rob engle china research luncheon february 5, 2013pages.stern.nyu.edu/~jcarpen0/chinaluncheon/engle...
TRANSCRIPT
RobEngleChinaResearchLuncheonFebruary5,2013
Whenthefailureofoneormorefinancialinstitutionstomeetitsobligationshassubstantialnegativeimpactsontherealeconomy,thenthesearesystemicinstitutions.
WesawthatLehmanbankruptcybegantheworstepisodeofthefinancialcrisis.ButitcoincidedwithdeepdistressatFANNYandFREDDIE,Citi,BankofAmerica,MerrillLynch,Goldman,MorganStanley,AIG,WAMU,Wachovia,andmanymore.
Howmuchcapitalwouldafinancialinstitutionneedtoraiseinordertofunctionnormallyifwehaveanotherfinancialcrisis?
Wemeasurethiseconometricallybasedonmarketdataonequitiesandbalancesheetdataonliabilities.WeupdateweeklyonV‐LABforUSandGlobalfinancialfirms.WecallthisSRISK.
Principleinvestigators:ViralAcharya,MattRichardsonandmeattheVolatilityInstituteatNYU’sSternSchool.CollaborationwithHECLausanneandtheInstituteforGlobalFinanceatUniversityofNewSouthWales.ContributionsbyChristianBrownlees,RobCapellini,DianePerriet,EmilSiriwardane.
Regulatorsmeasurethisbasedonsupervisorydataandstressscenarios.
ManyotherrelatedmeasuresarebeingdevelopedorareinusebyregulatorsinEuropeandtheUS.
SomemeasuresarefirmspecificsuchasCoVaR,andnetworkmodelsthattracelinkages.Othersarefinancialindustryqualitymeasuressuchasvolatility.
RecentsurveysbyBrunnermeierandOehmkeandbyBisias,Flood,LoandValvaniscovermanymeasures.
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Thedominoornetworkmodelsaysthatonefirmcanbesoimportantorinterconnectedthatitsfailurewillprecipitatethefailureofitscounterpartiesandthentheywillbringdowntheircounterpartiesuntilthesectorandtherealeconomyfails. Question:whataretheotherdominosdoingwhilethefirstarefalling?Whatareinvestorsdoing?
Question:whatisthedifferencebetweeninterconnectednessandrisksharing?
Thetsunamimodelisbasedonmanyinstitutionshavinglargerisksonthesameevents.Iftheseeventsoccur,thenalltheinstitutionswillbestressedatthesametimeandthesectorandeconomywillcollapse.
SRISKiscomputedfrom:
Wherekisaprudentiallevelofequityrelativetoassetstakentobe8%(and5.5%forIFRSfirms)andLRMESisthedeclineinequityvaluestobeexpectedifthereisanotherfinancialcrisis.
SRISKdependsuponsize,leverageandrisk.
BankofAmericahasamarketcapof$114billion.Itsaccountingliabilitiesare$1.9trillionforaleverageratioof17.9
Ifwehaveanotherfinancialcrisiswhichisassumedtobeafallof40%inbroadUSequitiesoversixmonths,thenweestimatesharesinBACwillfallby60%.
ThisreflectsaDynamicConditionalBetaof1.7todaythatwillmoveinthefutureduetomeanreversioninvolatilitiesandcorrelationsandalsowillrisewithdownsidereturns.
SRISK=$112billion. Itisundercapitalizedsomewhattodayandthiswillbemoresevere
underthestressofanequitydecline.
CreditAgricolehasamarketcapof$19billion Ithasliabilitiesof$2.1trillionforaleverageratioof124
Anyfluctuationinassetorliabilityvaluationscaneasilymovethefirmintobankruptcy.
Mostofthecapitalshortfallisneededtobringtheleveragedownnow.Theriskisonlyasmallpartofthecapitalshortfallcalculation.
Mostlikely,CreditAgricoleisnolongermakingloansexceptpossiblythemostsecure.
