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Michael Grill

25 July 2014
WORKING PAPER SERIES - No. 1698
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Abstract
In this paper we examine the quantitative effects of margin regulation on volatility in asset markets. We consider a general equilibrium infinite-horizon economy with heterogeneous agents and collateral constraints. There are two assets in the economy which can be used as collateral for short-term loans. For the first asset the margin requirement is exogenously regulated while the margin requirement for the second asset is determined endogenously. In our calibrated economy, the presence of collateral constraints leads to strong excess volatility. Thus, a regulation of margin requirements may have stabilizing effects. However, in line with the empirical evidence on margin regulation in U.S. stock markets, we show that changes in the regulation of one class of assets may have only small effects on these assets' return volatility if investors have access to another (unregulated) class of collateralizable assets to take up leverage. In contrast, a countercyclical margin regulation of all asset classes in the economy has a very strong dampening effect on asset return volatility.
JEL Code
D53 : Microeconomics→General Equilibrium and Disequilibrium→Financial Markets
G01 : Financial Economics→General→Financial Crises
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates
G18 : Financial Economics→General Financial Markets→Government Policy and Regulation
25 November 2015
FINANCIAL STABILITY REVIEW - ARTICLE
Financial Stability Review Issue 2, 2015
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Abstract
The Basel III leverage ratio aims to constrain the build-up of excessive leverage in the banking system and to enhance bank stability. Concern has been raised, however, that the non-risk-based nature of the leverage ratio could incentivise banks to increase their risk-taking. This special feature presents theoretical considerations and empirical evidence for EU banks that a leverage ratio requirement should only lead to limited additional risk-taking relative to the induced benefits of increasing loss-absorbing capacity, thus resulting in more stable banks.
JEL Code
G00 : Financial Economics→General→General
24 May 2016
FINANCIAL STABILITY REVIEW - ARTICLE
Financial Stability Review Issue 1, 2016
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Abstract
Financial institutions can build up leverage via the use of derivatives and securities financing transactions (SFTs). In order to limit the build-up of excessive leverage and the associated liquidity risks, as well as the pro-cyclical effects of margin and haircut setting practices, the macro-prudential toolkit needs to be extended. This special feature presents the general case for setting macro-prudential margins and haircuts using theoretical and empirical evidence on the effectiveness of various design options. Furthermore, it addresses implementation and governance issues that warrant attention when developing a macro-prudential framework for margins and haircuts. It concludes by recommending a way forward that is intended to inform the ongoing policy discussions at the European and international levels.
JEL Code
G00 : Financial Economics→General→General
30 August 2016
WORKING PAPER SERIES - No. 1954
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Abstract
This paper investigates whether credit constraints in the US economy amplify the international propagation of US financial shocks. We model the dynamics of the US economy jointly with global macroeconomic and financial variables using a threshold vector autoregression. This model captures regime-specific dynamics conditional on the severity of credit constraints in the US economy. We identify three main episodes of tight credit in US financial history over the past thirty years. These occur in the late-1980s, in the early 2000s, and during the 2007-09 financial crisis. We find that US financial shocks are associated with a significant contraction in global economic activity in times of tight credit. By contrast, there is little impact of US financial shocks on the global economy in normal times. This asymmetry highlights an international dimension of the US financial accelerator mechanism.
JEL Code
C32 : Mathematical and Quantitative Methods→Multiple or Simultaneous Equation Models, Multiple Variables→Time-Series Models, Dynamic Quantile Regressions, Dynamic Treatment Effect Models, Diffusion Processes
C34 : Mathematical and Quantitative Methods→Multiple or Simultaneous Equation Models, Multiple Variables→Truncated and Censored Models, Switching Regression Models
E32 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Business Fluctuations, Cycles
G01 : Financial Economics→General→Financial Crises
F44 : International Economics→Macroeconomic Aspects of International Trade and Finance→International Business Cycles
24 November 2016
FINANCIAL STABILITY REVIEW - ARTICLE
Financial Stability Review Issue 2, 2016
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Abstract
Alternative investment funds (AIFs) in Europe operate without regulatory leverage limits. Competent authorities within the EU have the legal power to impose macroprudential leverage limits on AIFs, but no authority has implemented this tool so far. This joint European Central Bank-De Nederlandsche Bank (DNB) special feature (i) presents a macroprudential case for limiting the use of leverage by investment funds, (ii) develops a framework to inform the design and calibration of macroprudential leverage limits to contain the build-up of leverage-related systemic risks by AIFs, and (iii) discusses different design and calibration options. By way of example, it uses supervisory information on AIFs managed by asset managers based in the Netherlands. The article concludes by recommending a way forward to develop an EU-level framework for a harmonised implementation of macroprudential leverage limits for AIFs, which forms a key part of the agenda of the European Systemic Risk Board (ESRB) to develop macroprudential policy beyond banking.
