, Sleeping financial giants-Opportunities in financial leadership for climate stability, has been... more , Sleeping financial giants-Opportunities in financial leadership for climate stability, has been published by the Global Economic Dynamics and the Biosphere programme, Future Earth and the Stockholm Resilience Centre. It is part of the Earth System Finance project funded by Swedish funding agency Vinnova.
The paper develops an early warning system to identify banks that could face liquidity crises. To... more The paper develops an early warning system to identify banks that could face liquidity crises. To obtain a robust system for measuring banks’ liquidity vulnerabilities, we compare the predictive performance of three models – logistic LASSO, random forest and Extreme Gradient Boosting – and of their combination. Using a comprehensive dataset of liquidity crisis events between December 2014 and January 2020, our early warning models’ signals are calibrated according to the policymaker's preferences between type I and II errors. Unlike most of the literature, which focuses on default risk and typically proposes a forecast horizon ranging from 4 to 6 quarters, we analyse liquidity risk and we consider a 3-month forecast horizon. The key finding is that combining different estimation procedures improves model performance and yields accurate out-of-sample predictions. The results show that the combined models achieve an extremely low percentage of false negatives, lower than the value...
Using a comprehensive dataset of Italian SMEs, we find that differences between private and publi... more Using a comprehensive dataset of Italian SMEs, we find that differences between private and public information on creditworthiness affect firms' decisions to issue debt securities. Surprisingly, our evidence supports positive (rather than adverse) selection. Holding public information constant, firms with better private fundamentals are more likely to access bond markets. Additionally, credit conditions improve for issuers following the bond placement, compared with a matched sample of non-issuers. These results are consistent with a model where banks offer more flexibility than markets during financial distress and firms may use market lending to signal credit quality to outside stakeholders.
Capturing financial network linkages and contagion in stress test models are important goals for ... more Capturing financial network linkages and contagion in stress test models are important goals for banking supervisors and central banks responsible for micro-and macroprudential policy. However, granular data on financial networks is often lacking, and instead the networks must be reconstructed from partial data. In this paper, we conduct a horse race of network reconstruction methods using network data obtained from 25 different markets spanning 13 jurisdictions. Our contribution is twofold: first, we collate and analyze data on a wide range of financial networks. And second, we rank the methods in terms of their ability to reconstruct the structures of links and exposures in networks.
Abstract This paper introduces a coincident indicator of systemic liquidity risk in the Italian f... more Abstract This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial markets. In order to take account of the systemic dimension of liquidity stress, standard portfolio theory is used. Three sub-indices, that reflect liquidity stress in specific market segments, are aggregated in the systemic liquidity risk indicator in the same way as individual risks are aggregated in order to quantify overall portfolio risk. The aggregation takes account of the time-varying cross-correlations between the sub-indices, using a multivariate GARCH approach. This is able to capture abrupt changes in the correlations. We evaluate the indicator on its ability to match the results of a survey conducted among financial market experts to determine the most liquidity stressful events for the Italian financial markets. The results show that the systemic liquidity risk indicator accurately identifies events characterized by high systemic risk.
This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial ... more This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial markets. In order to take account of the systemic dimension of liquidity stress, standard portfolio theory is used. Three sub-indices, that reflect liquidity stress in specific market segments, are aggregated in the systemic liquidity risk indicator in the same way as individual risks are aggregated in order to quantify overall portfolio risk. The aggregation takes account of the time-varying cross-correlations between the sub-indices, using a multivariate GARCH approach. This is able to capture abrupt changes in the correlations and makes it possible for the indicator to identify systemic liquidity events precisely. We evaluate the indicator on its ability to match the results of a survey conducted among financial market experts to determine the most liquidity stressful events for the Italian financial markets. The results show that the systemic liquidity risk indicator accurately identifies events characterized by high systemic risk, while not exaggerating the level of stress during calm periods.
