Binary interest rate sensitivities of emerging market corporate bonds

We develop a framework to assess interest rate sensitivities of emerging market corporate debt. Our analysis, based on yield indexes, is applied to investment grade and high yield portfolios. We reach beyond correlation-based analyses of interest rate sensitivity and keep our scope centered at capital gains of emerging market corporates and U.S. government bonds portfolios. Our empirical analysis spans over the period 2002–2015. We address interest rate sensitivity of assets during the ignition, apogee, and the aftermath of the global financial crisis. Based on historical data series, we evidence that the emerging market corporate bonds exhibit two different regimes of sensitivity to interest rate changes. We observe switching from a positive sensitivity under the normal market conditions to a negative one during distressed phases of business cycles and provide economical explanations of such phenomena. We show that emerging market corporate bonds, which on average could appear rather insensitive to the interest rate risk, in fact, present binary interest rate sensitivities. This research sheds light on how financial institutions may approach interest rate risk management including the downside risk hedge. Our findings allow banks and financial institutions to optimize economic capital under Basel III regulatory capital rules.     

International Insurance Society Roundtable on Risk Management After the Crisis

In this roundtable, an adviser to several central banks and founding member of the Group of 30 discusses regulatory reform and corporate risk management strategies with senior executives from three of the world's largest insurance companies. Much of the discussion attempts to explain why insurance and reinsurance companies have proven less vulnerable to the crisis than commercial and investment banks. Part of the explanation has to do with their financial conservatism, which is attributed to a habitual tendency to decision‐making that gives heavy weight to long‐term probabilities and risks. But along with this “actuarial” cast of mind is a growing willingness to accept and make use of risk‐based capital requirements—a decision‐making framework that is, in some respects, in conflict with the accounting and regulatory capital conventions that still prevail in the industry. In particular, “Solvency II”—the risk‐based capital guidelines that are set for adoption in 2012 by insurers in the European Union—is held up as a possible model for global use.     

Prudential,Pragmatic, and Prescient,Reform of Bank Resolution Schemes

This article examines current initiatives in respect of bank financial distress in response to the 2008‐2009 financial crisis, suggesting that there is considerably more work to be undertaken before bank regulatory oversight, bank corporate governance, and bank resolution regimes have the appropriate preventive safeguards, governance, and timely, efficient and fair responses to bank financial distress. The corporate governance of banks and other financial institutions differs from the governance of corporations because of prudential regulation, banks' significance to the financial system, the different nature of stakeholders with investments at risk, and the existence of deposit insurance. The article offers a number of policy options in respect of how banks and other financial institutions could enhance their prudential, prescient, and pragmatic oversight and governance in a way that protects creditors, deposit holders, and other stakeholders, as well as the public interest in a healthy and sustainable financial sector. Copyright © 2012 John Wiley & Sons, Ltd.     

A Look Back at Merton Miller's “Financial Markets and Economic Growth”

The author begins by agreeing with Miller's characterization of the fragility of U.S. banks and of the shortcomings of the Asian model of bank finance‐driven growth. The article also expresses “emphatic agreement” with Miller's arguments that the protection of banks through deposit insurance, regulatory forbearance, and other forms of “bailout” have created costly moral‐hazard problems that encourage excessive risk‐taking. And the author endorses, at least in principle, Miller's main argument that the development of capital markets that do not require the direct involvement of banks should make economies if not less prone to financial crises, then at least more resilient in recovering from them. But having acknowledged the limitations of bank‐centered systems and the value of developing non‐bank alternatives for savers and corporate borrowers, the author goes on to point to the surprising durability of some banking systems outside the U.S.—notably Canada's, which has not experienced major problems since the 1830s. And even more important, the author views banks and capital markets not as “substitutes” for one another, but as mutually dependent “complements” whose interdependencies and interactions must be recognized by market participants and regulators alike.     

Does Risk Management Add Value? A Survey of the Evidence

The fact that 92% of the world's 500 largest companies recently reported using derivatives suggests that corporate managers believe financial risk management can increase shareholder value. Surveys of finance academics indicate that they too believe that corporate risk management is, on the whole, a valueadding activity. This article provides an overview of almost 30 years of broadbased, stock‐market‐oriented academic studies that address one or more of the following questions:

• ? Are interest rate, exchange rate, and commodity price risks reflected in stock price movements?
• ? Is volatility in corporate earnings and cash flows related in a systematic way to corporate market values?
• ? Is the corporate use of derivatives associated with reduced risk and higher market values?

