The Global Financial Crisis

Mark Taylor, Richard Clarida, Mark P. Taylor, Richard Clarida

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317983354
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The global financial crisis has sent shockwaves through the world's economies, and its effects have been deep and wide-reaching. This book brings together a range of applied studies, covering a range of international and regional experience in the area of finance in the context of the global downturn.

The volume includes an exploration of the impact of the crisis on capital markets, and how corporate stakeholders need to be more aware of the decision-making processes followed by corporate executives, as well as an analysis of the policy changes instituted by the Fed and their effects. Other issues covered include research into the approach of solvent banks to toxic assets, the determinants of US interest rate swap spreads during the crisis, a new approach for estimating Value-at-Risk, how distress and lack of active trading can result in systemic panic attacks, and the dynamic interactions between real house prices, consumption expenditure and output. Highlighting the global reach of the crisis, there is also coverage of recent changes in the cross-currency correlation structure, the costs attached to global banking financial integration, the interrelationships among global stock markets, inter-temporal interactions between stock return differential relative to the US and real exchange rate in the two most recent financial crises, and research into the recent slowdown in workers' remittances.

This book was published as a special issue of Applied Financial Economics.

Introduction

The global financial crisis: introduction and overview

Mark P. Taylor^a,b,c,d

Editor, Applied Economics Series

^aDepartment of Economics, University of Warwick, Coventry CV4 7AL, UK

^bWarwick Business School, University of Warwick, Coventry, CV4 7AL, UK

^cBarclays Global Investors, San Francisco, CA, USA

^dCentre for Economic Policy Research, London EC1V 0DG, UK

We provide an introduction and overview to the 12 applied financial studies making up this special issue on the Global Financial Crisis (GFC). The studies cover a wide range of international and regional experience and employ a variety of applied techniques.

This book on the Global Financial Crisis (GFC) brings together 12 applied studies covering a range of international and regional experience in the area of finance, using a variety of applied techniques.

In the first article, Les Coleman and Sean Pinder show that the impact of the GFC on capital markets has demonstrated that corporate stakeholders need to be more aware of the decision-making processes followed by corporate executives. Gaining such insight is difficult at any time, yet attempting to uncover how executives reached critical decisions in the lead-up to the GFC is almost impossible in hindsight. The authors overcome this problem in that they report the results of interviews conducted with senior Australian finance executives in the lead-up to the GFC. These interviews were designed to elicit granular explanations for the rationale underpinning major corporate finance decisions, and their timing and subjects provide a unique ex ante profile of the perceptions of senior executives in large firms as the GFC developed. The most significant finding of Coleman and Pinder’s work is that the corporate executives shared a decision framework with core features similar to those of financiers that are thought to have contributed to the GFC; particularly permanently increasing asset prices, easy liquidity and safety in powerful risk management techniques. Coleman and Pinder’s findings have strong implications for independent Board members who – at least in hindsight – failed to identify and mitigate risks from systemic reliance on appreciating markets and the inevitability of mean reversion.

Facing the worst financial crisis since the Great Depression, the US Federal Reserve (Fed) has responded with sweeping, unprecedented actions to aid a slowing economy and stimulate a frozen credit market. In their article, Abdullah Mamun, M. Kabir Hassan and Mark Johnson focus on the policy changes instituted by the Fed and their wealth effects on banks, insurance companies, brokerage firms, savings and loan institutions, and primary dealers. They analyse the actions of the Fed that involved the modification of the terms on which financial institutions can borrow from the Discount Window and the creation of new liquidity enhancing facilities like the Term Auction Facility, the Term Securities Lending Facility and the Primary Dealer Credit Facility. Mamun, Hassan and Johnson find that changes to the Discount Window and the creation of a similar program, the Term Auction Facility, had almost no effect on its intended beneficiaries – depository institutions. Also, they find that new measures implemented by the Fed towards restoring the repurchase agreement market were well received by both depository institution and primary dealers.

Next, Linus Wilson uses the option pricing arguments of Merton (1974) to demonstrate that even solvent banks will be reluctant to sell volatile, toxic assets at market prices. Banks’ shareholders have insolvency puts that give them limited liability in the event of default. The insolvency puts are more valuable when the banks’ assets are more volatile. Shareholders in banks will require any buyer to pay for the lost volatility as well as the market price of the toxic assets. Thus, Wilson suggests that taxpayers must be ready to richly overpay if they want banks to voluntarily part with their toxic assets.

