5 2- Financial backdrop Financial innovations: Credit risk transfer and securitization –Erosion of lending standards (Keys et al., 2008) –Increased opaqueness and shadow banking (Eichengreen, 2008) –Shortening of the maturity structure and increased maturity mismatch (Brunnermeier, 2008) –Rating agencies and the rating of ABS (Calomiris, 2008) –Disincentive to monitor loans (Duffie, 2007) –… and many other agency problems (Ashcraft & Schermann, 2008) Aversion to uncertainty and the difficulty to assign probabilities to outcomes (Caballero & Krishnamurthy, 2008) Risk management incentives and compensation schemes (Vives, 2008) Financial turmoil: multiples causes (2/2)
6 Financial backdrop – Spectacular development of CRT instruments Source: Borio, 2008
7 All these varied and multiple causes are intertwinned and entertain each other… What’s the (highly tentative but broadly hopefully comprehensive) main story? What are the modelling strategies that are available / related?
8 A consensual story: The Building-up “Easy” money… Global savings glut Rates “too low for too long” Asset price bubble …Combined with a series of agency problems… Tax distortions Banks compensation schemes Credit risk transfers instruments (securitisation) … led to (too) high leverage, risk-taking, and credit growth.
9 A consensual Story: A Trigger Fed fund rate rises in 2004 Materialisation of the risks on the sub-prime mortgages First SIV failed and ABS market dried-up
10 A consensual Story: Strong and wavy propagation (1/5) First phase: US subprime crisis Interbank market crisis –Lack of transparency and absence of ABS valuation –All banks that detained ABS suffered fall in equity capital, spreading of the shock from the US to the rest of the world –Increased distrust between banks –Banks refinancing difficulties on interbank market –Substantial rises in various interest rate spreads
11 A consensual Story: Strong and wavy propagation (2/5) First phase: US subprime crisis Interbank market crisis (cont’d) –General shortage of liquidity –Wild fire-selling and resulting asset depreciations –Further increase in banks’ liquidity need –Investments banks, the most dependent of wholesale finance, went into trouble
12 A consensual Story: Strong and wavy propagation (3/5) Second phase: Interbank market crisis Extension to “non-banks” –Failure of Lehmann Brothers as a second “trigger” –Liquidity hoarding by banks and collapse of interbank market –Further increases in various spreads –Further declines in asset valuation –Deleveraging and resulting credit tightening –[possibly developing into a credit crunch]
13 A consensual Story: Strong and wavy propagation (4/5) Evolution of the interbank market The figure shows the spread in the unsecured 3-month interbank market, recourses to the ECB deposit facility, and liquidity-absorbing fine-tuning operations, July 2006 – November 2008 Source: Heider et al., 2008 Before turmoil 1 st phase
14 A consensual Story: Strong and wavy propagation (5/5) Source: ECB staff computations. Vertical bars for 08-07 and 09-08.
15 What’s old? What’s new? The origins are somewhat familiar (Vives, 2008) Easy money + financial innovation = Asset price bubble (housing) Financial market correction What’s new in this proposed underlying story? The disproportionate propagation of the shock (Greenshaw et al., 2007) The combination of many propagation channels reinforcing each others The role of securitisation in the run-up to the crisis (Borio, 2008)
16 Objectives of our research project The severity of the current crisis is intimately linked to the way it built up The objective of the project is to model the run-up to the turmoil and the specific boom-bust dynamics underlying it The model should have the following features: Interactions between assets (equity and housing) price bubble and credit Central role to securitisation in these interactions Endogenous boom-bust of the credit cycle
17 Model framework: 2 main parts The modelling of the financial / housing market bubble The joint dynamics between assets prices and credit cycle through 2 complementary channels: “Old” collateral channel (Kiyotaki and Moore, 1998) “New” regulatory capital channel (Adrian and Shin, 2007)
18 Modelling of the financial bubble (1/2) Which model of financial bubble to use? Herd behaviour can be both fully or imperfectly rational (Hirshleifer et al., 2001) We build upon Abreu and Brunnermeier (Econometrica, 2003), where financial bubbles persist, even with rational agents “For several months, many informed observers were seriously concerned about how low credit spreads had gone. Some even spoke of a “liquidity bubble” or “credit bubble.” [Wall Street Journal, March 2007] “When the music stops, in term of liquidity, things will be complicated. But as long as the music is playing, you’ve got up to get up and dance. We’re still dancing”. [Citigroup’s former CEO, in the Financial Times, July 2007]
19 Rational agents are sequentially aware of the bubble But they do not know how early they receive the information w.r.t. other agents Waiting-time model can be of help in such a context: Agents who get out of the market just prior to the crash make the highest profit Agent who leave too early forego much of the higher returns available in the latter phase of the bubble Agents who stay in the market for too long lose all capital gains that result from the bubble “get out of the bubble, neither too early nor too late” Modelling of the financial bubble (2/2)
20 Joint dynamics between assets prices and credit (1/2) Securities at market (“fair”) value Loans to private sector Equity Debt AssetsLiabilities Kiyotaki and Moore (1998): Asset price - induced financial accelerator, based on borrower’s credit constraints and collateral value Adrian and Shin (2007) : asset prices bank’s equity value equity to capital ratio security purchases and credit supply
21 " Bank equity value " Borrower collateral Asset price bubble Capital ratio Number of borrowers Credit demand Credit supply Joint dynamics between assets prices and credit (2/2) Joint dynamics between assets prices and credit
22 Securitisation acts as a way to relax banks’ regulatory capital constraint (Brunnermeier, 2008) " Bank equity value " Borrower collateral Asset price bubble Capital ratio Number of borrowers Securitisation Credit demand Credit supply … The magnifying effect of securitisation
23 " Bank equity value " Borrower collateral Asset price bubble Capital ratio Number of borrowers Country 1 Securitisation Credit demand Credit supply " Bank equity value " Borrower collateral Capital ratio Number of borrowers Country 2 Credit demand Credit supply Securitisation increases the positive correlation between the returns in the two countries (Goldstein and Pauzner, 2004) … The systemic effect of securitisation
24 Additional points of interest How is the dynamics affected by agency problems? Bank compensation schemes based on relative, short-term performance (with no specific penalty for risk exposure) Reduced banks’ incentives to monitor the loans There may be scope for a monetary policy action based on observable fundamentals (in relation to asset prices) There may be scope for banking regulation via regulatory capital and accounting rules (market valuation, off balance sheet items…)
25 Conclusion This is all just started WIP… Feedback welcome