Conferences

Risks of Financial Institutions

An NBER Conference on the Risks of Financial Institutions was held in Cambridge on November 10. Mark Carey, Federal Reserve Board, and Rene M. Stulz, NBER and Ohio State University, organized the meeting, at which the following papers were discussed:

• Deborah Lucas, Northwestern University and NBER, and Robert McDonald, Northwestern University, “An Options-Based Approach to Evaluating the Risk of Fannie Mae and Freddie Mac”
• Diana Hancock and Wayne Passmore, Federal Reserve Board, “Understanding Market Discipline in the Presence of Implicit Government Guarantees: An Analysis of Subordinated Bond and Stock Returns for GSEs and for Bank Holding Companies”  Discussant for both papers: Thomas Wilson, ING
• Markus Brunnermeier, Princeton University, and Lasse Heje Pedersen, New York University, “Market Liquidity and Funding Liquidity” Discussant: Jeremy C. Stein, Harvard University and NBER
• Gregory W. Brown, University of North Carolina, Chapel Hill; Söhnke M. Bartram, Lancaster University; and John E. Hund, University of Texas at Austin, “Estimating Systemic Risk in the International Financial System” Discussant: Anthony Saunders, New York University
• Viral Acharya and Timothy Johnson, London Business School, “Insider Trading in Credit Derivatives” Discussant: Louis Scott, Morgan
• Stanley Torben G. Andersen, Northwestern University and NBER; Tim Bollerslev, Duke University and NBER; and Francis X. Diebold, University of Pennsylvania and NBER, “Roughing It Up: Including Jump Components in the Measurement, Modeling, and Forecasting of Return Volatility”(NBER Working Paper No. 11775) Discussant: Eric Ghysels, University of North Carolina, Chapel Hill
• Samuel Hanson, Harvard University; M. Hashem Pesaran, University of Cambridge; and Til Schuermann, Federal Reserve Bank of New York, “Firm Heterogeneity and Credit Risk Diversification” Discussant: David M. Lando, Copenhagen Business School
• Sanjiv Das, Santa Clara University; Darrell Duffie, Stanford University and NBER; Nikunj Kapadia, University of Massachusetts; and Leandro Saita, Stanford University, “Common Failings: How Corporate Defaults Are Correlated”  Discussant: David Li, Barclays Capital

Fannie Mae and Freddie Mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the eight trillion dollar U.S. residential mortgage market. Their hybrid government-private status, and the perception that they are too big to fail, make them a potentially large, but mainly unaccounted for, risk to the federal  government. Measuring the size and risk of this liability is technically difficult, but important for the debate over the appropriate regulation of these institutions. Lucas and McDonald take an options pricing approach to evaluating these costs and risks. Under the base case assumptions, the estimated value of the guarantees is $7.9 billion over ten  years, with a combined 0.5 percent value at risk of $122 billion. The authors evaluate the sensitivity of these estimates  to various modeling assumptions, and also to the regulatory regime, including forbearance policies and capital requirements. Their analysis highlights the benefits, but also the challenges, of taking on options-based approach to evaluating the value of federal credit guarantees.

When studying changes in the risks of large bank holding companies (BHCs) and government-sponsored enterprises (GSEs), researchers routinely argue that changes in the responsiveness of stock and subordinated bond returns to exogenous risk factors can be interpreted as reflecting changes in investors’ views about the firm’s expected losses. However, investors may perceive that these large firms have substantial implicit government guarantees. Hancock and Passmore show that  these guarantees can confound the interpretation of stock and bond return responsiveness, making changes in the responsiveness of bond returns difficult to interpret. They also show that changes in the responsiveness of stock returns are almost impossible to interpret. These results suggest that implicit guarantees can hide investors’ perceptions of changes in expected loss attributable to important risk factors, thereby confounding market and regulatory efforts to correctly price and manage risks. The authors provide conditions under which bond returns can be usefully interpreted as reflecting expected losses and thus the relative riskiness of firms. They consider the risk-sensitivity of subordinated bond returns of highly rated HCs and of GSEs to macroeconomic shocks during two periods: April 1, 2001 to May 31, 2003 and June 1, 2003 to September 15, 2004. Although the GSEs (Fannie Mae and Freddie Mac) and the largest U.S. bank holding companies may benefit substantially from a perceived implicit government guarantee of their liabilities, the political support for government backing of the GSEs seemed less certain to investors in the later period, while there was no news, or legislative developments, that likely would have changed the perceived implicit government guarantees for BHCs. The authors show that the responsiveness of subordinated bond returns to macroeconomic shocks during the two sample periods indicate that: 1) BHCs’ bond returns across the two periods became less sensitive to changes in macroeconomic factors that affect credit risks but more sensitive to changes in macroeconomic factors that influence interest rate risks; 2) changes in implicit guarantees made it difficult to interpret GSE bond returns across the two periods; and 3) bond investors generally believed that GSEs are at least as risky, and maybe more risky, (that is, their expected losses are more sensitive to macroeconomic risk factors) when compared with BHCs. While their technique does not identify the source of this potentially greater risk, the authors note that financial theory would suggest that GSEs might have greater risks because they are less diversified and not as well capitalized as BHCs.