Takayasu Ito investigates the determinants of US interest rate swap spreads in the period including the financial crisis. The asymmetric impacts of the financial crisis on interest rate swap spreads are focused by dividing the whole sample period into two. One sample includes the period when the financial market was relatively stable and the other sample includes the period when the financial market was volatile under the financial crisis. Four determinants of swap spreads – default risk, the slope of yield curve, T-bill and Eurodollar (TED) spread and volatility – are chosen by Ito. AAA default risk is incorporated in the US swap spreads in both period, but BAA risk is incorporated only in the period of normal time. Ito finds that the slope is positively incorporated in short-term spread in both periods of normal and the financial crisis. Also, the liquidity premium is incorporated in interest rate swap market in both short- and long-term maturities in normal period and only in short-term maturity in the period of the financial crisis. The market participants were uncertain as for the future of monetary policy by Federal Reserve Board (FRB). Thus the speculation on the path of monetary policy is considered to cause volatility. It can be a determinant of swap spreads in the period of the financial crisis.

In his contribution, John L. Simpson takes the position that there have been significant costs attached to global banking financial integration and these costs were identified in a period prior to the 2008 GFC revealed by the analysis of daily country banking index data from December 1999 to September 2008. Regression, correlation, cointegration, causality and variance decomposition analysis of daily bank price index data indicate that banking systems had achieved a high level of global integration, exemplified in the global involvement in the US sub prime mortgage market. Simpson finds that integration implies interdependence, which in turn implies the existence of systemic risk or the threat of contagion. He finds that re-focusing by banks on a culture of portfolio diversification of investments and borrowings is necessary. Also greater involvement by a global banking regulatory authority, such as the Bank for International Settlements (BIS), to monitor undiversified systemic interdependence may be inevitable (e.g. the administration of insurance schemes for interbank lines of credit).

In their study, Xin Zhao, Carl Scarrott, Les Oxley and Marco Reale introduce a new approach for estimating Value-at-Risk (VaR), which they then use to show the likelihood of the impacts of the current financial crisis. A commonly used two-stage approach is taken, by combining a Generalized Autoregressive Conditional Heteroscedasticity (GARCH) volatility model with a novel extreme value mixture model for the innovations. The proposed mixture model permits any distribution function for the main mode of the innovations, with the very flexible generalized Pareto distribution for the upper and lower tails. They find that a major advance with the mixture model is that it overcomes the problems with threshold choice in traditional methods, as it is treated as a parameter in the model to be estimated. The model describes the tail distribution of both the losses and gains simultaneously, which is natural for financial applications. As the threshold is treated as a parameter, the uncertainty from its estimation is accounted for, which is a challenging and often overlooked problem in traditional approaches. Zhao, Scarrott, Oxley and Reale find that the model is shown to be sufficiently flexible that it can be directly applied to reliably estimate the likelihood of impact of the financial crisis on stock and index returns.

The liquidity crunch and the ensuing financial crisis have unambiguously affected all national economies and global currency exchange rates. Georgios Chalamandaris and Andrianos E. Tsekrekos ask whether the cross-currency correlation structure has changed since 2007. Using an extensive set of volatility surfaces implied from over-the-counter options on 11 different exchange rates, as well as recent advances in static and dynamic factor models, they show that the number of factors that innovate the correlation structure has not changed in the last 2.5 years. It is the volatility, the persistence and the significance of global systematic factors, vis-à-vis regional or economy-specific ones, that appears to have changed dramatically. They also outline the implications for the risk management of currency exposures and the predictability of exchange rate volatility.

Next, William Cheung, Scott Fung and Shih-Chuan Tsai examine the impact of the 2007–2009 GFC on the interrelationships among global stock markets and the informational role of the TED spread as perceived credit risk. The current crisis, originated from the dominant US market, has a prompt and pervasive spillover effect into other global markets. Using the Vector Autoregression (VAR) model, Granger causality test, cointegrating Vector Error-Correction Model (VECM), they document enhanced leadership of the US market with respect to the UK, Hong Kong, Japan, Australia, Russia and China markets during the crisis. Consistent with the contagion theory, the interdependence among international stock markets becomes stronger in the crisis. The TED spread serves as a leading ‘fear’ indicator and adjusts to new information rapidly during the crisis. While the impact of orthogonalized shocks from the US market on other global markets increases by at least two times during the crisis, the impact of orthogonalized shocks from the TED spread on global market indices increase by at least five times. Overall, they find that their findings shed light on the dynamics of international stock market linkage and the spillover effect of credit risk.