We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and Ger... more We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and German ten-year government bond yields. In line with the existing literature, we find that estimated premia have followed a downward trend since the 1980s: from 4.9 per cent in 1981 to 0.7 per cent in 2006 for the US bond and from 3.3 to 0.5 per cent for the German one. Subsequently, using an Error Correction Model (ECM) we prove that the decline is explained by a decrease in global output variability and an increase in the power of ten-year government bonds to diversify the investors' portfolios. In addition, the ECM also forecasts both the US and the German term premia converging to around one percentage point over a five year horizon. Long-term return expectations for ten-year government bonds will have to incorporate bond risk premia that-while in line with average excess returns during the twentieth century-are significantly lower than average excess returns over the last two decades.
In examining the risk premiums for U.S. and German 10-year government bond yields, the authors fo... more In examining the risk premiums for U.S. and German 10-year government bond yields, the authors found that the decline in bond risk premiums since the 1980s is associated with a decrease in global output variability and an increase in the power of 10-year government bonds to diversify portfolios. This article examines the dynamics of risk premiums for U.S. and German 10-year government bond yields and shows that the estimated patterns are associated with a decrease in the systematic component of risk. Using a no-arbitrage, essentially affine three-factor model and in line with the existing literature, we found that bond risk premiums have followed a downward trend since the 1980s: from 4.9 percent in 1981 to 1.2 percent in mid-2009 for the U.S. bond and from 3.3 percent to 1.1 percent for the German bond. We studied the relationship between the estimated government bond risk premiums and the risk associated with such securities in the context of fully integrated financial markets. Our basic conjecture is derived from modern portfolio theory (MPT): Holders of a financial asset can expect a premium over the risk-free asset only if they bear systematic risk, measured by the covariance between the asset returns and the returns of a global market portfolio. We estimated an error correction model (ECM) to analyze the co-movements between bond premiums (as implied by the affine model) and two variables: (1) the standard deviation of the world GDP growth rate and (2) the correlation between government bond returns and the returns of a portfolio diversified by asset class, geographic region, and currency. The use of variables that may be regarded as a single proxy for the MPT systematic risk allows us to interpret the ECM-fitted premiums as the fair values that investors require as remuneration for the risk of long-term government bonds. We show that the decrease in government bond premiums since the mid-1980s is mainly attributable to the reduction in the systematic component of risk and that the low premiums that prevailed until the third quarter of 2008 were broadly consistent with the perceived level of risk at the time. We also show that data from the most recent period—fourth quarter of 2008 to second quarter of 2009—reveal a dramatic gap between the level of premiums embedded in bond prices (those premiums remain extremely low) and the level of premiums that investors should require given their risk (such premiums have risen to historically high values). Although it is too early to say whether this fact constitutes evidence of a structural breakdown in the relationship we have estimated, our guess is that it is simply the result of investors shunning almost every asset class with an uncertain payoff in the aftermath of the Lehman Brothers bankruptcy. If so, as economic agents’ behavior returns to normal, most of the gap should narrow and disappear. We believe that these results are important for long-term investors. The lower the risk of government bonds, the lower the premium investors require (ex ante) to hold such securities, and the higher the price they are willing to pay. Over 1980–2005, a period seemingly marked by declining required bond premiums, (ex post) excess returns on government bonds were highly significant, especially when compared with the average values recorded over the 20th century. Of course, in order to answer the question about future bond risk premiums, one must explicitly express a view about the most plausible evolution of the current macroeconomic environment. To the extent that the great moderation of economic systems and the well-anchored inflation expectations we have experienced in the last two decades may be traced to structural changes that will persist even after the current crisis, investors may be confident that long-run bond risk premiums will remain low. Conversely, if financial markets have entered a completely new (and riskier) era and the past reduction in macroeconomic uncertainty has been merely the lucky upshot of fewer and smaller shocks hitting the economy, the outlook for long-term government bonds is gloomy. The main conclusion of this article is that investors’ expectations about long-term excess returns for 10-year government bonds will have to be significantly lower than the average values over the last two decades. Taking the current macroeconomic uncertainty into account, strategic investors should allow for an increase in (ex ante) bond risk premiums that may even depress bond prices. Investors will have to reconsider excess returns more in line with the average over a very long-term horizon, such as the last century. Note: The views expressed in this article are the authors’ own and do not necessarily reflect the views of the Bank of Italy.