Brunnermeier and Pedersen provide a model that links a security’s market liquidity — that is, the ease of trading it — to traders’ funding liquidity — that is, their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding — that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model here explains the empirically documented features that market liquidity: 1) can suddenly dry up (in other words, is fragile); 2) has commonality across securities; 3) is related to volatility; 4) experiences “flight to liquidity” events; and 5) co-moves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improving funding in a potential future crisis.

With a unique and comprehensive dataset, Bartram, Brown, and Hund develop and use three distinct methods to quantify the risk of a systemic failure in the global banking system. They examine a sample of 334 banks (representing 80 percent of global bank equity) in 28 countries around six global financial crises (such as the Asian and Russian crises and September 11, 2001), and show that these crises did not create large probabilities of global financial system failure. First, they show that cumulative negative abnormal returns for the subset of banks not directly exposed to a negative shock (unexposed banks) rarely exceed a few percent. Second, they use structural models to obtain more precise point estimates of the likelihood of systemic failure. These estimates suggest that systemic risk is limited, even during major financial crises. For example, maximum likelihood estimation of bank failure probabilities implied by equity prices suggests  the Asian crisis induced less than a single percent increase in the probability of systemic failure. Third, the authors estimate systemic risk as implied by equity option prices of U.S. and European banks. The largest values are for the Russian crisis and September 11; these show increases in estimated average default probabilities of only around 1-2 percent. Taken together, the results suggest statistically significant, but economically small, increases in systemic risk around even the worst financial crises of the last ten years. Although policy responses are endogenous, the low estimated probabilities suggest that the distress of central bankers, regulators and politicians about the events they study may be overstated, and that current policy responses to financial crises and the existing institutional framework may be adequate to handle major macroeconomic events.

Insider trading in the credit derivatives market has become a significant concern for regulators  and participants. Acharya and Johnson attempt to quantify the problem. Using news reflected in the stock market as a benchmark for public information, they report evidence of significant incremental information revelation in the credit default swap (CDS) market under circumstances consistent with the use of non-public information by informed banks. Specifically, the information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks. Moreover, the degree of advance information revelation increases with the number of banks that have lending/monitoring relations with a given firm, and this effect is robust to controls for non-informational trade. They find no evidence, howver, that the degree of asymmetric information adversely affects prices or liquidity in either the equity or credit markets. If anything, with regard to liquidity, the reverse appears to be true.

A rapidly growing literature has documented important improvements in financial return volatility measurement and forecasting through the use of realized variation measures constructed from high-frequency returns, coupled with simple modeling procedures. Building on recent theoretical results in Barndorff-Nielsen and Shephard (2004a, 2005) for related bi-power variation measures, Andersen, Bollerslev, and Diebold provide a practical and robust framework for non-parametrically measuring the jump component in asset return volatility. In an application to the DM/$ exchange rate, the S&P500 market index, and the 30-year U.S. Treasury bond yield, they find that jumps are both highly prevalent and distinctly less persistent than the continuous sample path variation process. Moreover, many jumps appear directly associated with specific macroeconomic news announcements. Separating jump from non-jump movements in a simple but sophisticated volatility forecasting model, the authors find that almost all of the predictability in daily, weekly, and monthly return volatilities comes from the non-jump component. Their results thus set the stage for a number of interesting future econometric developments and important financial applications by separately modeling, forecasting, and pricing the continuous and jump components of the total return variation process.

Hanson, Pesaran, and Schuermann consider a simple model of credit risk and derive  the limit distribution of losses under different assumptions regarding the structure of systematic and idiosyncratic risks and the nature of firm heterogeneity. Their theoretical results indicate that if firm-specific risk exposures (including their default thresholds) are heterogeneous but come from a common parameter distribution, then there is no scope for further risk reduction through active credit portfolio management for sufficiently large portfolios. However, if the firm risk exposures are drawn from different parameter distributions, say for different sectors or countries, then further risk reduction is possible, even asymptotically, by changing the portfolio weights. In either case, neglecting parameter heterogeneity can lead to underestimation of expected losses. But, once expected losses are controlled for, neglecting parameter heterogeneity can lead to overestimation of risk, whether measured by unexpected loss or value-at-risk. These results are confirmed empirically using returns and credit ratings for firms in the United States and Japan across seven sectors. Ignoring parameter heterogeneity results in far riskier credit portfolios.

Das, Duffie, Kapadia, and Saita develop, and apply to data on U.S. corporations from 1979-2004, tests of the standard doubly-stochastic assumption under which firms’ default times are correlated only as implied by the correlation of factors determining their default intensities. This assumption is violated in the presence of contagion or “frailty” (unobservable explanatory variables that are correlated across firms). The tests here do not depend on the time-series properties of default intensities. The data do not  support the joint hypothesis of well-specified default intensities and the doubly-stochastic assumption. There is also some evidence of default clustering in excess of that implied by the doubly-stochastic model with the given intensities.

