inflation, which the observable headline ILS
rates are tied to. - Our estimates of core ILS rates reflect both market participants? genuine core
inflation expectations and a core inflation risk premium, but our model explicitly allows for
this decomposition. - The model-implied estimates of core ILS rates appear reasonable along several dimensions:
(i) like realized core inflation is less volatile than headline inflation, the core ILS rates are less
volatile than headline ILS rates, (ii) core ILS rates comove less with oil prices than headline
ILS rates, (iii) the core inflation expectations, as reflected in core ILS rates, typically evolve
similarly as the core inflation projections by Eurosystem staff, and (iv) consistent with market
commentary at the time, core ILS rates suggest that market participants expected core inflation
to be substantially more persistent than headline inflation following the 2022 energy price spike. - To the best of our knowledge, we are the first to price core ILS rates and decompose them into
market-based expectations for and risks around the core inflation outlook. - Our approach to inferring core ILS
rates from headline ILS rates, realized headline and core inflation as well as survey expectations
for headline and core inflation is also related to Ang et al. - Relative
to their study, we separately measure core inflation expectations and risk premia, we provide
core inflation expectations at a higher-frequency, and we provide evidence on the causal effectsECB Working Paper Series No 2908
6
of monetary policy shocks on core inflation expectations and risk premia.
- Specifically, we decompose the synthetic core ILS rates
into average expected core inflation over the lifetime of the swap contract and a core inflation
risk premium that compensates investors for core inflation risk. - In
our model below, this term is constant over time and relatively small, so we will simply refer
to the core inflation risk premium as the difference between the core ILS rate and the average
expected core inflation over the lifetime of the swap contract. - 3.2
Core ILS rates
To have a joint model for headline and core ILS rates, we need one further assumption on the
dynamics of realized core inflation. - The assumption that core inflation is driven by the same set of factors as headline inflation
should be relatively uncontroversial: since headline inflation is a weighted average of core and
food and energy inflation, it should reflect any factors driving core inflation. - If there are factors
driving food and energy inflation, which do not show up in core inflation, then those factors
should still show up in headline inflation. - In step two, to be able to infer the factor
loadings of core inflation, we would regress realized core inflation onto the estimated latent
factors to identify the additional parameters in equation (12). - Before the fourth
quarter of 2016, the SPF did not ask respondents for their core inflation expectations, so we
are not able to use survey-based information about core inflation before then. - Before
2016, the fitted core inflation series is somewhat above the realized one, potentially reflecting
that the model has limited information about core inflation over this early period due to the
lack of information about core inflation from surveys. - This could have been the
case if one of the factors moved core inflation and energy and food inflation in exactly offsetting
direction, so the overall impact on headline inflation was exactly zero. - During 2021, for example, there were
ECB Working Paper Series No 2908
25
Figure 7: Decomposition of synthetic core ILS rates
2y core ILS5y core ILS
5
45
ILSpremia
exp
4
ILS
premia
exp
3
3
2
2
1
1
0
0
-1
-1
-2
2017 2018 2019 2020 2021 2022 2023-2
2017 2018 2019 2020 2021 2022 202310y core ILS
5y5y core ILS
5
45
ILSpremia
exp
4
ILS
premia
exp
3
3
2
2
1
1
0
0
-1
-1
-2
2017 2018 2019 2020 2021 2022 2023-2
2017 2018 2019 2020 2021 2022 2023Note: Synthetic core ILS rates decomposed into genuine core inflation expectations and core inflation risk
premia. - ECB Working Paper Series No 2908
26
Figure 8: Decomposition of ILS rates
2y ILS5y ILS
5
45
ILSpremia
exp
4
3
3
2
2
1
1
0
0
-1
-1
-2
20062010
2014
2018
2022
-2
2006ILS
2010
10y ILS
2018
2022
5
ILSpremia
exp
4
3
3
2
2
1
1
0
0
-1
-1
-2
20062014
exp
5y5y ILS
5
4premia
2010
2014
2018
2022
-2
2006ILS
2010
premia
2014
2018
exp
2022
Note: ILS rates decomposed into genuine core inflation expectations and core inflation risk premia.
- We find that the headline inflation risk premium
indeed does responds more strongly than the core inflation risk premium. - The key
assumption underlying our approach is that traded headline ILS rates span core inflation, whichECB Working Paper Series No 2908
35
should be reasonably uncontroversial as core inflation is a sub-component of headline inflation.
- We fit the model to euro area headline ILS rates, realized headline and core inflation, and
both headline and core inflation expectations reported in the SPF. - Decomposing our core ILS rates into genuine core inflation expectations and core
inflation risk premia shows that shorter maturities mainly reflect core inflation expectations,
while the core inflation risk premium matters relatively more for longer maturities. - Our results suggest that a monetary policy tightening surprise significantly lowers
near-term core inflation expectations, although less so than it lowers headline inflation expectations.