The most widely used gauges of the money market liquidity conditions reflect both credit and liqu... more The most widely used gauges of the money market liquidity conditions reflect both credit and liquidity risk. In this paper, we put forward two approaches to infer the liquidity component. A first type of approach gauges the credit risk of the banks participating in the Euribor panel by first inferring their default probability from prices on own Credit Default Swap (CDS) contracts. The liquidity component is estimated as a residual. In the second approach, the liquidity component is derived along a simultaneous model estimate, where variables include unsecured inter-bank deposit rates, zero coupon yields on financial bonds, and zero coupon yields on Treasury bonds. The results presented in this paper confirm that, throughout the market turmoil, the rise in the money market spreads owed to both liquidity and credit risks, where the relative weights of these two components changed over time with credit risk becoming more and more relevant, while initially the liquidity risk accounted ...
In this paper we examine the holdings of government securities by domestic banks along with those... more In this paper we examine the holdings of government securities by domestic banks along with those of five other sectors: foreign banks, foreign non-banks, the official foreign sector, the domestic central bank and domestic non-banks. We use data for 21 advanced economies from 2004 Q1 to 2016 Q2. The results offer four main insights. First, banks are reluctant to undertake major changes in their holdings of domestic bonds but do accept frequent changes of more intermediate size. Second, the foreign official sector emerges as the clearest example of a contrarian investor, buying when prices fall and selling when prices rise. Third, the greater the holdings by domestic and foreign banks, the lower the yields tend to be on 10-year benchmark sovereign bonds. Finally, in all countries included in the sample we find a positive home bias in banks’ sovereign holdings while foreign banks hold fewer bonds than predicted by a neutral portfolio measure. These results suggest that banks regard domestic government bonds as a special asset class (hence the positive bias and avoidance of major changes in inventories) which they manage in a flexible manner (hence the frequent intermediate changes and lack of systematic timing of transactions), in all likelihood to meet requests from their customers. All in all, this behaviour by domestic banks provides a positive contribution to the liquidity of the market.
, Sleeping financial giants-Opportunities in financial leadership for climate stability, has been... more , Sleeping financial giants-Opportunities in financial leadership for climate stability, has been published by the Global Economic Dynamics and the Biosphere programme, Future Earth and the Stockholm Resilience Centre. It is part of the Earth System Finance project funded by Swedish funding agency Vinnova.
The paper develops an early warning system to identify banks that could face liquidity crises. To... more The paper develops an early warning system to identify banks that could face liquidity crises. To obtain a robust system for measuring banks’ liquidity vulnerabilities, we compare the predictive performance of three models – logistic LASSO, random forest and Extreme Gradient Boosting – and of their combination. Using a comprehensive dataset of liquidity crisis events between December 2014 and January 2020, our early warning models’ signals are calibrated according to the policymaker's preferences between type I and II errors. Unlike most of the literature, which focuses on default risk and typically proposes a forecast horizon ranging from 4 to 6 quarters, we analyse liquidity risk and we consider a 3-month forecast horizon. The key finding is that combining different estimation procedures improves model performance and yields accurate out-of-sample predictions. The results show that the combined models achieve an extremely low percentage of false negatives, lower than the value...
Using a comprehensive dataset of Italian SMEs, we find that differences between private and publi... more Using a comprehensive dataset of Italian SMEs, we find that differences between private and public information on creditworthiness affect firms' decisions to issue debt securities. Surprisingly, our evidence supports positive (rather than adverse) selection. Holding public information constant, firms with better private fundamentals are more likely to access bond markets. Additionally, credit conditions improve for issuers following the bond placement, compared with a matched sample of non-issuers. These results are consistent with a model where banks offer more flexibility than markets during financial distress and firms may use market lending to signal credit quality to outside stakeholders.
Capturing financial network linkages and contagion in stress test models are important goals for ... more Capturing financial network linkages and contagion in stress test models are important goals for banking supervisors and central banks responsible for micro-and macroprudential policy. However, granular data on financial networks is often lacking, and instead the networks must be reconstructed from partial data. In this paper, we conduct a horse race of network reconstruction methods using network data obtained from 25 different markets spanning 13 jurisdictions. Our contribution is twofold: first, we collate and analyze data on a wide range of financial networks. And second, we rank the methods in terms of their ability to reconstruct the structures of links and exposures in networks.
