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CDS: Liquidity Shortage or Structural Insolvency? Francesco Giuliani Sumy, 24-25 May 2012.

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Presentation on theme: "CDS: Liquidity Shortage or Structural Insolvency? Francesco Giuliani Sumy, 24-25 May 2012."— Presentation transcript:

1 CDS: Liquidity Shortage or Structural Insolvency? Francesco Giuliani Sumy, May 2012

2 Outline  Introduction  Research gap, purpose and question  Literature review: Meaning of Liquidity and implications for the event of default.  Model describing banks ALM  Empirical analysis of Financial CDS  Data and sample  Novelty of the research and implication of the expected results 2

3 Introduction The current crisis has demonstrated that the functioning of the banking system may be questioned by market: some variables are currently under scrutiny: Liquidity Leverage Distribution of Debt and imminent refinancing needs. Trust in the financial system Adequate capitalization Central Bank and Sovereign State : concerned on Smooth functioning of the economy Controlled evolution of Money Both objectives are subordinate to the proper functioning of the baking system Central bank and government: role in the Crisis and degree of intervention: Global consolidation Independence of central banks and importance of flexible FX rates. 3

4 Research Gap Standard literature on monetary policy sees the banking system as a transmission tool for monetary input. CDS levels and interest rates seem to belong to different asset classes: a risk free world versus credit risk variables. Can we fill the gap? Accommodative monetary policy: an environment with low rates? Capital and liquidity: are they really microeconomic variables? 4

5 Purpose of the paper Research questions: –Liquidity and deleverage: can banks contemplate both variables? –Interbank deposit and financial senior market: what if these markets stop functioning? –Can liquidity explain the solvency of the banking sector? –The dilemma of a central bank: bias the input to save the transmission mechanism? –Global consolidation: how do we measure the resilience of the banking system? Should we include the Government and the Central Bank when we face periods of distress? –Solvency: is it a microeconomic problem? 5

6 Purpose of the paper (2) To answer these questions: –We no longer consider a framework of Maximization of return on Equity and focus on the constraint to roll debt due for redemption –We analyze the distribution of debt maturities and Assets maturities: both are legacy from the past. We adopt a framework where the balance sheet of the bank is a backward looking sequence of investments and issuance activity. –We obtain that profitability is derived as a backward looking average of the credit spread paid on the liabilities and received on the assets. –When profitability drops and the capability to redeem debts is under dispute, then debt market no longer clears: default is then the event that a bank is no longer capable to roll debt: it then taps into central bank facilities posting “Elegible Collateral” –The transmission mechanism is out of control: the focus is the liability side of the balance sheet and the credit origination is structurally reduced: the deleverage wave is then stronger and transmitted to the real economy 6

7 Implications and themes What can we derive from such framework? –Deleverage and Capital: the relevance of an adequate capital structure to face a deleverage program –The relevance of the consequences for real economy: the Sovereign State intervenes and participates to the reshaping of the capital structure of the banking sector –Government guaranteed Issuance –Subscription of Hybrid Capital –Subscription of Equity –Nationalization of some banks. –The central bank loses control on M3 aggregate: the difficulties in the banking sector are ultimately a lack of control on the transmission mechanism of monetary policy. –Financial CDS: do they reflect a liquidity shortage or a structural insolvency? –Are we not facing a structural need of more liquidity for the proper functioning of banks’ balance sheet throughout the deleverage mode in the banking industry? 7

8 Literature Review Plenty of topics mentioned in this paper are explored in depth by literature, namely –Banks crisis and the link existing with governments financial health  Are Banks too big to save or too big to fail? (Kunt and Huizinga)  Credit Spread Interdependencies of European States and Banks during the Financial Crisis (Alter, Schuler)  The Janus-Headed Salvation. Sovereign and Bank Credit Risk Premia During (Ejsing, Lemke) –CDS and evolution of bonds yields issued by the same reference entities: the base  Sovereign Basis An analysis of Euro area sovereign CDS and their relation with government Bonds (Fontana, Scheicher)  Corporate Bond Pricing Liquidity and arbitrage in the Market of Credit Risk” (Nashikkar, Subrahmanyam, Mahanti) 8 “Monetary and Fiscal policy are being conducted in unchartered waters, without any intellectual map to guide them. Policy makers are flying blind” (Alistair Milne, in “Liquidity, bank credit and money”).

