Quarterly Bulletin
Financial Stability Articles

Capital inflows into EMEs since the millennium: risks and the potential impact of a reversal (651k)
By Guillermo Felices, Glenn Hoggarth and Vasileios Madouros of the Bank's International Finance Division.
Capital inflows into emerging market economies (EMEs) were at a record level in 2007 and higher than prior to the East Asian and Russian crises a decade earlier. These inflows largely reflect improvements in EMEs' economic and financial strength in recent years. But some EMEs, especially in Central and Eastern Europe, may be vulnerable to a reversal of capital flows if the global credit squeeze is prolonged or global GDP growth falls sharply. This could adversely affect both EMEs and foreign investors.

Recent developments in portfolio insurance (2.2mb)
By Darren Pain of the Bank's Foreign Exchange Division and Jonathan Rand of the Bank's Sterling Markets Division.
The aim of this article is to describe how portfolio insurance works, the main strategies employed and how these have evolved over recent years, and the possible links between their use and financial market stability. The key benefit of portfolio insurance is that it enables financial risk to be distributed among those agents most willing to absorb it. The downside is that it can possibly create conditions for greater fragility in financial markets and leaves issuers of portfolio insurance exposed to potential unexpectedly high losses. It seems unlikely that portfolio insurance-related investments contributed significantly to the financial market volatility that began in Summer 2007. Nonetheless, it is important to keep alert to situations when portfolio insurance could potentially work to amplify financial market instability.

Costs of sovereign default (506k)
(By Bianca De Paoli of the Bank's Monetary Instruments and Markets Division, Glenn Hoggarth of the Bank's International Finance Division and Victoria Saporta of the Bank's Systemic Risk Reduction Division). Over the past quarter of a century, emerging market economies (EMEs) have defaulted on their sovereign debts frequently. This article assesses the size and types of costs that have been associated with these defaults. It emphasises that costs, measured by the fall in output, are particularly large when default is combined with banking and/or currency crises. Output losses also seem to increase the longer that countries stay in arrears or take to restructure their debts. The paper concludes with a number of policy suggestions to improve debt crisis prevention and management and the role played by the IMF.

Financial stability, monetary stability and public policy (151k)
(by Chay Fisher, System Stability Department, Reserve Bank of Australia and Prasanna Gai of the Bank’s Systemic Risk Assessment Division). The interplay between financial and monetary stability has received considerable attention in recent times, from policymakers and academics alike. This article reviews the broad themes that have emerged in the recent literature and highlights several key issues that merit attention by researchers. In particular, the optimal combination of instruments designed to achieve these twin goals of policy simultaneously remains a relatively underexplored area of research.

The determination of UK corporate capital gearing (440k)
(by Peter Brierley of the Bank’s Financial Stability area and Philip Bunn of the Bank’s MacroPrudential Risks Division). This article seeks to explain the high current level of UK corporate capital gearing. It also explores the empirical relationship between gearing and a range of financial characteristics. Analysis of aggregate data suggests that the sharp rise in gearing between 1999 and 2002 cannot all be explained by an increase in its long-run equilibrium level, according to a model where that equilibrium is determined by the trade-off between the tax benefits of debt and the risks of financial distress. There are a number of factors not captured by that model that could have contributed to a sustainable increase in gearing. But on balance it seems that gearing has been above a sustainable level, causing firms to adjust their balance sheets by paying lower dividends and issuing more equity and perhaps by investing less than they otherwise would have done. Analysis of company accounts data suggests that gearing levels are persistent, positively related to company size and negatively correlated with growth opportunities and the importance of intangible assets. In the past, highly profitable companies had low gearing, but this relationship has broken down since 1995 as more profitable firms have increased their debt.

Credit channel effects in the monetary transmission mechanism (97k)
(By Simon Hall of the Bank's International Finance Division). Economic models often assume for simplicity that the impact on the wider economy of changes in financial conditions can be summarised by a relatively limited set of financial variables, such as short-term risk-free interest rates and long-term government bond rates. However, financial developments can, at times, have important effects on the economy, which these variables would not necessarily indicate. For example, following the suspension of debt payments by Russia in the summer of 1998 and the emergence shortly afterwards of problems at the hedge fund Long Term Capital Management (LTCM), interest rates on corporate debt rose relative to rates on government debt, and a number of central banks reduced official interest rates to mitigate possible effects on spending in the wider economy. In practice, policy-makers take account of a wide range of information on conditions in financial markets to monitor, and potentially respond to, these sorts of developments.

This article reviews potential theoretical explanations for two features of finance provision—the apparent preference by many borrowers to finance spending using own funds, and for many of those who do borrow, to rely on bank rather than capital market finance. These so-called 'credit channel' models help to explain why borrowers' financial positions might affect their spending, and why shocks to banks can have a marked impact on borrowers that are particularly dependent on bank finance. As such, these models illustrate some important interactions between the monetary and financial stability objectives of central banks and highlight the need for policy-makers to monitor a wide range of financial indicators.

