European monetary arrangements: Implications for the dollar,exchange rate variability and credibility

This paper uses the recent history of the ERM to gain insights into what might happen to exchange rates on the road to EMU. to do this, the paper examines the variability of exchange rates, the transmission of monetary policy between countries, the role of the dollar in ERM exchange rate crises, and ERM members' credibility as measured by the realignment probabilities prior to the September 1992 crisis. We identify two factors that might have contributed to the September 1992 crisis: high German interest rates and weakness of the US dollar. We find that behaviour of exchange rates has changed over time and differs between ERM and non-ERM currencies. We also demonstrate that changes in German short-term interest rates influence interest rates in other ERM countries and vice versa.     

Information uncertainty and auditor reputation

This paper explores the relationship between information uncertainty and auditor reputation revealed by the failure of Arthur Andersen (AA). AA’s reputation deteriorated considerably when it announced on January 10, 2002, that it had shredded documents related to its audit of Enron. AA’s demise was sealed on March 14, 2002, with its indictment for obstruction of justice. We find that on these dates the clients of AA and other Big Five auditors that are characterized by higher information uncertainty experience relatively larger share price declines compared to clients with lower information uncertainty. The findings suggest that the market relies more heavily on auditor reputation for higher information uncertainty firms, which implies that the value of an audit is greater when a firm is harder to value. Our results highlight the importance of information uncertainty in financial markets: where there is a shock to auditor reputation, firms with greater information uncertainty suffer the largest losses.     

Money, intermediation, and banking

The business of money creation is conceptually distinct from that of intermediation. Yet, these two activities are frequently—but not always—combined together in the form of a banking system. We develop a simple model to examine the question: When is banking essential? There is a role for money due to a lack of record-keeping and a role for intermediation due to the existence of private information: both money and intermediation are essential. When monitoring costs associated with intermediation are sufficiently low, the two activities can be separated from one another. However, when monitoring costs are sufficiently high, a banking system that combines these two activities is essential.     

A study of competing designs for a liquidity-saving mechanism

We study two designs for a liquidity-saving mechanism (LSM), a queuing arrangement used with an interbank settlement system. With a balance-reactive LSM, banks can set a balance threshold below which payments are not released from the queue, an action not possible with a receipt-reactive LSM. Payments that are costly to delay are settled earlier with a receipt reactive LSM. Payments that are not costly to delay may be queued with a balance reactive LSM but are always delayed with a receipt reactive LSM. We show that either system can provide higher welfare.     

Liquidity-saving mechanisms

This paper studies the incentives of participants in a real-time gross settlement system with and without the addition of a liquidity-saving mechanism (LSM). Participants in the model face a liquidity shock and different costs for delaying payments. They trade off the cost of delaying a payment against the cost of borrowing liquidity from the central bank. The main contribution of the paper is to show that the design of an LSM has important implications for welfare. In particular, parameters determine whether the addition of an LSM increases or decreases welfare.     

A practical approach to validating a PD model

The capital adequacy framework Basel II aims to promote the adoption of stronger risk management practices by the banking industry. The implementation makes validation of credit risk models more important. Lenders therefore need a validation methodology to convince their supervisors that their credit scoring models are performing well. In this paper we take up the challenge to propose and implement a simple validation methodology that can be used by banks to validate their credit risk modelling exercise. We will contextualise the proposed methodology by applying it to a default model of mortgage loans of a commercial bank in the Netherlands.     

Limits-to-arbitrage, investment frictions, and the asset growth anomaly

We empirically evaluate the predictions of the mispricing hypothesis with limits-to-arbitrage suggested by Shleifer and Vishny (1997) and the q-theory with investment frictions proposed by Li and Zhang (2010) on the negative relation between asset growth and average stock returns. We conduct cross-sectional regressions of returns on asset growth on subsamples split by a given measure of limits-to-arbitrage or investment frictions. We show that: (i) proxies for limits-to-arbitrage and proxies for investment frictions are often highly correlated; (ii) the evidence based on equal-weighted returns shows significant support for both hypotheses, while the evidence from value-weighted returns is weaker; and (iii) in direct comparisons, each hypothesis is supported by a fair and similar amount of evidence.     

Unintended consequences of the increased asset threshold for FDICIA internal controls: Evidence from U.S. private banks

We examine the unintended consequences of the 2005 increase from $500 million to $1 billion in the asset threshold for the Federal Deposit Insurance Corporation Improvement Act (FDICIA) internal control reporting requirements. We focus on a test sample of banks that increased their total assets from between $100 million and $500 million prior to the change in regulation to between $500 million and $1 billion within two years following the change. These “affected” banks are no longer subject to the internal control requirements but would have been had the regulation not been changed. We hypothesize that these affected banks are likely to make riskier loans, which will increase the likelihood of failure during the crisis period. We find evidence consistent with this hypothesis. Affected banks have higher likelihood of failure during the crisis period than banks from two different control samples. We also find that auditor reputation (i.e., whether the bank is audited by a Big 4 auditor or an industry specialist auditor) has a moderating effect on the likelihood of failure for these affected banks.     

