DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Volatile Capital Flows: Monitoring Systemic Risks Giampiero M. Gallo DiSIA Università di Firenze, Italy South East Europe in an Environment of Volatile Capital Flows CBBH Sarajevo June 6, 2014

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Concentrate on Potential Global Factors Main view: EMs (hence SEE) suffer from cascading effects, possibly dominating domestic factors Domestic financing needs crucially depend on international capital market conditions Government needs Market yields depend on evolution of risk premia (domestic – debt, deficit, growth, inflation - and external factors) Financing needs for domestically operating financial institutions (composition across equity, deposits, debt) Financing needs for the economy (credit, money and capital markets – level of development of such markets?): recent phenomenon of huge excess reserves by banks Lessons for regulations (e.g. carry trade) CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Public and Corporate Debt Management in EM Overall improvement in the management of debt Extend time to maturity Reduce exposure in foreign currency Reduce floating rate exposure Better awareness of controlling public spending On the demand side: rising foreign participation Broader investment base (reduce funding costs, risk diversification) Capital outflows related to reactions to global news Need to track Investors’ base and Systemic risks CBBH- Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Investors’ Base for Sovereigns (Arslanap and Tsuda, 2014) Shifts in the composition of the investor base can have implications for governments’ borrowing costs A rising share of foreign investors in the investor base can make borrowers more sensitive to external funding conditions A high share of domestic banks in the investor base may jeopardize domestic financial stability A diverse investor base, reflecting different investor characteristics in terms of risk tolerance and trading motives, may increase the liquidity of government debt securities in the secondary market (may be limited if herding effects) CBBH- Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Monitoring Investors’ Base Composition CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Different Compositions, Different Risks CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" The Interdependences at Stake CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Ingredients of a Monitoring System Monitor what affects investors’ portfolio choices by type of investor (leading indicators of impending shifts) Sovereign Bonds (yields, spreads and volatility) Corporate Bonds (yields, spreads and volatility) Equities (volatilities and spreads in volatilities) Correlations across asset classes Systemic Important Financial Institutions: Estimation of Marginal Expected Shortfall Capital Shortfall vs volatility Estimation of SRISK and ranking of SIFIs CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" US Corporate Risk CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Country Risk CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Spillover Effects CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Monitoring Systemic Risk Two main common features behind systemic risk: initial impairment to the financial system consequent spillover to the real economy Soundness of individual institutions is a necessary, but not a sufficient condition to guarantee systemic stability Monitoring market volatility as a potential source of transmission channel but it is the joint distribution of asset returns that matters, mainly the tail dependence. CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" The Fear Index and the Fear Premium CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Correlation across Asset Classes CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Systemic Important Financial Institutions Characteristics their big size, their scant substitutability as service providers, and their extremely high interconnectedness that greatly contributes to spread out individual vulnerabilities Relevance for the debate today Monitoring the SIFI’s risk dynamics has implications for the volatility of Capital Flows CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Beyond VaR The CoVaR (Adrian and Brunnermeier, is the VaR of one financial institution conditional on the whole system being in distress. The difference between the CoVaR and the unconditional VaR of the financial system gives the marginal contribution of that particular institution to systemic risk. Key point: some institutions can have a low VaR, but a high CoVaR. This is why the simple VaR is not a sufficient measure to evaluate the systemic riskiness of financial institutions. CoVar has complement in Marginal Expected Shortfall CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Acharya, Engle and Richardson (2012) Systemic risk should not be described in terms of a financial firm’s failure per se but in the context of a firm’s overall contribution to system ‐ wide failure. When only an individual financial firm’s capital is low, the firm can no longer financially intermediate. This has minimal consequences though because other financial firms can fill in for the failed firm’s void. When capital is low in the aggregate, however, it is not possible for other financial firms to step into the breach. This breakdown in aggregate financial intermediation is the reason there are severe consequences for the broader economy. CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Capital Shortfall as a Source of Volatile Capital Flows Real systemic risk of a firm = Real social costs of a crisis per dollar of capital shortage times Probability of a crisis i.e., an aggregate capital shortfall times Expected capital shortfall of the firm in a crisis Expected capital shortfall captures in a single measure many of the characteristics considered important for systemic risk such as size, leverage, and interconnectedness Alternative or complement to stress tests CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Methodology CBBH – Sarajevo June 6, Market volatility and Firm’s Volatility Econometric models for volatility and correlations

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Evaluating Losses under Crisis Scenarios To calculate the systemic risk, this system first evaluates the losses that an equity holder would face if there is a future crisis. To do this, the system is simulated for six months into the future many times. The most pessimistic scenarios for the market return are treated as Crisis scenarios The expected loss of equity value of firm i is called the Long Run Marginal Expected Shortfall or LRMES. This is just the average of the fractional returns of the firm’s equity in the crisis scenarios. CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Construction of SRISK from Balance Sheets Capital shortfall with a prudential capital ratio of k If SRISK=0 CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" SRISK for Deutsche Bank CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Volatility for Deutsche Bank CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Rankings as of May 30, 2014 CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" A Silver Lining? CBBH – Sarajevo June 6,

DiSIA DIPARTIMENTO DI STATISTICA, INFORMATICA, APPLICAZIONI "GIUSEPPE PARENTI" Implications for SEE Use the monitoring system to evaluate the relevance of indicators for the specific domestic banking/capital market dynamics Monitoring SRISK for major European SEFIs may signal impending reversals in global strategies Compare differences across SEE countries to isolate possible institutional differences Indications for regulatory scenarios CBBH – Sarajevo June 6,