The answer to the first question, at least in the case of financial institutions and interest rate risk, is a definite yes; all studies with this focus find that the stock returns of financial firms are clearly sensitive to interest rate changes. The stock returns of industrial companies exhibit no pronounced interest rate exposure (at least as a group), but industrial firms with significant cross‐border revenues and costs show considerable sensitivity to exchange rates (although such sensitivity actually appears to be reduced by the size and geographical diversity of the largest multinationals). What's more, the corporate use of derivatives to hedge interest rate and currency exposures appears to be associated with lower sensitivity of stock returns to interest rate and FX changes. But does the resulting reduction in price sensitivity affect value—and, if so, how? Consistent with a widely cited theory that risk management increases value by limiting the corporate “underinvestment problem,” a number of studies show a correlation between lower cash flow volatility and higher corporate investment and market values. The article also cites a small but growing group of studies that show a strong positive association between derivatives use and stock price performance (typically measured using price‐to‐book ratios). But perhaps the nearest the research comes to establishing causality are two studies—one of companies that hedge FX exposures and another of airlines' hedging of fuel costs—that show that, in industries where hedging with derivatives is common, companies that hedge outperform companies that don't.     

Banks’ equity performance and the term structure of interest rates

Using an extensive global sample, this paper investigates the impact of the term structure of interest rates on bank equity returns. Decomposing the yield curve to its three constituents (level, slope and curvature), the paper evaluates the time‐varying sensitivity of the bank's equity returns to these constituents by using a diagonal dynamic conditional correlation multivariate GARCH framework. Evidence reveals that the empirical proxies for the three factors explain the variations in equity returns above and beyond the market‐wide effect. More specifically, shocks to the long‐term (level) and short‐term (slope) factors have a statistically significant impact on equity returns, while those on the medium‐term (curvature) factor are less clear‐cut. Bank size plays an important role in the sense that exposures are higher for SIFIs and large banks compared to medium and small banks. Moreover, banks exhibit greater sensitivities to all risk factors during the crisis and post‐crisis periods compared to the pre‐crisis period; though these sensitivities do not differ for market‐oriented and bank‐oriented financial systems.     

Monetary Policy,Bank Lending,and the Risk‐Pricing Channel

This paper identifies a monetary policy channel through the risk pricing of bank debt in the market for jumbo certificates of deposit (jumbo CDs). Adverse policy shocks increase debt holder perceptions of bank default, increasing the risk premia for some banks, thereby decreasing their external funding of loans. The results show that contractionary policy increases the sensitivity of jumbo‐CD spreads to leverage and asset risk for small banks, and to leverage for large banks. The results also show a distributional and aggregate effect on banking system jumbo CDs and total loans, producing a risk‐pricing (or market discipline) channel. This channel has implications for monetary and regulatory policies, and financial stability.     

The Impact of the Federal Reserve's Large‐Scale Asset Purchase Programs on Corporate Credit Risk

Estimating the effect of Federal Reserve's announcements of Large‐Scale Asset Purchase (LSAP) programs on corporate credit risk is complicated by the simultaneity of policy decisions and movements in prices of risky financial assets, as well as by the fact that both interest rates of assets targeted by the programs and indicators of credit risk reacted to other common shocks during the recent financial crisis. This paper employs a heteroskedasticity‐based approach to estimate the structural coefficient measuring the sensitivity of market‐based indicators of corporate credit risk to declines in the benchmark market interest rates prompted by the LSAP announcements. The results indicate that the LSAP announcements led to a significant reduction in the cost of insuring against default risk—as measured by the CDX indexes—for both investment‐ and speculative‐grade corporate credits. While the unconventional policy measures employed by the Federal Reserve to stimulate the economy have substantially lowered the overall level of credit risk in the economy, the LSAP announcements appear to have had no measurable effect on credit risk in the financial intermediary sector.     