Ifwehaveafinancialcrisis,thenallfirmswithpositiveSRISKwilltrysimultaneouslytoraisecapitalandtheonlysourceislikelytobetaxpayers.ThebiggerSRISK,themoreseriousthethreattofinancialstability.
SRISKisestimatedconditionalonanendogenousvariable–astresstestdoesnotindicatecausality.
Buthowdoesthishappen?
IfanyfirmshavehighSRISK,theywillrecognizetheirvulnerabilityandwillbegintodeleverandderisk,therebyimpactingtherealeconomy.IfonlyafewfirmshavehighSRISK,theremainingfirmscantakeuptheslack.
Asthemacroeconomyslows,stockpriceswillfall,volatilitywillrise,andSRISKwillgoupmore.
Firmsmaydeleverandderiskbyattemptingtosellilliquidassetsandhoardingcashleadingtofurtherdeclinesinrealandfinancialsectors.
Investorsrecognizefinancialinstitutionweaknessandlowervaluations,increasingSRISK
Forwardlookinginvestorscouldmakethishappeninonestep.
Bankruptciesandotherfailureswilloccuruntileventually,thereturntocapitalishighenoughtobringnewcapitaltotheindustry.
Thespiralcanbearrestedbeforethebottom.
However,thiswillerodemarketdisciplineandmayimposehugeregulatorycostsonthefinancialsectorgoingforward.
Thusregulationisneededinadvance.Ideallyitwouldbecountercyclical.
Externalities–ifonlyonefirmhashighSRISK,thereisnospiral.
ImplicitandExplicitgovernmentguaranteessuchasdepositinsuranceor“toobigtofail”
Regulatoryincentives–themeasure:“riskweightedassets”ignorescorrelationandhenceleadstonon‐diversifiedassetmix
Riskweightsmaybepoormeasuresofrisk.
Miscalculation:useshortrunriskmeasurestochooseleverageratherthanlongrunrisk.
Miscalculation:valuingexoticsecuritiessuchasCDOswithoutrecognizingalltherisks.
Miscalculation:housingpricescangodown Agencyproblems–wallstreetbigshots. ……..Toomanypossibilities
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RegulatorsmightrequirethatfirmsholdsufficientcapitalsothattheirSRISKiszero.Thustheywouldnothavetoraisecapitalinafuturecrisis.
ThusfirmswouldberequiredtoreduceSRISKwhichcanbedoneby Deleveraging Demerging Derisking Decliningtofollowtheherdwithidenticalbets.
Itisbestifcapitalrequirementscanbeincreasedingoodtimessincethebankscaneasilyraisecapitalandincreasetheirbuffer.
Inbadtimes,itisnaturaltoreducerequirementsbecausenewcapitalisveryhardandexpensivetoraiseatthattimeandbecausedraconiancutswillhurttherestoftheeconomy.
DYNAMICCONDITIONALBETA
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Conditionont‐2
Theequation
ButucanbeanMA(1)andGARCH.Infact,itmusthaveMA(1)ifRiistobeaMartingaledifference.
Combiningtheconstantbetaanddynamicconditionalbetaintooneregression:
WhereuwillbeanMA(1)GARCH
For1200globalfinancialinstitutionsweupdateweeklyestimatesofSRISK.ThesenowuseNestedDynamicConditionalBetawithMA(1)andGARCH.
http://vlab.stern.nyu.edu ImayalsoshowyouresultscorrectingfordifferencesbetweenGAAPandIFRSaccountingthatarenotyetonthewebsite.
ThechangeinSRISKfromonetimeperiodtoanothercanbeattributedtochangesindebt,equityorrisk.
Inearly2008LocalGovernmentDebtinChinawas1.7trillionyuan.Attheendof2010itwas10.7trillionor27%ofGDP(NationalAuditOfficeJune2011)
LocalGovernmentscannotborrowdirectlyandestablished6,576specialfinancingvehicles.