9 Literature Review (2) What common denominator can we find across these topics? –Systemic risk  Banks regulation, Credit ratings and Systemic Risk (Iannotta, Pennacchi)  European Systemic Risk in Post-LTRO World (Calamaro)  Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis (Dieckmann, Plank)  Risk management and balance sheet volatility during turbulent times (Giuliani, Forthcoming) –Capital structure  Contingent Capital: The Case of COERCs (Pennacchi, Vermaelen, Wolff)  Capital regulation and Monetary Policy with Fragile Banks (Angeloni, Faia)  Optimal Capital Structure of a Bank: the role of asymmetry of information and Equityzation of Debt (Giuliani) –Liquidity, mainly explored as a microeconomic variable within banks. Yet this paper points at emphasizing this concept under a Macro approach  Bank Liquidity Risk Management: which lesson from recent market turmoil (Vento, La Ganga)  Funding Liquidity risk in a quantitative model of systemic stability (Aikman and others). 9

10 Assets and Liabilities: modelling a BS Asset side of the balance sheet –Redemption of assets, new investments and impairments describe the evolution of the assets from one year to another.  New investments : A n ( (t)  Redemptions: a(t) * A(t-1)  Depreciation/ impairment of assets: d(t) * A(t-1) –Hence assets evolve according to:  Liability side of the balance sheet –The liability side of a banks’ balance sheet requires a distinction between various instruments:  Deposits: D(t)  Bonds outstanding at time t: B(t)  Liabilities against the central bank at time t: CB(t)  Capital at time t: S(t) Stock of assets at time t Stock of Bonds at time t 10

11 Cost of the liabilities and revenues from assets Profitability of the core banking activity is only partially determined by current market variables: stock of assets and liabilities depend on the past and so do the average yield on assets and the average cost of liabilities. –Average spread paid on outstanding bonds depends on the turnover of the stock of issued debt: it will depend on the number of years that have contributed to the composition of the outstanding bonds. We will denote such number as y b ( (t) –Average credit spread on the stock of assets depends on the turnover of assets: it will depend on the number of years that have contributed to the composition of current assets. We will denote such number as y a ( (t) –Hence we derive that the profitability of the bank derives, among other factors, from the difference between 11

12 Modelling Liabilities: assumptions We do not aim at modelling the capital structure evolution, a topic explored in a previous work by the same author : “Optimal Capital Structure of a bank: the role of asymmetry of information and Equityzation of debt” Leverage is endogenous and depends primarily on the evolution of Credit Market Capital structure is endogenous and a strong deterioration of credit market make the value of CDS dependent from volatility We do not aim at embedding within the model an analysis including panic induced reduction of deposits: deposits are assumed constant. We also assume constant the amount of issued equity. In essence we keep the “extremes” of the capital structure constant and we model the evolution of debt and liability versus the central bank as the most important tools during the financial crisis. Deposits and rights issuance are actually respectively decreasing and increasing as the crisis is unfolding: is this model then irrealistic? A run to the counter is a tail event which cannot be managed: the survival of the bank under such event is left mainly to the interventions of financial authorities. Equity is not the adequate instrument to address liquidity requirement, hence the analysis benefits from a reduced amount of variables. 12

13 Liabilities Rolling The general constraint is Under the assumption that Deposits and Equity will not change from one period to another –Hence the minimum debt amount to be issued is Such constraint in the ALM management of the bank is so central during crisis times that we can define the event of default as the event not to be capable to roll liabilities (net of redeeming assets) We are not analyzing the microeconomic stress of a single financial institution, whose lack of liquid assets can be addressed by the orderly functioning of financial markets. We are instead looking at major disfunctional events when Bonds issuance and interbank deposit markets can handle too few transactions compared to the need of market players to roll liabilities and extend debt maturity. 13

14 The relevance of maturities distribution 14 At a certain time t the market looks at the redemptions due in the next s years, both on the liability side and the asset side. i.Liabilities due for redemption between time t and time t+s: ii.Assets due for redemption between time t and time t+s: iii.The bank will also grant credit and make new investments: A n ( (t,t+s) iv.Therefore the bank will have to satisfy the constraint that the minimum issuance required is Event of default is, in this framework, that such minimum issuance is higher than market demand: hence the amount issued is such scenario is lower then required