Efficiency, Ownership and Market Structure, Corporate Control and Governance in the Turkish Banking Industry

Turkish banks are quite heterogeneous in terms of organizational form, ownership structure, size, age, portfolio concentration, growth prospects and attitude toward risk. They also exhibit strong variations in performance as measured by several efficiency indices. In the light of theoretical advances in corporate finance and financial institutions, this paper is an in-depth cross-sectional analysis of the Turkish banking sector, which explores the various bank, market and regulatory characteristics that may explain the efficiency variations across banks. Consistent with the related hypotheses investigated, the results indicate that a number of independent bank characteristics are significantly correlated with various efficiency measures.     

Impact of corporate governance and related controversies on the market value of banks

Effective corporate governance of financial institutions, particularly in the banking sector, is vital for the stability of the financial system and the prevention of financial crises. Thus, this study examines the impact of corporate governance and related controversies on the market value of banks. For this purpose, we utilized Refinitiv’s corporate governance scores, including management, shareholder value, and corporate social responsibility (CSR), as well as its corporate governance controversies scores to analyze their impact on the market value of 242 banks in 43 countries. Using Refinitiv’s ESG database from 2017 to 2021, we conducted a path analysis and found a positive and statistically significant relationship between the CSR strategy scores and the market value of banks as well as between the management scores and the market value of banks. Moreover, there is a statistically significant relationship between the corporate governance controversies scores and the market value of banks.     

Bankers Trust and the Birth of Modern Risk Management

A leading financial practitioner traces the origins of the risk management concepts and applications widely used in today's financial institutions to their development at Bankers Trust in the 1970s. The bank became a pioneer out of necessity and entrepreneurship. Lacking the relationships with large corporations enjoyed by J.P. Morgan and Chase, Bankers Trust had to find ways to offer financial products its well‐established competitors could not. The innovations in risk management came from the Bank's “Resources Management” group, which was responsible for its trading and funding activities (but not corporate lending). By applying probability theory to its trading positions, the bank found an effective way to measure “market risk.” Extensions and refinements of this methodology were then used to measure credit risk and, later, liquidity risk and operational risk. These statistical methods and probabilistic concepts were brought together in a metric called Risk Adjusted Return On Capital, or “RAROC,” as it eventually became known throughout the financial services industry. RAROC was a concise way to measure and communicate the economic profits that had been generated by a transaction, product, or business unit, given the amount of “risk‐based” equity capital that was necessary to generate that profit. At Bankers Trust, RAROC eventually was used not only to evaluate profitability, but to guide strategic planning, capital allocation, and incentive compensation. And tools incorporating the same concepts, but with names like Value at Risk (or VaR), were later adopted by many other banks as well as regulators, including the framers of the Basel Accords. The author closes by suggesting how and why Bankers Trust's risk management culture began to deteriorate after 1995, and the bank was acquired by Deutsche Bank in 1998.     

Investor behaviour and reaching for yield: Evidence from the sterling corporate bond market

We provide evidence on how corporate bond investors react to a change in yields, and how this behaviour differs in times of market‐wide stress. We also investigate ‘reaching for yield’ across investor types, as well as providing insights into the structure of the corporate bond market. Using proprietary sterling corporate bond transaction data, we show that insurance companies, hedge funds and asset managers are typically net buyers when corporate bond yields rise. Dealer banks clear the market by being net sellers. However, we find evidence for this behaviour reversing in times of stress for some investors. During the 2013 ‘taper tantrum’, asset managers were net sellers of corporate bonds in response to a sharp rise in yields, potentially amplifying price changes. At the same time, dealer banks were net buyers. Finally, we provide evidence that insurers, hedge funds and asset managers tilt their portfolios towards higher risk bonds, consistent with ‘reaching for yield’ behaviour.     

The Capital Structure of PE‐Funded Companies (and How New Debt Instruments and Investors Are Expanding Their Debt Capacity)