8.5trillionyuanarefrombankloansdue2011‐2013
530billionyuanofirregularitiesinlocalgovernmentdebt 46billioninirregularcreditguarantees 73billionsecuredwithirregularcollateral 35billionspentonstocks,housingandpollutingplants
132billionnotmadebyapproveddeadline 244billionoffraudulentunderpaymentofregisteredcapitalinfinancingvehicles
Orderstocorrecttheseirregularitieshaveonlybeenpartiallysuccessfulthusfar.
Localgovernmentsarenotpermittedtoborroworissuebonds
Localgovernmenttaxrevenuesgrewmoreslowlythanexpenditures
Stimuluswasallocatedtolocalexpendituresandexacerbatedtheproblem.
4trillionyuan($618billion)allocatedto10areasincludingincludinglow‐incomehousing,ruralinfrastructure,water,electricity,transportation,theenvironment,technologicalinnovation,andreconstructionfromseveraldisasters.
Financedby1.2trillionfromcentralgovernmentandtherestbylocalgovernments.Theysetupfinancingvehiclesandborrowedmassivelyfromthebanksascreditstandardswereeasedandregulatorsshiftedflowstolocalgovernments.
Netinterestmarginsshrunkbecauseofmacroeconomicpolicy;banksexpandedloanstomakeuptherevenue.
Chiefrevenuesourceforlocalgovernmentsislandsaleswhichareslowing.Inflationfearswillleadtomacroeconomictighteningwhichwillfurtherslowthisgrowth.
Projectshavelonglivesandcannotcoverinterestpaymentsintheshortrun.MorethanhalfofChina’sGDPgrowthoverthelastcoupleofyearsisbasedonfixedinvestment.Butsuchstimulusisnotnecessarilycommerciallyviableonitsown.
Muchofthisborrowingisoffbalancesheetusinggovernmentlandorassetsascollateral.
RecentlyWSJreportedthatallmunicipalloanswererolledoverattheendof2012.
Banklendingtostateownedenterprisesgrewrapidlyinthisperiodpresumablyastheseweremoresecure.
GrowthofSOEsattheexpenseofprivatefirmsislikelytosloweconomicgrowth
SOEsreportedlyinvestedinrealestateratherthancorebusinesses.
Debtforgivenessorrolloveraretemporaryfixes.
Municipalitiesneedgreateraccesstofunds.Needtaxreformtogivemoresources.
Municipalitiesneedtobeabletoissuebondswhichwouldmakefinancingmoretransparent.Thisisnowbeingexperimentallytried.
“TOOBIGTOFAIL”guaranteeleadseachinstitutiontotakemoreriskthansociallyorprivatelyoptimal.
“LEVERAGEEXTERNALITY”leadseachbanktotakemoreleveragethanissociallyoptimal
“RISKMYOPIA”leadsinstitutionstotakelongrunpositionsbasedonshortrunrisks.
“HERDING”leadseachinstitutiontochoosesameinvestmentportfolio.Regulationmayalsodothis.
“REGULATION”mustoffsettheseincentives.
Theyarestate‐ownedandwillsurelyberescuedshouldtheyneedit.
Thesovereignhas$3trillionofreservessorescueshouldbeeasy.However,sellingthese$assetswillmakeithardtomanageexchangerates.
TotalSRISKisonly$200billiontoday. OffbalancesheetitemsarelikelytobeimportantsoSRISKisprobablyunderstated.
FinancialequitymaybemorevaluablebecauseoftheguaranteesandhenceleadtolowerSRISK.
ThecausesofsystemicfinancialriskareallveryapparentintheChinesesettingthustherisktothefinancialsectorislikelytogrow.
Regulationmayoffsettheseincentivesifitiseffective.
FSBlistsonlyBankofChinaasGSIFI. MyGuess–probablynotnowbutpayattention!