IASE: Strengthening Global Financial Markets

The NBER and Pontificia Universidade Catolica do Rio de Janeiro (PUC-Rio) jointly sponsored a meeting of the Inter-American Seminar on Economics in Brazil on December 2 and 3. This Seminar focused on “Strengthening Global
Financial Markets.” NBER Research Associate Sebastian Edwards of University of California, Los Angeles,
and Marco Garcia of PUC-Rio, organized the following program:

• Joshua Aizenman, University of California at Santa Cruz and NBER, and Ilan Noy, University of Hawaii, “Endogenous Financial and Trade Openness in a Volatile World” Comments: Maria Cristina Terra, Postgraduate School of  Economics - Brazil (EPGE), and Thierry Verdier, Centre for Economic Policy Research
• Bernardo S. de M. Carvalho, Gávea Investments, and Marcio Garcia, “Ineffective Controls on Capital Inflows under Sophisticated Financial Markets: Brazil in the Nineties” Comments: Gustavo Franco and Marcelo Abreu, PUC-Rio
• Sebastian Edwards, “Financial Openness, Crises, and Output Losses” Comments: Edmar Bacha, Bank of Italy, and Marcelo Muinhos, Banco Central do Brasil
• Viviana Fernandez, Universidad de Chile, “The International CAPM and a Wavelet-based Decomposition of Value at Risk” Comments: Marcelo Medeiros, PUCRio, and Caio Ibsen, IBMEC Business School-Rio
• Ross Levine, NBER and Brown University, and Sergio L. Schmukler, The World Bank, “Internationalization and Stock Market Liquidity” Comments: Ugo Panizza, Inter-American Development Bank, and Eduardo Loyo, IMF
• Ricardo J. Caballero, NBER and MIT; Takeo Hoshi, NBER and University of California at San Diego; and Anil K Kashyap, University of Chicago and NBER, “Zombie Lending and Depressed Restructuring in Japan” Comments:
• Vinicius Carrasco and Walter Novaes, PUC-Rio Ana Carla A Costa, Banco Central do Brasil, and Joao Manoel Pinho de Mello, PUC-Rio, “Judicial Risk and Creditor Expropriation: Micro Evidence from Brazilian Payroll Loans” Comments: Renato Flores, EPGE/FGV, and Beny Parnes, PUC-Rio
• Eduardo Levy-Yeyati, Universidad Torcuato di Tella, “Liquidity Insurance in Financially Dollarized Economy” Comments: Marco Bonomo, EPGE, and Alejandro Werner, Subsecretaria de Hacienda y Credito Publico do Mexico
• Barry J. Eichengreen, University of California at Berkeley and NBER; and Poonam Gupta and Ashoka Mody, IMF, “Sudden Stops and IMF Programs” Comments: Ilan Goldfajn, PUC-Rio, and Affonso Celso Pastore, ACPastore& Associados 

Aizenman and Noy study the endogenous determination of financial and trade openness when both are volatile. First, they outline channels leading to two-way feedback between the different modes of openness; next, they identify these feedbacks empirically. They find that a single standard deviation increase in commercial openness is associated with a 9.5 percent (of GDP) increase in de-facto financial openness, controlling for political economy and macroeconomic factors. Similarly, an increase in de-facto  financial openness has powerful effects on future trade openness. While de-jure restrictions on capital mobility do not affect de-facto financial openness, dejure restrictions on the current account have large adverse effect on commercial openness. This suggests that it is much easier to overcome restrictions on capital account convertibility than restrictions on commercial trade. Having established (Granger) causality, the authors investigate the relative magnitudes of these directions of causality using Geweke’s (1982) decomposition methodology. They find that almost all of the linear feedback between trade and financial openness can be accounted for by G-causality from financial openness to trade openness (53 percent) and from trade to financial openness (34 percent). They conclude that, in an era of rapidly growing trade integration, countries cannot choose financial openness  independent of their degree of openness to trade —dealing with greater exposure to financial turbulence by curbing financial flows  will likely be ineffectual.

Carvalho and Garcia analyze the Brazilian experience in the 1990s to assess the effectiveness of  ontrols on capital inflows in restricting financial inflows and changing their composition towards long-term flows. Econometric exercises (VARs) lead them to conclude that controls on capital inflows were effective in deterring financial inflows for only a brief period, from two to six months. The hypothesis to explain the ineffectiveness of the controls is that financial institutions performed several operations aimed at avoiding capital controls. The authors conducted interviews with market players in order to provide several examples of the financial strategies that were used in this period to invest in the Brazilian fixed income market while bypassing capital controls. Their main conclusion is that controls on capital inflows, while they may be desirable, are of very limited effectiveness under sophisticated financial markets. Therefore, policymakers should avoid spending the scarce resources of bank supervision trying to implement them and focus more in improving economic policy.