The capital structures and financial policies of companies controlled by private equity firms are notably different from those of public companies. The concentration of ownership and intense monitoring of leveraged buyouts by their largest investors (that is, the partners of the PE firms who sit on their boards), along with the contractual requirement of PE funds to return their capital within seven to ten years, have resulted in capital structures that are far more leveraged than those of their publicly traded counterparts, but also considerably more provisional and “opportunistic.” Whereas the average U.S. public company has long operated with roughly 30% debt and 70% equity, today's typical private‐equity sponsored company is initially capitalized with an “upside‐down” structure of 70% debt and just 30% equity, and then often charged with working down its debt as quickly as possible. Although banks supplied most of the debt for the first wave of LBOs in the 1980s, the remarkable growth of the private equity industry in the past 25 years has been supported by the parallel development of a new leveraged acquisition finance market. This financing innovation has led to a general movement away from a bankcentered funding base to one comprising a relatively new set of institutional investors, including business development corporations and hedge funds. Such investors have shown a strong appetite for new debt instruments and risks that banks have been unwilling or, thanks to increased capital requirements and other regulatory burdens, prohibited from taking on. Notable among these new instruments are second‐lien loans and uni‐tranche debt—instruments that, by shifting the allocation of claims on the debtor's cash flow and assets in ways consistent with the preferences of these new investors, have had the effect of increasing the debt capacity of their portfolio companies. And such increases in debt capacity have in turn enabled private equity funds—now sitting on near‐record amounts of capital from their limited partners—to bid higher prices and compete more effectively in today's intensely competitive M&A market, in which high target acquisition purchase prices are being fueled by a strong stock market and increased competition from corporate acquirers.     

THE STATE OF U.S. CORPORATE GOVERNANCE: WHAT'S RIGHT AND WHAT'S WRONG?

Largely as a result of failures at Enron, WorldCom, Tyco, and other prominent American companies, U.S. corporate governance practices have come under attack. These much publicized failures and the resulting popular outcry have served as catalysts for legislative and regulatory changes that include the Sarbanes‐Oxley Act of 2002 and new governance guidelines from the NYSE and NASDAQ. But is the U.S. corporate governance system really as bad as critics suggest? And will the recent legislative and regulatory changes lead to a more effective system? The authors begin by noting that the broad evidence is not consistent with a failed U.S. governance system. During the past two decades, the U.S. economy and stock market have performed well both on an absolute basis and relative to other countries, even in the wake of the corporate scandals in 2001. Moreover, the most notable changes in U.S. corporate governance in the 1980s and 1990s‐including the institutionalization of U.S. share‐holders and the dramatic increase in equity‐based pay‐have served mainly (though not always) to strengthen the accountability of U.S. managers to their shareholders. The authors' message, then, is that while parts of the U.S. corporate governance system gave way under the exceptional strain created by the bull market of the 1990s, the overall system‐which includes corrective market forces as well as oversight by the public and government‐has reacted quickly and decisively to address its weaknesses. The net effect of the recent legislative and regulatory changes has been to make a good governance system an even better one. But, as the authors caution, perhaps the greatest risk now facing the U.S. financial market system (of which corporate governance is a critical part) is that of overregulation.     

Corporate Taxes and Securitization

Most banks pay corporate income taxes, but securitization vehicles do not. Our model shows that, when a bank faces strong loan demand but limited deposit market power, this tax asymmetry creates an incentive to sell loans despite less‐efficient screening and monitoring of sold loans. Moreover, loan‐selling increases as a bank's corporate income tax rate and capital requirement rise. Our empirical tests show that U.S. commercial banks sell more of their mortgages when they operate in states that impose higher corporate income taxes. A policy implication is that tax‐induced loan‐selling will rise if banks’ required equity capital increases.     

Statement of the Financial Economists Roundtable: How to Manage and Help to Avoid Systemic Liquidity Risk

In the summer of 2010, when legislative and regulatory responses were being finalized to address financial institution and market liquidity problems, the Financial Economists Roundtable, a group of prominent financial economists over 50 years old, convened with the aim of developing principles that would address both market‐wide and institution‐specific liquidity problems exposed by the 2007–2008 financial crisis. As summarized in this statement, the eight principles that came out of this meeting should be used to assess the strengths and weakness of not only the Dodd‐Frank legislation that was passed, but also of the regulatory proposals to implement the law as they continue to emerge. Among the eight principles endorsed, the Roundtable urges regulators to seek to ensure that:

• ? the failures of large complex institutions are independent events so as to minimize spillover effects;
• ? the interdependence of capital and liquidity requirements is recognized;
• ? such requirements are flexible and cost‐effective;
• ? central banks continue to provide lender‐of‐last‐resort lending against sound collateral; and
• ? the disclosure of institutions' risk exposures is timely and transparent.

