Robert Engle Robert Engle Director Volatility Institute at NYU - - PowerPoint PPT Presentation

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Robert Engle Robert Engle Director Volatility Institute at NYU - - PowerPoint PPT Presentation

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Robert Engle Robert Engle Director Volatility Institute at NYU Stern September 27, 2012 G-20 Conference on FINANCIAL SYSTEMIC RISK Istanbul 10/12/2012 VOLATILITY INSTITUTE 1 DEFINITION How much capital would a financial institution need

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Robert Engle Robert Engle Director Volatility Institute at NYU Stern September 27, 2012 G-20 Conference on FINANCIAL SYSTEMIC RISK Istanbul

10/12/2012

VOLATILITY INSTITUTE

1

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DEFINITION

How much capital would a financial institution need

to raise in order to function normally if we have another financial crisis?

We measure this econometrically based on market We measure this econometrically based on market

data on equities and balance sheet data on liabilities. We update weekly on V-LAB for US and Global financial firms. We call this SRISK.

Principle investigators: Viral Acharya, Matt Richardson and me at the

Volatility Institute at NYU’s Stern School. Collaboration with HEC Lausanne and University of New South Wales, Sydney. Contributions by Christian Brownlees, Rob Capellini, Diane Perriet, Emil Siriwadane.

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RESEARCH ON SYSTEMIC RISK

Regulators measure this based on supervisory data and

stress scenarios.

Many other related measures are being developed or

are in use by regulators in Europe and the US. are in use by regulators in Europe and the US.

Some measures are firm specific such as CoVaR, and

network models that trace linkages. Others are financial industry quality measures such as volatility.

This conference will introduce many of these

alternative approaches.

10/12/2012 VOLATILITY INSTITUTE 3

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SRISK

SRISK is computed from:

( )

( )

( ) ( )

, 1 1 i t t i t

SRISK E Capital Shortfall Crisis E k Debt Equity Equity Crisis

− −

= = + −

Where k is a prudential level of equity relative to

assets taken to be 8% (and 5.5% for IFRS firms) and LRMES is the decline in equity values to be expected if there is another financial crisis.

SRISK depends upon size, leverage and risk.

( )(

)

, ,

1 1

i t i t

kDebt k LRMES Equity = − − −

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FOR EXAMPLE:

Bank of America has a market cap of $102 billion. Its

accounting liabilities are $1.9 trillion for a leverage ratio of 20.

If we have another financial crisis which is assumed to be a If we have another financial crisis which is assumed to be a

fall of 40% in broad US equities over six months, then we estimate shares in BAC will fall by 66%.

This reflects a Dynamic Conditional Beta of 2.5 today that

will move in the future due to mean reversion in volatilities and correlations and also will rise with downside returns.

SRISK = $122 billion.

It is undercapitalized somewhat today and this will be more severe

under the stress of an equity decline.

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FOR EXAMPLE:

Credit Agricole has a market cap of $19 billion It has liabilities of $2.1 trillion for a leverage ratio of 114 Any fluctuation in asset or liability valuations can

easily move the firm into bankruptcy. easily move the firm into bankruptcy.

Its beta is bigger than 3 suggesting that any downturn

in Europe will be disastrous for CA.

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WHY IS THIS A MEASURE OF SYSTEMIC RISK?

If we have a financial crisis, then all firms with positive

SRISK will try simultaneously to raise capital and the

  • nly source is likely to be taxpayers. The bigger SRISK,

the more serious the threat to financial stability. the more serious the threat to financial stability.

SRISK is estimated conditional on an endogenous

variable – a stress test does not indicate causality.

But how does this happen?

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A MACRO-FINANCE LINK

If any firms have high SRISK, they will recognize their

vulnerability and will begin to delever and derisk, thereby impacting the real economy. If only a few firms have high SRISK, the remaining firms may take firms have high SRISK, the remaining firms may take up the slack.

As the macro economy slows, stock prices will fall,

volatility will rise, and SRISK will go up more.

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SPIRAL

Investors recognize financial institution weakness and

lower valuations, increasing SRISK

Forward looking investors could make this happen in

  • ne step.
  • ne step.

Bankruptcies and other failures will occur until

eventually, the return to capital is high enough to bring new capital to the industry.

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IF TAXPAYERS STEP UP

The spiral can be arrested before the bottom. However, this will erode market discipline and may

impose huge regulatory costs on the financial sector impose huge regulatory costs on the financial sector going forward.

Thus regulation is needed in advance. Ideally it would

be countercyclical.

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SO WHY WOULD ANY INSTITUTION HAVE POSITIVE SRISK?

Externalities – if only one firm has high SRISK, there

is no spiral.

Implicit and Explicit government guarantees Regulatory incentives – the measure: “risk weighted Regulatory incentives – the measure: “risk weighted

assets” ignores correlation and hence leads to non- diversified asset mix

Risk weights may be poor measures of risk.

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MISCALCULATION

Miscalculation: use short run risk measures to choose

leverage rather than long run risk.

Miscalculation: valuing exotic securities such as CDOs

without recognizing all the risks. without recognizing all the risks.

Miscalculation: housing prices can go down ……..Too many possibilities

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FIRM SPECIFIC CAPITAL REQUIREMENTS

Regulators might require that firms hold sufficient

capital so that their SRISK is zero. Thus they would not have to raise capital in a future crisis.