In practice, banking system distress and significant disruptions to bank loan supply are relatively rare in developed banking sectors, as in the United Kingdom. As such, bank lending credit channel effects may be relatively infrequent. Balance sheet credit channel effects probably play a more continuous role in the economy, but they too will likely vary in strength over time, reflecting structural changes in the financial system and cyclical fluctuations in borrower financial health. This article focuses on a representative model of balance sheet effects. Two other articles in this Bulletin use the framework of this model to show how credit channel effects may affect spending in the UK corporate and household sectors.

Bank capital standards: the new Basel Accord
(78k)
(by Patricia Jackson of the Bank's Financial Industry and Regulation Divison). The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.

On 16 January 2001 the Basel Committee released a consultation package setting out the details of the new Accord. The Bank of England and Financial Services Authority jointly represent the United Kingdom on the Basel Committee. Comments are requested by the end of May and the Committee is expecting to release the final version of the Accord by end-2001 for implementation in 2004. A parallel consultative process is also operating at the EU level. A directive to implement the Basel proposals in the EU, which will cover both banks and investment firms, is also due to take effect from 2004.

The 1988 Accord was based on broad credit risk requirements, although it was amended in 1996 to introduce trading-book requirements as well. The proposed new Accord has three pillars: Pillar 1 will set new capital requirements for credit risk and an operational risk charge; Pillar 2 will require supervisors to take action if a bank's risk profile is high relative to capital held; and Pillar 3 will require greater disclosure from banks than hitherto to enhance market discipline.

The new credit risk requirements will be much more closely tied to the riskiness of particular exposures. In order to set such risk-based requirements the Committee had to consider a wide range of issues regarding the determinants of credit risk. This article sets out the background to the proposed changes and some of the issues that arise.

International financial crises and public policy: some welfare analysis (64k)
(by Michael Chui, Prasanna Gai and Andy Haldane of the Bank's International Finance Division). During the 1990s, a number of emerging market economies experienced well-publicised financial crises: Mexico in 1994/95; South East Asia during 1997; Russia in 1998; and, most recently, Brazil in 1999. On some estimates, the frequency of financial crisis has increased since the 1980s. For example, the World Bank documents 69 instances of 'systemic' crisis since the late 1970s. These crises have afflicted developed and developing countries alike.

There have been a number of recent attempts to measure the output costs of these crises—either the direct fiscal costs (such as the cost of recapitalising banks), or the indirect opportunity costs (of below-trend growth) associated with crisis. These cost estimates are large, often lying between 10% and 20% of annual pre-crisis GDP. The GDP contractions are also often protracted, averaging—on some estimates—more than four years for industrial countries and around three years for emerging economies.

The cost and frequency of financial crises suggests that crisis prevention and crisis resolution are major international public policy concerns. In recent years, this has been reflected in a debate on what has become known as the reform of the 'international financial architecture'. There are many facets of this debate. What are the causes of financial crisis? What public policy measures best address these frictions? And what are the welfare implications of crisis and of different approaches to dealing with them?

This article describes a model of financial crisis and explores its implications for public policy. The framework nests the key features of earlier models but is better able to address international architecture questions in a welfare setting. In particular, this framework is used to assess the welfare costs of creditor coordination failure and several recent public policy proposals on reforming the international financial architecture. The costs of creditor coordination failures are found to be high. But policies that improve sovereign liquidity management or that stall creditor runs—such as payments standstills—can mitigate these costs.

Analytical models can be useful in assessing public policy means of preventing and resolving crisis. They allow quantified, welfare-based policy analysis. This article has outlined one particular model of crisis and used it to explore the welfare costs of crisis and the implications of certain policy measures to resolve crisis. Future research might usefully consider relaxing some of the more restrictive assumptions in the model. First, we assume that the quantum of debt and the form of the debt contract is fixed in advance. Debt size and debt structure might be affected importantly by some of the public policy measures considered here. Second, the model uses a simple measure of welfare and side-steps difficult issues about the distribution of gains and losses between different parties. Third, only a sub-set of the myriad policy proposals currently on the table are considered here. It would be useful to explore these and other extensions in a quantitative, welfare-theoretic, setting.

Central banks and financial stability (64k)
(by P J N Sinclair, Director, Centre for Central Banking Studies). Each year the Governors of many central banks are invited to the Bank of England for a symposium. The subject this year was financial stability. This article is based on Financial Stability and Central Banks, a written report presented to the 2000 Central Bank Governors' Symposium, which, among other things, analyses the results of a survey of central banks, outlining the scope and diversity of their financial stability activities. The article goes on to discuss financial crises and the morbidity of banks, the trade-off between competition and safety in the financial system, the international dimension to financial crises, the many links between financial stability policy and monetary policy, and the nature of the work of those charged with safeguarding financial stability.