Edwards uses a broad  multi-country dataset to analyze the relationship between restrictions to capital mobility and external crises. The analysis  focuses on two manifestations of external crises: sudden stops of capital inflows; and current account reversals. He deals with two important policy-related issues: first, does the extent of capital mobility affect countries’ degree of vulnerability to external crises; and second, does the extent of capital mobility determine the depth of external crises — as measured by the decline in growth — once the crises occur? Overall, his results cast some doubts on the assertion that increased capital mobility has caused heightened macroeconomic vulnerabilities. He finds no systematic evidence suggesting that countries with higher capital mobility tend to have a higher incidence of crises, or to face a higher probability of having a crisis, than countries with lower mobility. His results do suggest, however, that once a crisis occurs, countries with higher capital mobility may face a higher cost, in terms of growth decline.

Fernandez formulates a time-scale decomposition of an international version of the Capital Asset Pricing Model that accounts for both market and exchange-rate risk. In addition, she derives an analytical formula for timescale value at risk and marginal value at risk (VaR) of a portfolio. She applies the methodology to stock indexes of seven emerging economies in Latin America and Asia, for the sample period 1990-2004. Her main conclusions are: 1) the estimation results hinge upon the choice of the world market portfolio. In particular, the stock markets of the sampled countries appear to be more integrated with other emerging countries than with developed ones. 2) Value at risk depends on the investor’s time horizon. In the short run, potential losses are greater than in the long run. 3) Additional exposure to some specific stock indices will increase value at risk to a greater extent, depending on the investment horizon. These results are in line with recent research in asset pricing that stresses the importance of heterogeneous investors.

What is the impact of internationalization (firms raising capital and trading in  international markets) on the liquidity of the remaining firms in domestic markets? To address this question, Levine and Schmukler assemble a panel database of more than 2,700 firms from 45 emerging economies over the period 1989-2000, constructed from annual and daily data. First, they find evidence of migration. There is a reduction in the domestic trading of firms that cross-list or issue depositary receipts in foreign public exchanges as trading migrates from domestic to international markets. Second, there are liquidity spillovers within markets. Aggregate domestic trading activity is associated with the liquidity of individual firms in the same market. The evidence is consistent with the view that when firms cross-list or issue depositary receipts in public international markets, the domestic trading activity of their shares falls, hurting the liquidity of the remaining firms in their home market.

Caballero, Hoshi, and Kashyap proposes a bank-based explanation for the decade-long Japanese slowdown. The starting point for their story is the well-known observation that most large Japanese banks were only able to comply with capital standards because regulators were lax in their inspections. To facilitate this forbearance, the banks often engaged in sham loan restructuring that kept credit flowing to otherwise insolvent borrowers (“zombies”). Thus, the normal competitive outcome, whereby the zombies would shed workers and lose market share, was thwarted. The authors’ model highlights the restructuring implications of the zombie problem. The counterpart of the congestion created by the zombies is a reduction in profits for potential new and more productive entrants, which discourages their entry. In this context, even solvent banks will not find good lending opportunities. The authors confirm their story’s key predictions — that zombie-dominated industries exhibit more depressed job creation and destruction, lower productivity, and greater excess capacity. Most importantly, they present firm-level regressions showing that the increase in zombies has depressed the investment and employment growth of non-zombies and has been associated with a widening of the productivity gap between zombies and non-zombies. The evidence suggests that the healthiest non-zombies were harmed the most by the zombies.

A large body of literature has stressed the institution-development nexus as critical in explaining differences in countries’ economic performance. The empirical evidence, however, has been mainly on the aggregate level, associating macro performance with measures of quality of institutions. A Costa and De Mello, by relating a judicial decision on the legality of payroll debit loans in Brazil to bank-level  decision variables, provide micro evidence on how creditor legal protection affects market performance. Payroll debit loans are personal loans with principal and interests payments directly deducted from the borrowers’ payroll check, which, in practice, makes collateral out of future income. In June 2004, a highlevel federal court upheld a regional court ruling that had declared  payroll deduction illegal. Using personal loans without payroll deduction as a control group, the authors assess whether the ruling had an impact on market performance. The evidence indicates that it had an adverse impact on banks’ risk perception, on interest rates, and on the amount lent.

Unlike the financial dollarization (FD) of external liabilities, the dollarization of domestic financial assets (domestic FD) has received comparatively less attention until very recently, when increasingly it has been seen as a key source of  real exchange rate exposure and balance sheet problems. Levy -Yeyati focuses on an a complementary —and often overlooked— angle of domestic FD: the limit it imposes on the central bank as domestic lender of last resort (LLR), and the resulting exposure to (dollar) liquidity runs. He addresses this issue in three steps. First, he illustrates the incidence of FD on the propensity to suffer bank runs (and the authorities’ belated reaction) by means of two recent banking crises, Argentina 2001 and Uruguay 2002, and shows that FD has been an important motive for self-liquidity insurance in the form of reserve accumulation. Next, he explores the incentive problems associated with centralized self-insurance (holdings of reserves at the central bank). In this light, he argues for a combined scheme of decentralized liquid asset requirement (LAR) and an ex-ante suspension-of-convertibility clause or “circuit breaker” (CBR), as a way to reduce self-insurance costs while limiting bank losses in the event of a run.