Thus firms would be required to reduce SRISK which Thus firms would be required to reduce SRISK which

can be done by

Deleveraging Demerging Derisking Declining to follow the herd with correlated bets.

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COUNTER CYCLICAL CAPITAL REQUIREMENTS

It is best if capital requirements can be increased in

good times since the banks can easily raise capital and increase their buffer.

In bad times, it is natural to reduce requirements

because new capital is very hard and expensive to raise at that time and because draconian cuts will hurt the rest of the economy.

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V-LAB

For 1200 global financial institutions we update weekly

estimates of SRISK. These now use Nested Dynamic Conditional Beta with MA(1) and GARCH.

http://vlab.stern.nyu.edu http://vlab.stern.nyu.edu I will also show you results correcting for differences

between GAAP and IFRS accounting that are not yet

  • n the web site.
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BETA

How does this really work? If the broad market falls 40% over the next six months

as in another financial crisis

Then the equity and market cap of an institution falls Then the equity and market cap of an institution falls

approximately by its beta.

The statistical approach allows beta to change over

  • time. Dynamic Conditional Beta is the methodology.

Volatilities and correlations may mean revert over the

six month period. But volatilities and correlations also tend to rise in bad times.

10/12/2012 VOLATILITY INSTITUTE 22

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BETA FOR JPMORGAN

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SRISK FOR JPMORGAN

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TOP 10 US FIRMS-SEPT 14,2012

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GLOBAL SYSTEMIC RISK

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WHERE IS THE SRISK?

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Beta for Deutsche Bank

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Beta for BNP Paribas

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Beta for Barclays

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Beta for Credit Agricole

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Beta for UniCredit

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BETA FOR SANTANDER

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TOP 15 EUROPEAN FINANCIALS

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WHERE IS EUROPEAN SRISK?

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WHERE IS EUROPEAN SRISK?

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VOLATILITY INSTITUTE

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THE COMPUTATION

ASSETS – LIABILITIES = NET WORTH ACCOUNTING LEVERAGE=ASSETS/NET WORTH

=1+LIABILITIES/NET WORTH

=1+LIABILITIES/NET WORTH

QUASI-LEVERAGE

= 1+LIABILITIES/MARKET VALUE OF EQUITY

10/12/2012 VOLATILITY INSTITUTE 40

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IFRS VS GAAP

EUROPEAN FIRMS SWITCHED FROM GAAP

ACCOUNTING TO IFRS BETWEEN 2005 AND 2008.

THE IMPORTANT DIFFERENCE IS THE NETTING

OF DERIVATIVES. FOR IFRS, DERIVATIVE ASSETS OF DERIVATIVES. FOR IFRS, DERIVATIVE ASSETS AND DERIVATIVE LIABILITIES ARE ONLY NETTED IN CERTAIN CIRCUMSTANCES.

FOR GAAP, THEY ARE NETTED MUCH MORE

  • WIDELY. THIS DOES NOT AFFECT NET WORTH,

ONLY THE SIZE OF ASSETS AND LIABILITIES.

WE WILL SHOW NET FOR ALL FIRMS.

10/12/2012 VOLATILITY INSTITUTE 41

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IMPLICATIONS

QUASI-LEVERAGE IS DEFINED BY NON-

DERIVATIVE LIABILITIES/EQUITY

FIRMS WITH WELL HEDGED DERIVATIVE BOOKS

WILL BE TREATED LIKE FIRMS WITH NO WILL BE TREATED LIKE FIRMS WITH NO DERIVATIVE OPERATIONS.

FIRMS WITH BADLY HEDGED DERIVATIVE BOOKS

WILL HAVE FLUCTUATING P&L AND CONSEQUENTLY EQUITY VALUES. THIS HIGHER LEVEL OF VOLATILITY IS A MEASURE OF THE ADDITIONAL RISK OF UNHEDGED DERIVATIVES.

10/12/2012 VOLATILITY INSTITUTE 42

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EUROPEAN SRISK

2000 2500

Total SRISK - Top European Firms

(USD billion)

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500 1000 1500 1.31.2001 1.31.2002 1.31.2003 1.31.2004 1.31.2005 1.31.2006 1.31.2007 1.31.2008 1.31.2009 1.31.2010 1.31.2011 1.31.2012 SRISK (Netting) SRISK (No Netting)

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EUROPE NETTING DERIVATIVES

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Global Systemic Risk Rankings

“A Look Back”

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GLOBAL RISK

November 4, 2011 BIS with FSB of the G-20 released its

list of Global Systemically Important Financial Institutions GSIFIs.

They listed 17 European Banks They listed 17 European Banks November, our list of the top 17 banks is identical with

  • ne exception:

We have Intesa Sanpaolo instead of Dexia

Furthermore, we have ranked these It took BIS two years and many meetings. We have

now updated many times.

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US FED STRESS TEST

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EUROPEAN STRESS TEST

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Risk Rankings Before Lehman

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PRE LEHMAN EUROPEAN FIN

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JAN 31, 2007

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JAN 31, 2005

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TODAY

The European Financial and Banking sector is fragile

and will need massive recapitalization to avoid financial meltdown. We think it is around $2 trillion.

Is this a sovereign crisis or a banking crisis? Is this a sovereign crisis or a banking crisis? BOTH – each is a primary cause of the other. A credible commitment to save the banking sector

would dramatically reduce sovereign debt differentials and raise bank shares and lower SRISK.

How to do this? Eurobonds or unlimited support for

ECB as regulator and lender of last resort.