Understanding Liquidity and Credit Risks in the Financial Crisis

This paper develops a structured dynamic factor model for the spreads between London Interbank Offered Rate (LIBOR) and overnight index swap (OIS) rates for a panel of banks. Our model involves latent factors which reflect liquidity and credit risk. Our empirical results show that surges in the short term LIBOR-OIS spreads during the 2007-2009 fi nancial crisis were largely driven by liquidity risk. However, credit risk played a more signifi cant role in the longer term (twelve-month) LIBOR-OIS spread. The liquidity risk factors are more volatile than the credit risk factor. Most of the familiar events in the financial crisis are linked more to movements in liquidity risk than credit risk.

Transmission of macro-liquidity shocks to liquidity-sorted stock portfolios’ returns: The role of the financial crisis

This study examines the impact of macro-liquidity shocks on the returns of UK stock portfolios sorted on the basis of a series of micro-liquidity measures. The macro-liquidity shocks are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in futures contracts on the 3-month LIBOR during the period June 1999- December 2009. We report definitive evidence that these shocks are transmitted to the cross-section of liquidity-sorted portfolios, with most liquid stocks playing a very active role. Our results emphatically document that the shocks-returns relationship has reversed its sign during the recent financial crisis; the standard inverse relationship between interest rate surprises and portfolios’ returns before the crisis has turned into positive during the crisis. This finding confirms the inability of interest rate cuts to boost returns in the shortrun during the crisis, because these were perceived by market participants as a signal of a deteriorating economic outlook.

Financial crisis and quantitative easing: can broad money tell us anything?

When Bank of England (and the Federal Reserve Board) introduced their quantitative easing (QE) operations they emphasised the effects on money and credit, but much of their empirical research on the effects of QE focuses on long-term interest rates. We use a flow of funds matrix with an independent central bank to show the implications of QE and other monetary developments, and argue that the financial crisis, the fiscal expansion and QE are likely to have constituted major exogenous shocks to money and credit in the UK which could not be digested immediately by the usual adjustment mechanisms. We present regressions of a reduced form model which considers the growth of nominal spending as determined by the growth of nominal money and other variables. These results suggest that money was not important during the Great Moderation but has had a much larger role in the period of the crisis and QE. We then use these estimates to illustrate the effects of the financial crisis and QE. We conclude that it would be useful to incorporate money and/or credit in wider macroeconometric models of the UK economy.

Stock Market Reaction to Fed Funds Rate Surprises: State Dependence and the Financial Crisis

This paper examines the impact of Federal Funds rate (FFR) surprises on stock returns in the United States over the period 1989-2009, focusing on the impact of the recent financial crisis. We find that prior to the crisis, stock prices increased as a response to unexpected FFR cuts. State dependence is also identified with stocks exhibiting larger increases when interest rate easing coincided with recessions, bear stock markets, and tightening credit market conditions. However, an important structural shift took place during the financial crisis, which changed the stock market response to FFR shocks, as well as the nature of state dependence. Specifically, during the crisis period stock market participants did not react positively to unexpected FFR cuts. Our results highlight the severity of the recent financial turmoil episode and the ineffectiveness of conventional monetary policy close to the zero lower bound for nominal interest rates.

Stock Market Liquidity and Macro-Liquidity Shocks: Evidence from the 2007-2009 Financial Crisis

We develop an empirical framework that links micro-liquidity, macro-liquidity and stock prices. We provide evidence of a strong link between macro-liquidity shocks and the returns of UK stock portfolios constructed on the basis of micro-liquidity measures between 1999-2012. Specifically, macro-liquidity shocks, which are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in 3-month LIBOR futures prices, are transmitted in a differential manner to the cross-section of liquidity-sorted portfolios, with liquid stocks playing the most active role. We also find that there is a significant increase in shares’ trading activity and a rather small increase in their trading cost on MPC meeting days. Finally, our results emphatically document that during the recent financial crisis the shocks-returns relationship has reversed its sign. Interest rate cuts during the crisis were perceived by market participants as a signal of deteriorating economic prospects and reinforced “flight to safety” trading.

On the real effects of financial pressure: Evidence from euro area firm-level employment during the recent financial crisis.

Using a large panel of unquoted euro-area firms over the period 2003-11, this paper examines the impact of financial pressure on firms’ employment. The analysis finds evidence that financial pressure negatively affects firms’ employment decisions. This effect is stronger during the 2007-2009 financial crisis, especially for firms in the periphery area compared to their counterparts in the core European economies. We also find that impact of financial pressure on employment is more potent for firms classified as financially constrained and operating in periphery economies during the financial crisis.

The role of education in equity portfolios during the recent financial crisis

Using a panel of 38 economies, over the period 2001 to 2010, we analyse the link between diversification in equity portfolios and different facets of education. We find that traditionally used measures of education play an important role in reducing equity home bias. After separating countries according to their level of financial development, we find that less developed economies tend to benefit more from an improvement in the level of education compared to their more developed counterparts. We also find that the beneficial effect of education is more pronounced during the most recent financial crisis, especially for economies with less developed financial markets.