Safeguarding financial stability is a core function of the modern central bank, no less than market operations and the conduct of monetary policy. This is evident from the detailed survey of central banks, drawn from a wide variety of industrial, transition and developing countries. For those central banks that have never acted as regulator or supervisor of financial institutions, and for those that have recently shed these roles, financial stability responsibilities may be shared with other agencies, but the central bank is still very much in the game. This is particularly true in circumstances where bank failure would pose systemic risk. Threats to financial stability may arise from many sources, including excessive competition or overcrowding in the banking sector, misguided or misapplied regulation or lending to troubled institutions, undue forbearance, and currency crises. Financial stability impinges upon monetary policy and reacts to it. There are therefore powerful arguments for retaining responsibility for both within the central bank.

Stock prices, stock indexes and index funds
(50k)
(by Richard A Brealey, special adviser to the Governor on financial stability issues). In recent years, many UK investors have given up the quest for superior performance and have instead simply sought to match the returns on some broad market index. This has led to the suggestion that the growth in index funds has depressed the stock prices of those companies that are not represented in the index and has thereby increased their cost of capital. This effect may have been accentuated by the actions of fund managers, whose performance is compared with that of a market index and so who also have an incentive to avoid those stocks that are not included in the index. This paper argues that, in practice, these price effects are likely to be very small. In support of this view, the paper examines the price adjustments that occur when a stock is added to, or removed from, a stock market index.

Accumulating evidence that active portfolio managers do not achieve consistently superior performance has led to a rapid growth in index funds with low turnover and reduced management costs. For the most part, these funds track the performance of major market indexes and therefore tend not to be invested in the stocks of very small firms. This growth in index funds has forced active managers to hold a higher proportion of small-firm stocks than they otherwise would and, since they need to be induced to do this voluntarily, the expected return on these stocks must rise. This article argues that the portfolio adjustments forced on active managers are in practice very small and, since small-firm stocks are fairly good substitutes for large-firm stocks, the effect of index funds on required returns is likely to be no more than several basis points.

If market indexes are used as benchmarks for measuring the performance of professional active managers, then index stocks become effectively riskless for these managers and they need to be induced to hold the remaining stocks. Unlike index-fund managers, these active managers are not totally averse to holding non-index stocks, and so the incremental effect on prices of benchmarking is likely to be less than if these funds were formally indexed.

Most empirical studies of the effect on prices of index composition cannot distinguish the effect of index funds from that of benchmarking or possible information effects. One such study suggests that membership of the S&P index has had a substantial effect on prices in recent years, while another finds that flows into index funds have also had a marked cumulative price effect. However, it is difficult to reconcile these results with studies of the effect of additions or deletions to the index. In the United States these have typically found a price impact of around 3%, which would imply a shift in required returns of a few basis points. Our sample of changes to the FTSE All-Share and FTSE 100 indexes from 1994 to 1999 indicated that in both cases an addition to the index resulted in a negligible rise in price. Deletions, however, were associated with an eleven-day cumulative abnormal return of -4.5% for All-Share stocks and -2.0% for the FTSE 100 index. If permanent, these returns suggest that index deletions result in a small increase in the required return on equity for the affected firms. However, the fact that abnormal returns are observed for both indexes suggests that the effect is not simply due to the growth of index funds or performance benchmarking.

Testing value-at-risk approaches to capital adequacy (643k)
(by Patricia Jackson and William Perraudin of the Bankís Regulatory Policy Division and David Maude of the Bank's Monetary Assessment and Strategy Division. This article looks at the nature of whole-book value-at-risk models, and describes how the Bank of England set out in 1995 to assess their performance in accurately predicting risk and in providing a basis for reliable trading-book capital calculations.

The article sets out the results of the tests carried out by the Bank to assess the accuracy of the risk-measurement models used by firms to evaluate risk on their trading-book portfolios. The main conclusions from these tests were as follows:

• Different VaR models performed more or less well in supplying unbiased measures of the value at risk. (For some VaR models built with a 99% confidence level, significantly more than 1% of losses exceeded the value-at-risk estimate.)
• Simulation-based VaR models met this test better than parametric VaR models based on normal distributions, because of the severely fat-tailed nature of reasonably diversified fixed-income exposures. Most banks' trading books are made up largely of such exposures.
• Use of short data samples (or a weighting scheme that places heavy weight on recent data) worsened the biases in the VaR estimates for parametric models.
• The extra safeguards around the use of the VaR models (the requirement that a firm must meet the higher of the estimated VaR, or three times the 60-day moving average of the current and past VaRs) would probably mean, for market-risk models of the kind tested, that only extremely risky portfolios would fail to be covered by sufficient capital.
• The back-testing requirements incorporated in the Basle approach are likely to lead to some banks holding higher capital. A bank holding the portfolios employed in the study could find its capital requirements adjusted upwards from time to time if it used the parametric approach.

Regulating investment business in the Single Market (39k)
(by Professor Richard Dale) examines the regulatory framework for investment business put in place by the Capital Adequacy and other Directives, focusing on the attempt to establish a level playing-field for banks and other financial institutions. The article is the second in an occasional series - begun in the May Bulletin - of pieces by contributors from outside the Bank.

The developing Single Market in financial services (27k)
summarises the views, outlined in discussions with the Bank, of a range of financial sector firms on the development to date of the Single Market in that sector.