Abstract This paper introduces a coincident indicator of systemic liquidity risk in the Italian f... more Abstract This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial markets. In order to take account of the systemic dimension of liquidity stress, standard portfolio theory is used. Three sub-indices, that reflect liquidity stress in specific market segments, are aggregated in the systemic liquidity risk indicator in the same way as individual risks are aggregated in order to quantify overall portfolio risk. The aggregation takes account of the time-varying cross-correlations between the sub-indices, using a multivariate GARCH approach. This is able to capture abrupt changes in the correlations. We evaluate the indicator on its ability to match the results of a survey conducted among financial market experts to determine the most liquidity stressful events for the Italian financial markets. The results show that the systemic liquidity risk indicator accurately identifies events characterized by high systemic risk.
This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial ... more This paper introduces a coincident indicator of systemic liquidity risk in the Italian financial markets. In order to take account of the systemic dimension of liquidity stress, standard portfolio theory is used. Three sub-indices, that reflect liquidity stress in specific market segments, are aggregated in the systemic liquidity risk indicator in the same way as individual risks are aggregated in order to quantify overall portfolio risk. The aggregation takes account of the time-varying cross-correlations between the sub-indices, using a multivariate GARCH approach. This is able to capture abrupt changes in the correlations and makes it possible for the indicator to identify systemic liquidity events precisely. We evaluate the indicator on its ability to match the results of a survey conducted among financial market experts to determine the most liquidity stressful events for the Italian financial markets. The results show that the systemic liquidity risk indicator accurately identifies events characterized by high systemic risk, while not exaggerating the level of stress during calm periods.
We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and Ger... more We use a no-arbitrage essentially affine three-factor model to estimate term premia in US and German ten-year government bond yields. In line with the existing literature, we find that estimated premia have followed a downward trend since the 1980s: from 4.9 per cent in 1981 to 0.7 per cent in 2006 for the US bond and from 3.3 to 0.5 per cent for the German one. Subsequently, using an Error Correction Model (ECM) we prove that the decline is explained by a decrease in global output variability and an increase in the power of ten-year government bonds to diversify the investors' portfolios. In addition, the ECM also forecasts both the US and the German term premia converging to around one percentage point over a five year horizon. Long-term return expectations for ten-year government bonds will have to incorporate bond risk premia that-while in line with average excess returns during the twentieth century-are significantly lower than average excess returns over the last two decades.
In examining the risk premiums for U.S. and German 10-year government bond yields, the authors fo... more In examining the risk premiums for U.S. and German 10-year government bond yields, the authors found that the decline in bond risk premiums since the 1980s is associated with a decrease in global output variability and an increase in the power of 10-year government bonds to diversify portfolios. This article examines the dynamics of risk premiums for U.S. and German 10-year government bond yields and shows that the estimated patterns are associated with a decrease in the systematic component of risk. Using a no-arbitrage, essentially affine three-factor model and in line with the existing literature, we found that bond risk premiums have followed a downward trend since the 1980s: from 4.9 percent in 1981 to 1.2 percent in mid-2009 for the U.S. bond and from 3.3 percent to 1.1 percent for the German bond. We studied the relationship between the estimated government bond risk premiums and the risk associated with such securities in the context of fully integrated financial markets. Our basic conjecture is derived from modern portfolio theory (MPT): Holders of a financial asset can expect a premium over the risk-free asset only if they bear systematic risk, measured by the covariance between the asset returns and the returns of a global market portfolio. We estimated an error correction model (ECM) to analyze the co-movements between bond premiums (as implied by the affine model) and two variables: (1) the standard deviation of the world GDP growth rate and (2) the correlation between government bond returns and the returns of a portfolio diversified by asset class, geographic region, and currency. The use of variables that may be regarded as a single proxy for the MPT systematic risk allows us to interpret the ECM-fitted premiums as the fair values that investors require as remuneration for the risk of long-term government bonds. We show that the decrease in government bond premiums since the mid-1980s is mainly attributable to the reduction in the systematic component of risk and that the low premiums