Central banks and house prices in the run-up to the crisis

The financial crisis and the role played within it by fluctuations in house prices has reopened the debate about whether monetary policy should respond to asset prices. This paper investigates how the central banks of the euro area, the UK and the US considered, understood and responded to the trends in house prices in the six or seven years preceding the crisis, and how they have analysed those developments since the crisis. It suggests that these central banks, particularly the Anglo-Saxon ones, might have been able to take some useful action if they had devoted more intellectual resources to analysing the possible misalignments of house prices and been willing to act on them.

Monetary Policy in Times of Financial Stress.

Some studies argue that the Fed reacts to financial market developments. Using data covering the period 1985:Q1 - 2008:Q4 and employing an augmented Taylor rule specification, we re-examine that conjecture. We find that evidence in favour of such a reaction is largely driven by the Fed’s behaviour during the 2007-2008 financial crisis.

Firm survival, uncertainty and financial frictions: Is there a financial uncertainty accelerator?

Using a large panel of unquoted UK over the period 2000-09, we examine the impact of firm-specific uncertainty on corporate failures. In this context we also distinguish between firms which are likely to be more or less dependant on bank finance as well as public and non-public companies. Our results document a significant effect of uncertainty on firm survival. This link is found to be more potent during the recent financial crisis compared with tranquil periods. We also uncover significant firm-level heterogeneity since the survival chance of bank-dependent and non-public firms are most affected by changes in uncertainty, especially during the recent global financial crisis.

The response of the external finance premium in Asian corporate bond markets to financial characteristics, financial constraints and two financial crises

Empirical investigation of the external finance premium has been conducted on the margin between internal finance and bank borrowing or equities but little attention has been given to corporate bonds, especially for the emerging Asian market. In this paper, we hypothesize that balance sheet indicators of creditworthiness could affect the external finance premium for bonds as they do for premia in other markets. Using bond-specific and firm-specific data for China, Hong Kong, Indonesia, Korea, Philippines, Singapore and Thailand during 1995-2009 we find that firms with better financial health face lower external finance premia in all countries. When we introduce firm-level heterogeneity, we show that financial variables appear to be both statistically and quantitatively more important for financially constrained firms. Finally, when we examine the effects of the 1997-98 Asian crisis and the 2007-09 global financial crisis, we find that the sensitivity of the premium is greater for constrained firms during the Asian crisis compared to other times.

From Bretton Woods to inflation targeting: financial change and monetary policy evolution in Europe

Different ‘monetary architectures’ are distinguished, as a background to a discussion of the change in developed country monetary policy frameworks from fixed exchange rates under the Bretton Woods international monetary system to, ultimately, formal or informal inflation targeting. The introduction and experience of monetary targets in the 1970s is considered, followed by an analysis of the changes in countries’ monetary architectures, with particular reference to money and bond markets and to France and Italy, in the 1980s. Exchange rate targeting in Europe in the 1980s and 1990s is examined, followed by the changes in central bank independence in the 1990s. This leads to a discussion of the introduction of inflation targeting, and the issues raised for inflation targeting by the financial crisis of the late 2000s.

Firm survival, uncertainty and financial frictions: Is there a financial uncertainty accelerator?

Using a large panel of unquoted UK firms over the period 2000-09, we examine the impact of firm-specific uncertainty on corporate failures. In this context we also distinguish between firms which are likely to be more or less dependent on bank finance as well as public and non-public companies. Our results document a significant effect of uncertainty on firm survival. This link is found to be more potent during the recent financial crisis compared with tranquil periods. We also uncover significant firm-level heterogeneity since the survival chances of bank-dependent and non-public firms are most affected by changes in uncertainty, especially during the recent global financial crisis.

Modeling U.S. Inflation Dynamics: A Bayesian Nonparametric Approach

This paper uses an infinite hidden Markov model (IIHMM) to analyze U.S. inflation dynamics with a particular focus on the persistence of inflation. The IHMM is a Bayesian nonparametric approach to modeling structural breaks. It allows for an unknown number of breakpoints and is a flexible and attractive alternative to existing methods. We found a clear structural break during the recent financial crisis. Prior to that, inflation persistence was high and fairly constant.

Estimating Phillips Curves in Turbulent Times using the ECB’s Survey of Professional Forecasters

This paper uses forecasts from the European Central Bank's Survey of Professional Forecasters to investigate the relationship between inflation and inflation expectations in the euro area. We use theoretical structures based on the New Keynesian and Neoclassical Phillips curves to inform our empirical work. Given the relatively short data span of the Survey of Professional Forecasters and the need to control for many explanatory variables, we use dynamic model averaging in order to ensure a parsimonious econometric speci cation. We use both regression-based and VAR-based methods. We find no support for the backward looking behavior embedded in the Neo-classical Phillips curve. Much more support is found for the forward looking behavior of the New Keynesian Phillips curve, but most of this support is found after the beginning of the financial crisis.