JEL Code
G00 : Financial Economics→General→General
20 June 2017
WORKING PAPER SERIES - No. 2079
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Abstract
This paper addresses the tradeoff between additional loss-absorbing capacity and potentially higher bank risk-taking associated with the introduction of the Basel III Leverage Ratio. This is addressed in both a theoretical and empirical setting. Using a theoretical micro model, we show that a leverage ratio requirement can incentivise banks that are bound by it to increase their risk-taking. This increase in risk-taking however, should be more than outweighed by the benefits of higher capital and therefore increased lossabsorbing capacity, thereby leading to more stable banks. These theoretical predictions are tested and confirmed in an empirical analysis on a large sample of EU banks. Our baseline empirical model suggests that a leverage ratio requirement would lead to a significant decline in the distress probability of highly leveraged banks.
JEL Code
G01 : Financial Economics→General→Financial Crises
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
29 November 2017
FINANCIAL STABILITY REVIEW - ARTICLE
Financial Stability Review Issue 2, 2017
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Abstract
Effectively functioning repo markets are of key importance for both financial stability and monetary policy, but the excessive use of repos may also be a source of systemic risk as witnessed during the recent financial crisis. Regulatory reforms introduced since the start of the crisis have aimed to contain systemic risk related to the excessive build-up of leverage and unstable funding, but recently some concerns have been raised about their potential effects on the functioning of the repo market. This special feature presents new evidence on the drivers of banks’ activity in the repo market with respect to regulatory reforms. In addition, it takes a closer look at the repo market structure and pricing dynamics, in particular around banks’ balance sheet reporting dates. While the observed volatility around reporting dates suggests that the calculation methodology for some regulatory metrics should be reviewed, overall, the findings indicate that unintended consequences of regulatory reforms on the provision of repo services by euro area banks have not been material.
JEL Code
G00 : Financial Economics→General→General
30 April 2018
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 5
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Abstract
The rapid growth of the asset management sector over recent years has raised questions about the interaction between traditional banks and investment funds, as well as the drivers behind this trend. Our analysis contributes to this debate by shedding light on the implications of increased competition between the two sectors. We first examine how competition between banks and investment funds drives the risk profiles and market shares of these two sectors. In a second step, we assess whether and how capital requirements for banks influence the relative market shares of the two sectors, contributing to both the analysis of the drivers behind the structural developments in the euro area financial sector and the work on the evaluation of the impact of post-crisis reforms.
JEL Code
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
2 October 2018
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 6
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Abstract
This article summarises the key findings from a counterfactual exercise where the effect of removing repo assets from the leverage ratio on banks’ default probabilities is considered. The findings suggest that granting such an exemption may have adverse effects on the stability of the financial system, even when measures are introduced to compensate for the decline in capital required by the leverage ratio framework. Increases in probabilities of default are mainly seen for larger banks which are more active in the repo market. Moreover, it is observed that the predictive power of the model improves when repo assets are included. Overall, the analysis in this article does not support a more lenient treatment of repo assets in the leverage ratio framework, e.g. by exempting them or allowing for more netting with repo liabilities or against high-quality government bonds.
JEL Code
G01 : Financial Economics→General→Financial Crises
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
29 November 2018
FINANCIAL STABILITY REVIEW - ARTICLE
Financial Stability Review Issue 2, 2018
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Abstract
Over the last decade, exchange-traded funds (ETFs) have grown at a fast pace both globally and in the euro area. ETFs typically offer low-cost diversified investment opportunities for investors. ETF shares can be bought and sold at short notice, making them efficient and flexible instruments for trading and hedging purposes. At the same time, the wider use of ETFs may also come with a growing potential for transmission and amplification of risks in the financial system. This special feature focuses on two such channels arising from (i) liquidity risk in ETF primary and secondary markets and (ii) counterparty risk in ETFs using derivatives and those engaging in securities lending. While ETFs still only account for a small fraction of investment fund asset holdings, their growth has been strong, suggesting a need for close monitoring from a financial stability and regulatory perspective, including prospective interactions with other parts of the financial system.
19 December 2018
WORKING PAPER SERIES - No. 2218
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Abstract
We assess the quantitative implications of collateral re-use on leverage, volatility, and welfare within an infinite-horizon asset-pricing model with heterogeneous agents. In our model, the ability of agents to reuse frees up collateral that can be used to back more transactions. Re-use thus contributes to the buildup of leverage and significantly increases volatility in financial markets. When introducing limits on re-use, we find that volatility is strictly decreasing as these limits become tighter, yet the impact on welfare is non-monotone. In the model, allowing for some re-use can improve welfare as it enables agents to share risk more effectively. Allowing re-use beyond intermediate levels, however, can lead to excessive leverage and lower welfare. So the analysis in this paper provides a rationale for limiting, yet not banning, re-use in financial markets.