Eichengreen, Gupta, and Mody present evidence on the impact of IMF programs on sudden stops in capital flows. Their results are consistent with the notion that IMF programs have some positive effect in reducing the incidence of these events. At the same time, there is little evidence that larger Fund programs more effectively inoculate countries against sudden stops. Newly-negotiated programs seem to be more effective in this regard than longstanding arrangements. It is tempting to interpret both observations as indicating that the signaling effect of IMF programs matters more than the emergency financial assistance. Finally, the authors are unable to identify evidence that IMF programs are more effective at insulating countries from sudden stops when they already have fundamentally strong policies in place.

Structural Changes in the Global Economy

On December 9 and 10, an NBER/Universities Research Conference on “Structural Changes in the Global Economy: Implications for Monetary Policy and Financial Regulation” took place in Cambridge. NBER Research Associates Andrew B. Abel, The Wharton School, and
Janice C. Eberly, Northwestern University’s Kellogg School of Management, organized this program:

• F. Owen Irvine, Michigan State University, and Scott Schuh, Federal Reserve Bank of Boston, “The Roles of Comovement and Inventory Investment in the Reduction of Output Volatility” Discussant: William Dupor, Ohio State University
• Stephen G. Cecchetti, Brandeis University and NBER; Alfonso Flores-Lagunes, University of Arizona; and Stefan Krause, Emory University, “Assessing the Sources of Changes in the Volatility of Real Growth” Discussant: James H. Stock, Harvard University and NBER
• Sebnem Kalemli-ozcan, University of Houston and NBER; Ariell Reshef, New York University; and Bent E. Sorensen, University of Houston, “Productivity and Capital Flows: Evidence from U.S. States” Discussant: John Coleman, Duke University
• Charles A. Trzcinka and Andrey D. Ukhov, Indiana University, “Financial Globalization and Risk Sharing: Welfare Effects and the Optimality of Open Markets” Discussant: Leonid Kogan, MIT and NBER
• Giovanni Olivei, Federal Reserve Bank of Boston, and Silvana Tenreyro, London School of Economics, “The Timing of Monetary Policy Shocks” Discussant: Marc Giannoni, Columbia University and NBER
• Hoyt Bleakley, University of California, San Diego, and Kevin Cowan, Inter-American Development Bank, “Maturity Mismatch and Financial Crises: Evidence from Emerging Market Corporations” Discussant: Mark Aguiar, Federal Reserve Bank of Boston
• Prasanna Gai and Nicholas Vause, Bank of England, and Peter Kondor, London School of Economics, “Procyclicality, Collateral Values, and Financial Stability” Discussant: Adriano Rampini, Northwestern University
• Söhnke Bartram, Lancaster University; Gregory W. Brown, University of North Carolina at Chapel Hill; and John Hund, University of Texas at Austin, “Estimating Systemic Risk in the International Financial System” Discussant: Craig Furfine, Federal Reserve Bank of Chicago

Most of the reduction in GDP volatility since 1983 is accounted for by a decline in the comovement of output among industries that hold inventories. This decline is not simply a passive byproduct of reduced volatility in common factors or shocks. Instead,  structural changes occurred in the long run and there were dynamic relationships among industries’ sales and inventory investment behavior — especially in the automobile and related industries, which are linked by supply and distribution chains that feature new production and inventory management techniques. Using a HAVAR model (Fratantoni and Schuh 2003) with only two sectors — manufacturing and trade — Irvine and Schuh discover structural changes that reduced the comovement of sales and inventory investment both within and between industries. As a result, the response of aggregate output to all types of shocks was dampened. Structural changes accounted for more than 80 percent of the reduction in output volatility, thus weakening the case for “good luck,” and altered industries’ responses to federal funds rate shocks, thus suggesting that the case for “better monetary policy” is complicated by changes in the real side of the economy.

In much of the world, growth is more stable than it once was. Looking at a sample of 25 countries, Cecchetti, Flores-Lagunes, and Krause find that in 16 of them, real GDP growth is less volatile today than it was 20 years ago. And, these declines are large, averaging more than 50 percent. What accounts for the fact that real  growth has been more stable in recent years? The authors survey the evidence and competing explanations and find support for the view that improved inventory management policies, coupled with financial innovation, adopting an inflation targeting scheme, and increased central bank independence have all  been associated with more stable real growth. Furthermore, they find weak evidence suggesting that increased commercial openness has coincided with increased output volatility.

Kalemli-Ozcan, Reshef, and Sorensen study the determinants of net capital income flows within the United States where capital freely moves across state borders. They use a simple neoclassical model in which total factor productivity (TFP) varies across states and over time and capital ownership is perfectly diversified across state borders. Capital will flow to states that experience an increase in TFP resulting in net cross-state investment positions. Net ownership positions revert to zero over time in the absence of further TFP movements. States with increasing TFP pay net capital income to states with declining TFP relative to the U.S. average. While TFP cannot be directly observed, the authors can identify states with high TFP growth as states with high output growth. By comparing the level of state personal income to state gross product, they construct indicators of net capital income flows. They then examine empirically whether net capital income flows between states correspond to the predictions of the model and whether net capital positions tend to converge to zero. The empirical findings indicate persistent net capital income flows across states, which are an order of magnitude larger than the equivalent counterparts across countries. Thus, the results imply that frictions associated with borders are likely to be the main explanation for low international capital flows.

