Financial Stability Review
Themes and Issues, Issue 14
26 June 2003
Issue
14 June 2003 - Themes and Issues (Full Article)
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Despite some deterioration in economic prospects over the past six months, there are now fewer signs of financial fragility than there were last autumn. Market indicators of credit risk have tended to fall and asset prices on the whole have been less volatile. As the Bank's regular assessment of The financial stability conjuncture and outlook points out, in most major economies banks are in a strong position to weather any adverse developments. And in the UK, it is reassuring that the IMF/World Bank Financial Sector Assessment Programme (FSAP) team, which studied the financial system last year, concluded that UK financial institutions, markets and infrastructure are fundamentally sound. The FSAP team's assessment is summarised in Strengthening financial infrastructure, which also reviews efforts by policymakers and market participants around the world to improve legal and regulatory frameworks, promote sound market and crisis management practices and develop market infrastructure.
One way of assessing the robustness of a financial system is to consider how it would cope with a range of hypothetical shocks. As part of the FSAP, the Bank and the Financial Services Authority designed and carried out an exercise of this sort with the co-operation of a number of UK banks, reported in Assessing the strength of UK banks through macroeconomic stress tests by Glenn Hoggarth and John Whitley. Overall, the exercise suggested that the stability of UK banks is unlikely to be threatened under a wide range of significant shocks - such as substantial declines in world equity prices or UK house prices. Further work is planned in order to develop such macro stress tests - for example, in gauging the severity of the scenarios used and in linking the scenarios with banks' own approaches to risk assessment.
In the stress testing exercise, banks themselves were asked to consider the consequences of the scenarios for their corporate credit exposures. An alternative approach is to use financial market information about individual companies. In Predicting default among UK companies: a Merton approach, Merxe Tudela and Garry Young take this route. The study treats the probability of default as a function of a firm's debt and the level and volatility of its market value, following the framework developed by Robert Merton. The authors find that their model is relatively effective in drawing up an ordinal ranking of companies by the likelihood of going into liquidation. But it tends to overpredict the number of failures in the past couple of years; it is possible that solutions other than liquidation are being found for more companies in distress.
The state of corporate balance sheets clearly affects the impact of macroeconomic and firm-specific shocks on the firms themselves but also, indirectly, the impact on the financial system. So does the state of the financial system's infrastructure, such as payment systems. In A statistical overview of CHAPS Sterling, Kevin James focuses on payment activity, liquidity provision and 'concentration risk' - the extent to which the failure of a single bank could disrupt the CHAPS system generally. He considers two types of risk - concentration of system liquidity and concentration of payment activity. He finds that the first is not a significant problem, as banks post significantly more eligible collateral than they use. But payment activity is relatively concentrated: hence the importance of effective systems and controls to minimise the likelihood of a participant bank's failure.
In exercising oversight of payments systems and participants, the Bank and FSA consider the incentives participants have to protect themselves against failure. The question of whether the incentive structure is appropriate or generates moral hazard also has policy implications in other contexts. In Moral hazard: how does IMF lending affect debtor and creditor incentives? Andrew Haldane and Ashley Taylor consider whether large-scale IMF loans might have induced excessive risk-taking by debtor countries or their creditors. They argue that past studies may have failed to detect some of the channels through which moral hazard may operate. And the authors find new evidence suggesting that in recent years the risk-taking incentives of both debtors - through insufficient effort to adjust economic policies - and creditors - through excessively risky lending - may have been affected by IMF loans.
Enhanced market discipline can in some circumstances improve the incentives facing financial market participants. In Market discipline and financial stability: some empirical evidence, Erlend Nier and Ursel Baumann find, in a cross-country study, that enhanced disclosure by banks seems to induce banks to limit their risk of default by keeping higher capital buffers for given asset risk. Their results also suggest that market discipline is stronger for banks that are funded by uninsured liabilities and weaker for those that benefit from wide deposit protection schemes or other safety nets. The latter may therefore be introducing a degree of moral hazard. The study provides some empirical support for the emphasis in Basel II on the importance of disclosure.
Key Resources
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Memorandum of Understanding between HM Treasury,
the Bank of England and the Financial Services Authority
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