Stress testing credit risk: the Great Depression scenario

By employing Moody’s corporate default and rating transition data spanning the last 90 years we explore how much capital banks should hold against their corporate loan portfolios to withstand historical stress scenarios. Specifically, we will focus on the worst case scenario over the observation period, the Great Depression. We find that migration risk and the length of the investment horizon are critical factors when determining bank capital needs in a crisis. We show that capital may need to rise more than three times when the horizon is increased from 1 year, as required by current and future regulation, to 3 years. Increases are still important but of a lower magnitude when migration risk is introduced in the analysis. Further, we find that the new bank capital requirements under the so-called Basel 3 agreement would enable banks to absorb Great Depression-style losses. But, such losses would dent regulatory capital considerably and far beyond the capital buffers that have been proposed to ensure that banks survive crisis periods without government support.

Developing “Best Practices” for bankers’ pay in line with Basel III

This paper proposes hybrid capital securities as a significant part of senior bank executive incentive compensation in light of Basel III, a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. The committee developed Basel III in a response to the deficiencies in financial regulation brought about by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The hybrid bank capital securities we propose for bank executives’ compensation are preferred shares and subordinated debt that the June 2004 Basel II regulatory framework recognised as other admissible forms of capital. The past two decades have witnessed dramatic increase in performance-related pay in the banking industry. Stakeholders such as shareholders, debtholders and regulators criticise traditional cash and equity-based compensation for encouraging bank executives’ excessive risk taking and short-termism, which has resulted in the failure of risk management in high profile banks during the global financial crisis. Paying compensation in the form of hybrid bank capital securities may align the interests of executives with those of stakeholders and help banks regain their reputation for prudence after years of aggressive risk-taking. Additionally, banks are desperately seeking to raise capital in order to bolster balance sheets damaged by the ongoing credit crisis. Tapping their own senior employees with large incentive compensation packages may be a viable additional source of capital that is politically acceptable in times of large-scale bailouts of the financial sector and economically wise as it aligns the interests of the executives with the need for a stable financial system.

The information content of REIT credit rating actions and transparency

We examine the short-run and long-run price reaction of equity REIT shares following credit rating actions, testing the transparency of the REIT structure. Generally, the economic effect on the stock price is subdued for both upgrades and downgrades compared to prior literature examining the broader U.S. equity market. An examination of trading volume revealed a significant increase in trading in reaction to downgrade credit rating changes, with a more subdued response to upgrades. The findings support the notion that REITs are more publicly forthcoming about the expectation of positive news in comparison to negative news.

Professionalism and professional institutions in times of change

Professionalism and professional institutions have developed and changed very gradually in recent decades, such that there are conflicting and competing definitions of what it means to be a professional. The direction of travel is examined through an institutional lens in terms of current trends and practices that have transformed professional life. At first sight, the evolution of professionalism appears to be developing into a new professionalism that requires less of professional institutions and more of the institutions of societal governance, such as contracts and statutes. These transformations are explored with reference to the need for a sustainable urban environment, showing that despite a reduced role of professional institutions, certain aspects of professionalism remain crucially important, especially in those jurisdictions where societal governance is not well developed. With the growing sophistication of legislation, insurance and commerce, the emphasis of what it means to be a professional is evolving. One key aspect of professionalism that is not usually listed in most texts is role definition and how this provides a sense of identity. Professionalism remains a relevant and important concept, but the exigencies of a sustainable urban environment transcend the objectives of the professions and demand a broader, collaborative and participative agenda.

The credit relationship between Henry III and merchants of Douai and Ypres, 1247-70

This article looks at an important but neglected aspect of medieval sovereign debt, namely ‘accounts payable’ owed by the Crown to merchants and employees. It focuses on the unusually well-documented relationship between Henry III, King of England between 1216 and 1272, and Flemish merchants from the towns of Douai and Ypres, who provided cloth on credit to the royal wardrobe. From the surviving royal documents, we reconstruct the credit advanced to the royal wardrobe by the merchants of Ypres and Douai for each year between 1247 and 1270, together with the king's repayment history. The interactions between the king and the merchants are then analysed. The insights from this analysis are applied to the historical data to explain the trading decisions made by the merchants during this period, as well as why the strategies of the Yprois sometimes differed from those of the Douaissiens.