Trzcinka and Ukhov study the welfare effects of  investment barriers and the opening of markets to foreigners. They construct an equilibrium model of international asset pricing  without agency costs that allows endogenous market participation among heterogeneous agents. Equilibrium prices and the set of  participating and non-participating agents are jointly determined in equilibrium and the ability of agents to choose to participate in the market affects prices of domestic and foreign assets. The authors examine the welfare effects of non-participation and find that when a country moves from complete segmentation to open markets for foreigners, the cost of capital falls in the domestic market. This is consistent with empirical findings in the international asset pricing literature. Through the endogenous participation mechanism, the model is able to capture sources of economic growth. Contrary to previous models, however, this one shows that opening markets is not Pareto-optimal and the authors identify a class of domestic agents whose welfare is lower after the opening of markets. These finding have political economy interpretations and policy implications.

A vast empirical literature has documented delayed and persistent effects of monetary policy on output. Olivei and Tenreyro show that this finding results from the aggregation of output impulse responses that differ sharply depending on the timing of the shock: When the monetary policy  hock takes place in the first two quarters of the year, the response of output is quick, sizable, and dies out at a relatively fast pace. In contrast, output responds very little when the shock takes place in the third or fourth quarter. The authors propose a potential explanation for the differential responses based on uneven staggering of wage contracts across quarters. Using a stylized dynamic general equilibrium model, they show that a very modest amount of uneven staggering can generate differences in output responses similar to those found in the data.

Substantial attention has been paid in recent years to the risk of maturity mismatch in emerging markets. Although this risk is microeconomic in nature, the evidence advanced thus far has taken the form of macro correlations. Bleakley and Cowan evaluate this mechanism empirically at the micro level by using a database of over 3000 publicly traded firms from fifteen emerging markets. They measure the risk of short-term exposure by estimating, at the firm level, the effect on investment of the interaction of shortterm exposure and aggregate capital flows. This effect is (statistically) zero, contrary to the prediction of the maturity- mismatch hypothesis. This conclusion is robust to using a variety of different estimators, alternative measures of capital flows, and controls for devaluation effects and access to international capital. The authors do find evidence that short-term-exposed firms pay higher financing costs and liquidate assets at resale prices, but not that this reduction in net worth translates into a drop in investment.

Gai, Kondor, and Vause analyze how the risk-sharing capacity of the financial system varies over the business cycle, leading to pro-cyclical fragility. They show how financial imperfections contribute to under-insurance by entrepreneurs, generating a pecuniary externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs attributable to financial frictions and the volatility costs attributable to amplification, also are illustrated.

With a unique and comprehensive dataset, Bartram, Brown, and Hund develop and use three distinct methods to quantify the risk of a systemic failure in the global banking system. They examine a sample of 334 banks (representing 80 percent of global bank equity) in 28 countries around 6 global financial crises (such as the Asian and Russian crises and September 11, 2001), and show that these crises did not create large probabilities of global financial system failure. First, they show that cumulative negative abnormal returns for the subset of banks not directly exposed to a negative shock (unexposed banks) rarely exceed a few percent. Second, they use structural models to obtain more precise point estimates of the likelihood of systemic failure. These estimates suggest that systemic risk is limited even during major financial crises. For example, maximum likelihood estimation of bank failure probabilities implied by equity prices suggests that the Asian crisis induced less than a 1 percent increase in the probability of systemic failure. Third, they obtain estimates of systemic risk implied by equity option prices of U.S. and European banks. The largest values are obtained for the Russian crisis and September 11 and these show increases in estimated average default probabilities of only around 1-2 percent. Taken together, the results suggest statistically significant, but economically small, increases in systemic risk around even the worst financial crises of the last ten years. Although policy responses are endogenous, the low estimated probabilities suggest that the distress of central bankers, regulators, and politicians about the events studied here may be over-stated, and that current policy responses to financial crises and the existing institutional framework may be adequate to handle major macroeconomic events.

18th Annual TRIO Conference

The Eighteenth Annual TRIO Conference, so-named because it is jointly sponsored by the NBER, the Centre for Economic Policy Research (CEPR), and the Tokyo Center for Economic Research (TCER), took place on December 9 and 10 in Tokyo. This year’s conference focused on “International Finance.” It was organized by Shin-ichi Fukuda, University of Tokyo; Takeo Hoshi, NBER and University of California, San Diego; Takatoshi Ito, NBER and University of Tokyo; and Andrew K. Rose, NBER and University of
California, Berkeley. The program was:

• Eiji Ogawa and Junko Shimizu, Hitotsubashi University, “Stabilization of Effective Exchange Rates under a Common Currency Basket System” Discussants: Taizo Motonishi, Kansai University, and Mark Spiegel, Federal Reserve Bank of San Francisco
• Etsuro Shioji, Yokohama National University, “Invoicing Currency and the Optimal Basket Peg for East Asia: A New Open Economy Macroeconomics Perspective” Discussants: Kentaro Iwatsubo, Hitosubashi University, and Eiji Ogawa
• Shang-jin Wei, IMF and NBER, “Connecting Two Views on Financial Globalization: Can We Make Further Progress?” Discussants: Yuko Hashimoto, Toyo University, and Elias Papaioannou, European Central Bank
• Takatoshi Ito, and Yuko Hashimoto, “Intra-Day Seasonality in Activities of the Foreign Exchange Markets: Evidence from the Electronic Broking System” Discussants: Robert F. Engle, University of California, San Diego and NBER, and Paolo Pesenti, Federal Reserve Bank of New York
• Shin-ichi Fukuda, and Masanori Ono, Fukushima University, “On the Determinants of Export Prices: History vs. Expectations” Discussants: Andrew K. Rose, and Kiyotaka Sato, Yokohama National University
• Allan Drazen, University of Maryland and NBER, and Stefan Hubrich, T. Rowe Price, “A Simple Test of the Effect of Exchange Rate Defense” Discussants: Shin-ichi Fukuda, and Shigenori Shiratsuka, Bank of Japan
• Paolo Pesenti, “Shocks, Reforms, and Monetary Rules: A Scenario Analysis for Japan” Discussants: Kazuo Ueda, University of Tokyo, and Tsutomu Watanabe, Hitotsubashi University
• Richard Portes, London Business School and NBER; Elias Papaioannou; and Gregorios Siourounis, Barclays Capital, “Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar” Discussants: Takeo Hoshi and Takatoshi Ito
• Mark Spiegel; Takeshi Kobayashi, Chukyo University; and Nobuyoshi Yamori, Nagoya University, “Quantitative Easing and Japanese Bank Equity Values” Discussants: Naohiko Baba, Bank of Japan, and Itsuhiro Fukao, Keio University
• Andrew K. Rose, “Size Really Doesn’t Matter: In Search of a National Scale Effect” Discussants: Allan Drazen and Etsuro Shioji

Ogawa and Shimizu investigate how effectively a common currency basket peg would stabilize the effective exchange rates of East Asian currencies. The authors use an Asian Monetary Unit (AMU), which is a weighted average of the ASEAN10 plus 3 (Japan, China, and Korea) currencies, as the common currency basket; they compare their results with others on the stabilization effects of the common G3 currency (the U.S. dollar, the Japanese yen, and the euro) basket in the East Asian countries (Williamson, 2005). They find that the AMU peg system would be more effective in reducing fluctuations of effective exchange rates as more countries in East Asia applied it. Further, the AMU peg system would more effectively stabilize effective exchange rates than a common G-3 currency basket peg system for four (Indonesia, the Philippines, Singapore, and Thailand) of the seven countries they study. These results suggest that the AMU basket peg would be useful for the East Asian countries whose intraregional trade weights are relatively higher than their trade weights with outsiders.

Shioji analyzes the relationship between East Asia’s choice of currency regime and the transmission of foreign shocks to this area. He develops a threecountry model that consists of East Asia, Japan, and the United States, in the tradition of the “new open economy macroeconomics” literature. Using numerical simulations, Shioji derives the optimal weight attached to the Japanese yen in East Asia’s currency basket, to which this region pegs its own currency; optimality is defined with respect to stabilization of its trade balance (or other measures). In particular, this paper takes into account the reality that most international transactions are invoiced in the U.S. dollar, and asks how incorporating that fact into the model changes the conclusion about the optimal basket weights.

For many developing countries, financial globalization does not  automatically lead to improvement. According to the literature, there is a threshold effect: only countries that have met a minimum set of conditions, such as having attained reasonable control of corruption and a certain level of rule of law, can expect to  benefit significantly from financial globalization. And, there is a composition effect: foreign direct investment (FDI), and  perhaps portfolio inflows, are likely to be more beneficial and less volatile than international bank lending, while total capital flows — the sum of all types of capital flows — may not have a strong positive effect on the recipient countries’ rates of growth and their consumption risk sharing. Further, the threshold and composition effects can be two sides of the same coin, as better institutional quality in a capital-importing country may lead to a more favorable composition of capital inflows for that country (Wei, 2000b, 2001; Wei and Wu, 2002; and Faria and Mauro, 2004). But the earlier literature did not disentangle the possibly  different effects of financial development and the quality of bureaucratic institutions. Wei shows that these effects can indeed be different. In particular, bad public institutions ( reflected, for example, in a higher level of bureaucratic corruption) strongly discourage FDI, and possibly foreign debt, in the shares of a country’s total foreign liabilities, but appear to encourage the relative prominence of borrowing from foreign banks. In comparison, low financial sector development discourages inward portfolio equity flows but encourages inward FDI. Therefore, views on the connection between domestic institutions and the structure of international capital flows must be nuanced. To gain confidence that the documented data patterns reflect causal relations, Wei uses instrumental variables for the institutional measures based on the economic histories of the countries in his sample (in particular, the mortality rate of earlier European settlers and the origin of legal systems). The instrumental variables approach bolsters the case that bad institutions are a cause of unfavorable composition of capital inflows.