The Roundtable also concluded that the crisis revealed critical weaknesses in the tri‐party repo market, and recommended consideration of reforms to the market that include moving such transactions to organized exchanges, and reducing dependence on the two private sector financial institutions that operate that market's infrastructure. Additional useful reforms would include limiting daylight overdrafts, imposing margin requirements on counterparties to limit systemic risk and prohibiting re‐hypothecation. Finally, the Roundtable believes that improved transparency of transactions and prices would enhance monitoring by responsible regulatory agencies.     

Shadow Banking,Risk Transfer,and Financial Stability

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub‐prime mortgage market disruptions into a global financial crisis on a “liquidity run” that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market‐based finance” to the term “shadow banking,” the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non‐bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non‐bank capital instead of remaining concentrated among commercial banks. The article also reviews post‐crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market‐based capital available for non‐bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.     

Default Risk Estimation,Bank Credit Risk,and Corporate Governance

This study explores the relationship between credit risks of banks and the corporate governance structures of these banks from the perspective of creditors. The cumulative default probabilities are estimated for a sample of US commercial and savings banks to measure their risk taking behavior. The results show that one year and five year cumulative default probabilities are time‐varying, with a significant jump observed in the year prior to the financial crisis of 2008–09. Generally speaking, corporate governance structures have a greater impact on US commercial banks than on savings institutions. We provide evidence that, after controlling for firm specific characteristics, commercial banks with larger boards and older CFOs are associated with significantly lower credit risk levels. Lower ownership by institutional investors and more independent boards also have lower credit risk levels, although these effects are somewhat less significant. For all the banks in our sample, large board size, older CFO, and less busy directors are associated with lower credit risk levels. When we restrict the sample to consider the joint effects of the governance variables, the results on board size and busy directors are maintained.     

The Financial and Economic Lessons of Italy's Privatization Program

Since 1994 the Italian government has sold equity stakes in some 75 large state enterprises, in the process raising over $125 billion‐more than any other country during the same period. In this article, a U.S. academic collaborates with the Italian government's Director of Privatization in summarizing the accomplishments and disappointments of Italy's privatization program, assessing its impact on Italian capital markets, and offering lessons for other countries embarking on new privatization programs. The article also describes the share issuance methods used by the government to execute several massive offerings, including the largest IPO in history. The principal benefits of Italian privatization have been dramatic increases in the size and efficiency of Italy's stock markets and in the safety and stability of its banking system. Despite such improvements, however, privatization has failed to bring about the increased competition in key industries and lower prices for consumers its planners originally envisioned. And based on this experience, the authors offer a number of lessons for government planners. Perhaps most important, privatization is likely to yield decisive benefits only if the divestment program is properly designed and sequenced. Governments should begin by privatizing state‐owned banks and other financial institutions, and as quickly as economically and politically feasible. Especially in less developed economies, commercial banks are for many companies both the only suppliers of credit and the only effective source of market discipline‐which explains why results have often been disastrous when governments have retained control of banks while privatizing other industries. Privatizing governments should also emphasize privatizations accomplished through share issuances rather than asset sales, with the aim of developing liquid and efficient stock markets and promoting effective corporate governance.     

Did the Market Signal Impending Problems at Northern Rock? An Analysis of Four Financial Instruments

The academic literature has regularly argued that market discipline can support regulatory authority mechanisms in ensuring banking sector stability. This includes, amongst other things, using forward‐looking market prices to identify those credit institutions that are most at risk of failure. The paper's key aim is to analyse whether market investors signalled potential problems at Northern Rock in advance of the bank announcing that it had negotiated emergency lending facilities at the Bank of England in September 2007. A further aim of the paper is to examine the signalling qualities of four financial market instruments (credit default swap spreads, subordinated debt spreads, implied volatility from options prices and equity measures of bank risk) so as to explore both the relative and individual qualities of each. The paper's findings, therefore, contribute to the market discipline literature on using market data to identify bank risk‐taking and enhancing supervisory monitoring. Our analysis suggests that private market participants did signal impending financial problems at Northern Rock. These findings lend some empirical support to proposals for the supervisory authorities to use market information more extensively to improve the identification of troubled banks. The paper identifies equities as providing the timeliest and clearest signals of bank condition, whilst structural factors appear to hamper the signalling qualities of subordinated debt spreads and credit default swap spreads. The paper also introduces idiosyncratic implied volatility as a potentially useful early warning metric for supervisory authorities to observe.