15 No clearing price for Debt 15 Standard microeconomics of supply and demand does not apply to financial debt. i.Lack of appetite cannot be addressed by price ii.A price is converted into yield: is it sustainable? What is the yield of the assets and how does it compare to liabilities? What is the implied profitability of the bank if debt converges towards the price for issuance just realized? iii.When a price is not sustainable the primary market not only does not clear, but it shows disaffection to debt and no new subscriptions take place If primary market is shut the reaction of the banking system is by selecting no new investments: the deleverage mechanism accelerates and central banks may intervene on the relaxation of financing parameters, by selecting a new refinancing percentage of assets,ρ̃. The event of default is then (when the debt market is not clearing)

16 Assets vs Liabilities: where is profitability heading? 16

17 Banking System: no longer a liquidity generator A stable function of liquidity generation (managing assets and liabilities with different liquidity and maturity) has made the banking system of public relevance for –A role of monetary policy transmission –A role of Credit multiplication by simultaneous generation of liabilities and assets The key variable to manage this delicate public role is micro-economic, yet subject to public scrutiny: Capital Structure. Questioning the functioning of debt market is equivalent to acknowledgement that the economy requires a lower leverage; the entire banking system is called to a deleverage of the balance sheet: this is the main theme of the financial crisis. In the deleverage mode, the banking system is absorbing liquidity and there is only one liquidity generator: the central bank.

18 Debt: a variable difficult to handle. Financial debt issuance was the key tool for liquidity adjustments. Yet recent years have witnessed First a reduction of appetite and demand for short tenor debt only, with the consequence of clustering the refinancing needs in the short term More recently, a collapse in demand for almost any financial debt, with no distinction relating to maturity The shortening of the tenor of the liabilities implies a cost for debt more reactive to higher level of CDS, and, in general, to deteriorating market conditions. Shortening of the average maturity also increases the maturity transformation between assets and liabilities. Shortening of the average maturity concentrates redemptions and refinancing needs in the immediate future: will supply of issued bonds find demand for similar size? Maturities cluster in very few years, hence a liquidity shock opens a strong refinancing risk: liquidity is no longer a microeconomic variable and can no longer be managed via a statistical approach where long positions finance short positions in the financial market. 18

19 Debt reduction Why are markets imposing a debt reduction? Profits are not growing in saturated economies with a speed consistent with debt interests A suboptimal point in the capital structure may erode equity: such a scenario increases correlation across different debtors. Debt bears then a systemic risk and no longer an idiosyncratic credit risk Financial markets are running ahead of regulators: they are imposing a deleverage which ultimately means that the global stock of debt is to be reduced, be it in the format of public debt, private debt or Financial senior debt. Are Basel III and its more stringent capital requirements simply imposing a market requirement? 19

20 Tools for Debt Reduction We are facing a structural change in the leverage of the economy where a micro-economic management of liabilities relies on Liabilities rolling, even for short term horizon, where possible (maturities clustering have exacerbated the importance of liquidity around the months of peaks in redemptions) Usage of existing liquidity for payments coming due (actual deleverage) Reduction of real value of liabilities, via inflation or FX rate Selective defaults (painful but ultimately a way to reduce debt). Default rates of SME are increasing and they reduce further the profitability and solvency of the banking sector: the market scrutinizes the capital and the resilience of the banking sector. 20

21 What is Global Consolidation? 21 The intuition is mainly empirical: the correlation we experience across Banks debt and public debt seems to suggest a consolidation of the balance sheets of these debtors. This facilitates the understanding of the resilience of the banking sector. A banking system under stress is a concern for the smooth functioning of the economy: the public sector intervenes to reduce financial stress and markets quote a strong correlation between public and banks’ debt. Kunt and Huizinga analyze the theme well beyond the mere intuition and analyze the difference between banks too big to fail or too big to save. The relevance of the public sector is econometrically derived when data show that i.CDS levels are related negatively to a country’s fiscal balance ii.Valuations of systemically large banks are lower when located in countries with weaker public finances. Central bank: another institution to consolidate when the transmission of monetary policy is at risk due to an aggressive deleverage?