Ito and Hashimoto examine intraday patterns of exchange rate behavior, using the “firm” bid-ask quotes and transactions of JPY-USD and Euro-USD pairs recorded in the electronic broking system of the spot foreign exchanges. First, activities of quotes and transaction volumes are  high in the beginning hours of the three major currency markets — Tokyo, London, and New York — and low during the Tokyo and London lunch hours and late afternoon in New York. The U-shape of intra-day activities only occurs among Tokyo and London participants.  Second, activities do not increase toward the end of business hours in the New York market, even on Fridays (ahead of weekend hours of non-trading). Third, an average bid-ask spread is narrow (wide), when quote and deal frequencies are high (low, respectively),  except for the beginning hour of Tokyo (GMT 0), when the bid-ask spread is ideal despite high levels of activity.

Fukuda and Ono investigate the choice of invoice currency under exchange rate uncertainty. Their analysis is motivated by the fact that the U.S. dollar has been the dominant vehicle currency in developing countries. Their theoretical analysis is based on an open economy model of monopolistic competition. The export prices are set before exchange rates are known. When the market is competitive enough, the exporting firms tend to set their prices so as not to deviate from those of the competitors. As a result, a coordination failure can lead the third currency to be an equilibrium invoice currency. Since multiple equilibriums are Pareto ranked, this implies that the equilibrium choice of the invoice currency may lead to a less efficient equilibrium. The role of expectations is important in the static framework. However, in the staggered price-setting framework, history becomes another key determinant of the equilibrium currency pricing. The role of history becomes conspicuous when the firms discount future profits, particularly in the competitive local market. The result suggests that both history and expectations explain why the firm tends to choose the U.S. dollar as vehicle currency.

High interest rates used to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. Drazen and Hubrich test the effectiveness of the interest rate defense by  disaggregating it into the effects on future interest rate differentials, expectations of future exchange rates, and risk premiums. While much previous empirical work has been inconclusive because of offsetting effects, tests that “disaggregate” the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.

Using a two-country general equilibrium model calibrated to the Japanese economy vis-à-vis the rest of the world, Pesenti simulates the macroeconomic transmission of demand and supply shocks contingent on whether or not the zero interest floor (ZIF) is binding in monetary policy. First, he shows that  negative demand shocks have more prolonged and startling effects on the economy when the ZIF is binding than during normal times when it is not binding. Next, he illustrates how positive supply shocks that raise potential output (such as structural reforms) can actually extend the period of time over which the ZIF may be expected to bind, and therefore make the economy more sensitive to negative demand shocks. Finally, he focuses on the problems associated with inflation-targeting rules and the advantages of policy rules that include price-level-path targeting, both in a deflationary environment and in normal times when the ZIF is not binding.

Foreign exchange reserve accumulation has risen dramatically over the past five years. The introduction of the euro and the increased liquidity in other major currencies has increased the pressure on central banks to diversify away from the dollar. This could have substantial implications for the international financial system. Papaioannou, Portes, and Siourounis use a meanvariance framework to estimate optimal weights among the main international currencies and to assess how the euro has changed this allocation over time. They also incorporate rebalancing costs, which they proxy with (mean and extreme) currency bid-ask spreads. The results indicate that the recent drop in euro spreads fully compensated for the diversification losses associated with fewer currencies. The authors then perform some simple simulations for the optimal currency allocation of four large emerging market countries (Russia, Brazil, China and India) incorporating a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its foreign debt and  international trade. The constrained optimization suggests that the euro potentially rivals the dollar as an international reserve currency. Actual dollar allocations are far greater than the optimizer implies, consistent with the current dominant role of the dollar as a reserve currency. But the increased tendency of many developing countries to issue euro-denominated assets and trade with the euro zone may shift this equilibrium and put pressure on the dollar.

One of the primary motivations offered by the Bank of Japan (BOJ) for its quantitative easing program — whereby it maintained a current account balance target in excess of required reserves, effectively pegging short-term interest rates at zero — was to maintain credit extension by the troubled Japanese  inancial sector. Kobayashi, Spiegel, and Yamori conduct an event study concerning the anticipated impact of quantitative easing on the Japanese banking sector by examining the impact of the introduction and expansion of the policy on Japanese bank equity values. They find that excess returns of Japanese banks were greater when increases in the BOJ current account balance target were  ccompanied by “non-standard” expansionary policies, such as raising the ceiling on BOJ purchases of long-term Japanese government bonds. The authors also provide cross-sectional evidence that suggests that the market perceived that the quantitative easing program would disproportionately benefit financially weaker Japanese banks.

Rose searches for a “scale” effect in countries. He uses a panel data set that includes 200 countries over forty years and links the population of a country to a host of economic and social phenomena. Using both graphical and statistical techniques, he searches for an impact of size on the level of income, inflation, material well-being, health, education, the quality of a country’s institutions, heterogeneity, and a number of different international indices and rankings. He has little success; small countries are more open to international trade than large  countries, but are not systematically different otherwise.