Is the market valuation of banks’ loan loss provision conditional on auditor reputation?

We examine how auditor reputation conditions the market valuation of banks’ loan loss provision (LLP). The inherent uncertainty associated with and discretion permitted in estimating the LLP contributes to information asymmetry. The auditor’s certification and monitoring roles influence firm value by mitigating this information asymmetry. We examine two aspects of auditor reputation, auditor type (Big 5 vs. non-Big 5) and auditor expertise, in the banking industry. We find a significant, positive association between the discretionary component of LLP and stock return for banks audited by the Big 5 auditors. Further analysis indicates that auditor expertise within banking and not auditor type drives this significant, positive association. Overall, our results are consistent with auditor expertise in the banking industry mitigating information asymmetry between bank managers and investors and enhancing the information conveyed by discretionary loan loss provision.     

Impact of FDICIA internal controls on bank risk taking

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was designed, among other things, to introduce risk-based deposit insurance, increase capital requirements, and improve banks’ internal controls. Of particular interest in this study are the requirements for annual audit and reporting of management’s and auditor’s assessment of the effectiveness of internal control for banks with $500 million or more in total assets (raised to $1 billion in 2005). We study the impact of these requirements on banks’ risk-taking behavior prior to the recent financial crisis and the consequent implications for bank failure and financial trouble during the crisis period. Using a sample of 1138 banks, we provide evidence that banks required to comply with the FDICIA internal control requirements have lower risk taking in the pre-crisis period. Specifically, the volatility of net interest margin, the volatility of earnings, and Z score show less risk-taking behavior. Furthermore, these banks are less likely to experience failure and financial trouble during the crisis period.     

Price adjustment to news with uncertain precision

We analyze how markets adjust to new information when the reliability of news is uncertain and has to be estimated itself. We propose a Bayesian learning model where market participants receive fundamental information along with noisy estimates of news’ precision. It is shown that the efficiency of a precision estimate drives the slope and the shape of price response functions to news. Increasing estimation errors induce stronger nonlinearities in price responses. Analyzing high-frequency reactions of Treasury bond futures prices to employment releases, we find strong empirical support for the model’s predictions and show that the consideration of precision uncertainty is statistically and economically important.     

Macroeconomic fundamentals, price discovery, and volatility dynamics in emerging bond markets

This study characterizes volatility dynamics in external emerging bond markets and examines how prices and volatility respond to macroeconomic news. As in mature bond markets, surprises about macroeconomic conditions in emerging markets are found to affect both conditional returns and volatility of external bonds, with the effects on volatility being more pronounced and longer lasting than those on prices. Yet the process of information absorption tends to be more drawn-out than in mature bond markets. Global and regional macroeconomic news is at least as important as local news for both price and volatility dynamics.     

Market uncertainty and disclosure of internal control deficiencies under the Sarbanes–Oxley Act

This study examines cross-sectional differences in stock market reactions to the disclosure of internal control deficiencies under Section 302 of the Sarbanes–Oxley Act. We hypothesize that the market punishment for internal control problems will be less severe for internal control disclosure that helps reduce market uncertainty around the disclosure. We also predict that such a relation is dependent on the types of disclosure and the market’s prior knowledge of the credibility of firms’ financial reporting. Consistent with our hypothesis, we find that when firms disclose their internal control deficiencies, their abnormal stock returns are negatively associated with changes in market uncertainty (e.g., changes in the standard deviations of daily stock returns) around the disclosure. We also find that the impact of the uncertainty reduction is greater for voluntary disclosures of non-material weakness, especially those made in the context of previous suspicious events. The negative impact of changes in market uncertainty on the abnormal stock returns remains intact even after controlling for possible simultaneity. An analysis using financial analysts’ earnings forecasts dispersion as an alternative proxy for uncertainty confirms the results.     

Intraday jumps and US macroeconomic news announcements

This paper applies recent non-parametric intraday jump detection procedures to investigate the presence and importance of intraday jumps in US futures markets. More importantly, the paper investigates the extent to which statistically significant intraday jumps are associated with US macroeconomic news announcements. Jumps are prevalent, large and contribute heavily to total daily price variation. Approximately one third of jumps correspond to US macroeconomic news announcements, with pure announcement effects causing large increases in the absolute sizes of jumps and the informational surprise of the announcement explaining large proportions of the jumps. The statistical and economic significance of news-related jumps is confirmed by results that show higher volatility persistence, predictability of lower frequency returns, larger effects on microstructure variables, jump clustering and co-jumps from these jumps versus non-news-related jumps, although there are some interesting variations across asset classes.