JEL Code
D53 : Microeconomics→General Equilibrium and Disequilibrium→Financial Markets
G01 : Financial Economics→General→Financial Crises
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates
G18 : Financial Economics→General Financial Markets→Government Policy and Regulation
29 October 2019
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 9
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Abstract
Initial margin (IM) reduces counterparty credit risk in derivative markets. Notwithstanding efforts to limit potential procyclical effects of IM-setting practices, there is an ongoing debate about whether the current framework sufficiently addresses this concern, in particular when Value-at-Risk (VaR) models are used for setting IM. This article provides further insights into this issue. First, using EMIR data, we provide an overview of outstanding IM in the euro area derivative market and identify the most relevant sectors for the exchange of IM. Second, using a VaR IM model in line with industry practice, we show that aggregate IM can potentially vary substantially over a long-term horizon. Finally, we show that an IM floor based on a standardised IM model could be an effective tool for reducing IM procyclicality.
JEL Code
G10 : Financial Economics→General Financial Markets→General
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
6 February 2020
ECONOMIC BULLETIN - BOX
Economic Bulletin Issue 1, 2020
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Abstract
The analysis provides empirical evidence that repo market liquidity is an important determinant of bond market liquidity and arbitrage opportunities in swap markets. The first part of the analysis is concerned with the role of repo market liquidity in funding bonds used as collateral in repo transactions. It explores whether tense repo markets reduce the liquidity in bond markets. The second part examines how lower liquidity in repo markets hampers arbitrage in swap markets. The results presented show that repo markets support both bond market liquidity and swap market efficiency, highlighting their important role in financial markets.
JEL Code
G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
12 April 2021
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 12
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Abstract
Large differences between the liquidity of investment funds’ assets and liabilities (i.e. liquidity mismatches) can create vulnerabilities in the financial system and expose funds to a risk of large outflows and sudden drops in market liquidity. From a macroprudential perspective, the current regulatory framework may not sufficiently address the risks stemming from liquidity mismatches in investment funds. By modelling the liquidity management of an open-ended fund, this article provides theoretical justification for pre-emptive policy measures such as cash buffers that enhance financial stability by helping to increase the resilience of investment funds.
JEL Code
G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
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12 April 2021
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 12
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Abstract
Following the onset of the coronavirus (COVID‑19) crisis, a significant number of European investment funds suspended redemptions. We find that many of those funds had invested in illiquid assets, were leveraged or had lower cash holdings than funds that were not suspended. Furthermore, suspensions were more likely to be seen in jurisdictions where pre-emptive liquidity measures were not available. Our findings also suggest that suspensions have spillover effects on other funds and sectors, highlighting the importance of pre-emptive liquidity management measures.
JEL Code
G23, G28, G01 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
12 April 2021
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 12
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Abstract
The turmoil seen in March 2020 highlighted key vulnerabilities in the money market fund (MMF) sector. This article assesses the effectiveness of the EU’s regulatory framework from a financial stability perspective and identifies three important lessons. First, investment in non-public debt assets exposes MMFs to liquidity risk, highlighting the need to limit investment in illiquid assets. Second, low-volatility net asset value (LVNAV) funds are particularly vulnerable to liquidity shocks, given that they invest in non-public debt assets while offering a stable net asset value (NAV). Enhanced portfolio requirements could strengthen their liquidity profile. And third, MMFs seem reluctant to draw down on their liquidity buffers during periods of stress, suggesting a need to make buffers more usable.
JEL Code
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
G01 : Financial Economics→General→Financial Crises
12 April 2021
MACROPRUDENTIAL BULLETIN - ARTICLE - No. 12
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Abstract
During the market turmoil of March 2020, many money market funds (MMFs) and other investment funds which were exposed to liquidity risk through a liquidity mismatch between their assets and liabilities experienced significant outflows. Those funds reacted in a procyclical manner by either selling assets in already stressed markets or curtailing investors’ access. That behaviour resulted in knock-on effects on other sectors of the economy and amplified the stress within the financial system. This overview article discusses financial stability risks arising from liquidity transformation by MMFs and other investment funds, a subject which is then explored in greater depth in the three other articles in this issue of the Macroprudential Bulletin. While the liquidity transformation carried out by investment funds serves an important economic function, by intermediating savings and real economy financing, it can also generate risks to financial stability. With this in mind, this article argues for a macroprudential approach to the regulation of investment funds to enhance their resilience and facilitate a stable provision of funding to the wider economy in both normal market conditions and periods of market stress.
JEL Code
G01 : Financial Economics→General→Financial Crises
G23 : Financial Economics→Financial Institutions and Services→Non-bank Financial Institutions, Financial Instruments, Institutional Investors
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
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