Contested institutions? Traditional leaders and land access and control in communal areas of Eastern Cape Province, South Africa

The South African government has endeavoured to strengthen property rights in communal areas and develop civil society institutions for community-led development and natural resource management. However, the effectiveness of this remains unclear as the emergence and operation of civil society institutions in these areas is potentially constrained by the persistence of traditional authorities. Focusing on the former Transkei region of Eastern Cape Province, three case study communities are used examine the extent to which local institutions overlap in issues of land access and control. Within these communities, traditional leaders (chiefs and headmen) continue to exercise complete and sole authority over land allocation and use this to entrench their own positions. However, in the absence of effective state support, traditional authorities have only limited power over how land is used and in enforcing land rights, particularly over communal resources such as rangeland. This diminishes their local legitimacy and encourages some groups to contest their authority by cutting fences, ignoring collective grazing decisions and refusing to pay ‘fees’ levied on them. They are encouraged in such activities by the presence of democratically elected local civil society institutions such as ward councillors and farmers’ organisations, which have broad appeal and are increasingly responsible for much of the agrarian development that takes place, despite having no direct mandate over land. Where it occurs at all, interaction between these different institutions is generally restricted to approval being required from traditional leaders for land allocated to development projects. On this basis it is argued that a more radical approach to land reform in communal areas is required, which transfers all powers over land to elected and accountable local institutions and integrates land allocation, land management and agrarian development more effectively.

Credit risk in covered bonds

Covered bonds are a promising alternative for prime mortgage securitization. In this paper, we explore risk premia in the covered bond market and particularly investigate whether and how credit risk is priced. In extant literature, yield spreads between high-quality covered bonds and government bonds are often interpreted as pure liquidity premia. In contrast, we show that although liquidity is important, it is not the exclusive risk factor. Using a hand-collected data set of cover pool information, we find that the credit quality of the cover assets is an important determinant of covered bond yield spreads. This effect is particularly strong in times of financial turmoil and has a significant influence on the issuer's refinancing cost.

A bank lending channel or a credit supply shock?

Shifts in credit supply could have a bearing on house prices e.g. through financial innovations and changes in regulation independently of the existence of a bank lending channel of monetary policy. This paper assesses the responses of US house prices to an exogenous credit supply shock and compares them with the effects from variations in credit supply associated with a bank lending channel. The contribution of the study is twofold. First, innovations in credit supply are identified using a mortgage mix variable, thereby accounting for the market-based financial intermediaries. As a robustness check a survey variable of bank lending standards for mortgage loans is also used. Second, the policy-induced credit supply effect on house prices is disentangled and compared with the effect from an exogenous credit supply shock. It is shown that in the first 3 years credit supply shocks affect house prices exogenously rather than through the bank lending channel. Monetary policy has still a large impact on house prices, even when the bank lending channel is ‘turned off’.

Credit and liquidity components of corporate CDS spreads

This paper investigates the role of credit and liquidity factors in explaining corporate CDS price changes during normal and crisis periods. We find that liquidity risk is more important than firm-specific credit risk regardless of market conditions. Moreover, in the period prior to the recent “Great Recession” credit risk plays no role in explaining CDS price changes. The dominance of liquidity effects casts serious doubts on the relevance of CDS price changes as an indicator of default risk dynamics. Our results show how multiple liquidity factors including firm specific and aggregate liquidity proxies as well as an asymmetric information measure are critical determinants of CDS price variations. In particular, the impact of informed traders on the CDS price increases when markets are characterised by higher uncertainty, which supports concerns of insider trading during the crisis.

Doing more harm than good? Community based natural resource management and the neglect of local institutions in policy development

Approaches to natural resource management emphasise the importance of involving local people and institutions in order to build capacity, limit costs, and achieve environmental sustainability. Governments worldwide, often encouraged by international donors, have formulated devolution policies and legal instruments that provide an enabling environment for devolved natural resource management. However, implementation of these policies reveals serious challenges. This article explores the effects of limited involvement of local people and institutions in policy development and implementation. An in-depth study of the Forest Policy of Malawi and Village Forest Areas in the Lilongwe district provides an example of externally driven policy development which seeks to promote local management of natural resources. The article argues that policy which has weak ownership by national government and does not adequately consider the complexity of local institutions, together with the effects of previous initiatives on them, can create a cumulative legacy through which destructive resource use practices and social conflict may be reinforced. In short, poorly developed and implemented community based natural resource management policies can do considerably more harm than good. Approaches are needed that enable the policy development process to embed an in-depth understanding of local institutions whilst incorporating flexibility to account for their location-specific nature. This demands further research on policy design to enable rigorous identification of positive and negative institutions and ex-ante exploration of the likely effects of different policy interventions.