that prevailed until the third quarter of 2008 were broadly consistent with the perceived level of risk at the time. We also show that data from the most recent period—fourth quarter of 2008 to second quarter of 2009—reveal a dramatic gap between the level of premiums embedded in bond prices (those premiums remain extremely low) and the level of premiums that investors should require given their risk (such premiums have risen to historically high values). Although it is too early to say whether this fact constitutes evidence of a structural breakdown in the relationship we have estimated, our guess is that it is simply the result of investors shunning almost every asset class with an uncertain payoff in the aftermath of the Lehman Brothers bankruptcy. If so, as economic agents’ behavior returns to normal, most of the gap should narrow and disappear. We believe that these results are important for long-term investors. The lower the risk of government bonds, the lower the premium investors require (ex ante) to hold such securities, and the higher the price they are willing to pay. Over 1980–2005, a period seemingly marked by declining required bond premiums, (ex post) excess returns on government bonds were highly significant, especially when compared with the average values recorded over the 20th century. Of course, in order to answer the question about future bond risk premiums, one must explicitly express a view about the most plausible evolution of the current macroeconomic environment. To the extent that the great moderation of economic systems and the well-anchored inflation expectations we have experienced in the last two decades may be traced to structural changes that will persist even after the current crisis, investors may be confident that long-run bond risk premiums will remain low. Conversely, if financial markets have entered a completely new (and riskier) era and the past reduction in macroeconomic uncertainty has been merely the lucky upshot of fewer and smaller shocks hitting the economy, the outlook for long-term government bonds is gloomy. The main conclusion of this article is that investors’ expectations about long-term excess returns for 10-year government bonds will have to be significantly lower than the average values over the last two decades. Taking the current macroeconomic uncertainty into account, strategic investors should allow for an increase in (ex ante) bond risk premiums that may even depress bond prices. Investors will have to reconsider excess returns more in line with the average over a very long-term horizon, such as the last century. Note: The views expressed in this article are the authors’ own and do not necessarily reflect the views of the Bank of Italy.
The most widely used gauges of the money market liquidity conditions reflect both credit and liqu... more The most widely used gauges of the money market liquidity conditions reflect both credit and liquidity risk. In this paper, we put forward two approaches to infer the liquidity component. A first type of approach gauges the credit risk of the banks participating in the Euribor panel by first inferring their default probability from prices on own Credit Default Swap (CDS) contracts. The liquidity component is estimated as a residual. In the second approach, the liquidity component is derived along a simultaneous model estimate, where variables include unsecured inter-bank deposit rates, zero coupon yields on financial bonds, and zero coupon yields on Treasury bonds. The results presented in this paper confirm that, throughout the market turmoil, the rise in the money market spreads owed to both liquidity and credit risks, where the relative weights of these two components changed over time with credit risk becoming more and more relevant, while initially the liquidity risk accounted ...
In this paper we examine the holdings of government securities by domestic banks along with those... more In this paper we examine the holdings of government securities by domestic banks along with those of five other sectors: foreign banks, foreign non-banks, the official foreign sector, the domestic central bank and domestic non-banks. We use data for 21 advanced economies from 2004 Q1 to 2016 Q2. The results offer four main insights. First, banks are reluctant to undertake major changes in their holdings of domestic bonds but do accept frequent changes of more intermediate size. Second, the foreign official sector emerges as the clearest example of a contrarian investor, buying when prices fall and selling when prices rise. Third, the greater the holdings by domestic and foreign banks, the lower the yields tend to be on 10-year benchmark sovereign bonds. Finally, in all countries included in the sample we find a positive home bias in banks’ sovereign holdings while foreign banks hold fewer bonds than predicted by a neutral portfolio measure. These results suggest that banks regard domestic government bonds as a special asset class (hence the positive bias and avoidance of major changes in inventories) which they manage in a flexible manner (hence the frequent intermediate changes and lack of systematic timing of transactions), in all likelihood to meet requests from their customers. All in all, this behaviour by domestic banks provides a positive contribution to the liquidity of the market.
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