22 Consequences of Global Consolidation 22 Not clearing markets of public debt is simultaneous with not clearing markets of financial debt (within the same region). The banking sector is highly interconnected: even banks structurally different and operating in different areas within the same monetary region are affected by each other balance sheet soundness Government under financial stress affect not only the banks of their own country; via an econometric analysis we will analyze the evolution of a basket of European CDS: its daily evolutions can be explained, among other factors, via the daily evolution of CDS levels of Sovereigns affected by a debt crisis. Such explanatory power on a European basket of financial CDS via CDS levels of certain Sovereigns is a feature shown by a time series with inception well before the sovereign crisis. Literature focuses on correlation and interdependencies within regions. Here instead we insist on a macroeconomic global interconnection across the entire European Banking Sector.

23 Consequences of Global Consolidation (2) 23 If probabilities of default are explained by means of macroeconomic variables, can solvency and liquidity be addressed at a microeconomic level? Default of a bank may no longer be considered a microeconomic event Market assigns a probability of default by quoting CDS levels: a deleverage mode exacerbated by reluctance to subscribe financial debt creates a unique link between liquidity conditions and probability of default Liquidity is the variable explaining the transmission mechanism in the banking sector. Hence the title of my work posing the question if levels (and variations) of financial CDS are to be explained, in the last 4 years, by a)Liquidity Shortage b)Structural insolvency

24 Inference on liquidity. Selection of variables (with a bias towards EUR area). Euribor -Eonia Euribor and Eonia are two indices that are considered respectively proxies for the unsecured interbank deposit rate (e.g. 3- month EURIBOR) and the secured interbank deposit rate (i.e. Deposits which are secured against collateral) We consider the evolution of such parameters considering the swap rate for each floating parameter, with maturity 2 years. Sovereign CDS – Bond par spread CDS is an unfunded transaction, hence market players are not affected by the availability of liquidity The investment in securities issued by the sovereign does require to satisfy a liquidity constraint. Cross Currency Swap Eur/Usd A higher cross currency spread quoted by the market is the signal that there is a higher demand for Dollars versus Euros at time zero, possibly due to the difficulty to roll the USD denominated liabilities. Fontana and Sheiker analyze such basis (Sovereign CDS – Yield of the bond), but they investigate the evolution with a much shorter time series, with weekly data and before the government bond crisis. They also see such difference as explained, among other regressors, by the log value of the Itraxx Financial Senior. Here insteead we propose the basis as one of the regressors to explain the daily variations of the Itraxx Financial Senior Index Lenza, Pill, Reichlin also consider crucial this variable in “Monetary Policy in Exceptional Times” 24

25 Monetary Policy in exceptional times (European Central Bank, working paper series) 25

26 Explaining CDS levels via Liquidity To exclude for cointegration, we analyze daily differences. We will explain the daily evolution of the index Itraxx Financial Senior by the adoption of the variables above. Such basket of CDS is composed by banks and insurances which are not restricted to a particular region of Europe. Not only we deduce the central role of Liquidity in the last 3.5 years of Crisis, but data encourage to view the banking sector as a whole, without restriction to regional samples or different phases of this crisis ( as per approach of Alter and Schuler) CDS will be regressed on variables typically monitored by central bank: when CDS reflect such a high percentage of systemic risk, should they be considered a crucial variable for monetary policy? 26

27 Regression Results Range: 09-Dec May-2012 (Days: 583) Adjusted R_squared: 49.4% 27

28 Regression Results Range: 04-Nov May-2012 (Days: 871) Adjusted R_squared: 37.8% 28

29 Regression Results Range: 04-Nov May-2012 (Days: 871) Adjusted R_squared: 57.9% 29

30 Conclusions We have analyzed the evolution of a basket of European CDS in terms of regressors which ultimately map into the liquidity concept We believe that Liquidity, Debt, Capital and Deleverage are not issues that can be addressed from a microeconomic point of view. Dealing with risk implies then the diversification theories will fail: the concept of indipendent variable is difficult to apply and risk management is challenged in the reduction of risk. Risk management and capital management need to address Balance Sheet volatility and Capital Structure to cope with these turbulent times. Monetary policy is now relying on a very unstable transmission mechanism: a sharp deleverage may mean a collapse in M3 which in the short term can be addressed only via Monetary Base. 30

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