The 2007–2008 financial crises made it painfully obvious that markets may quickly turn illiquid. Moreover, recent experience has shown that distress and lack of active trading can jump ‘around’ between seemingly unconnected parts of the financial system contributing to transforming isolated shocks into systemic panic attacks. Massimo Guidolin and Francesca Rinaldi develop a simple two-period model populated by both standard expected utility maximizers and by ambiguity-averse investors that trade in the market for a risky asset. They show that, provided there is a sufficient amount of ambiguity, market breakdowns where large portions of traders withdraw from trading are endogenous and may be triggered by modest re-assessments of the range of possible scenarios on the performance of individual securities. They find that risk premia (spreads) increase with the proportion of traders in the market who are averse to ambiguity. When they analyse the effect of policy actions, Guidolin and Rinaldi find that when a market has fallen into a state of impaired liquidity, bringing the market back to orderly functioning through a reduction in the amount of perceived ambiguity may cause further reductions in equilibrium prices. Finally, their model provides stark indications against the idea that policy-makers may be able to ‘inflate’ their way out of a financial crisis.

Douglas K. T. Wong and Kui-Wai Li use the dynamic conditional correlation model and the data from 10 economies to examine the inter-temporal interactions between stock return differential relative to the US and real exchange rate in the two financial crises of 1997 and 2008. Their theoretical model suggests that relative stock return differential and real exchange rate contain both permanent and temporary components and are negatively correlated with each other. Evidence shows that sharp and rapid changes in conditional correlation occurred during the two financial crises. Their study provides strong evidence in supporting the stochastic relationship between relative stock prices and real exchange rates, and exchange rate stability becomes crucial in a financial crisis.

In the next article, a small-scale macroeconomic system is estimated by Fabio C. Bagliano and Claudio Morana in the framework of a common trends model, in order to explore the dynamic interactions between real house prices, consumption expenditure and output in the US and major European economies. Their results point to important differences across countries, with long-run house price effects on consumption only for France, Germany and the US. However, they find that interactions between house prices and consumption are detected in all countries at shorter horizons, with important implications of the current unwinding of the sub-prime crisis for real activity. Bagliano and Morana also find evidence of international comovements in the common trend component of house price dynamics.

The effects of the current GFC are widespread. The economic downturn has affected large sectors of the population in developed and developing countries, and international immigrants have not been the exception. In the final article making up this special issue, Isabel Ruiz and Carlos Vargas-Silva document the recent slowdown in workers’ remittances, the money that international immigrants send to their countries of origin. Current data indicates that remittance flows have decreased for all regions of the world. Latin America stands out by reporting an almost 0% growth rate of remittances for 2008. They find that among Latin American countries, Mexico (the largest recipient of remittances in the region in terms of volume) seems to be the most affected with a decrease of more than US$900 million between 2007 and 2008. They also present the evidence of the impact of some of the factors associated with the current economic crisis on remittances flows. The results indicate that there is a strong link between housing activity in the US and remittances flows.

What were they thinking? Reports from interviews with senior finance executives in the lead-up to the GFC

Les Coleman and Sean Pinder

Department of Finance, The University of Melbourne, Parkville, Victoria 3010, Australia

The impact of the Global Financial Crisis (GFC) on capital markets has demonstrated that corporate stakeholders (including shareholders, lenders and independent board members) need to be far more aware of the decision-making processes followed by corporate executives. Gaining insight into these processes is difficult at any time, yet attempting to uncover (in any meaningful sense) how executives reached critical decisions in the lead-up to the GFC is almost impossible in hindsight. This article overcomes this problem in that it reports the results of interviews conducted with senior Australian finance executives in the lead-up to the GFC. These interviews were designed to elicit granular explanations for the rationale underpinning major corporate finance decisions, and their timing and subjects provide a unique ex ante profile of the perceptions of senior executives in large firms as the GFC developed. The most significant finding is that the corporate executives shared a decision framework with core features similar to those of financiers that are thought to have contributed to the GFC, particularly permanently increasing asset prices, easy liquidity and safety in powerful risk management techniques. Our findings have strong implications for independent board members who – at least in hindsight – failed to identify and mitigate risks from systemic reliance on appreciating markets and the inevitability of mean reversion.

I. Introduction

An important contributor to the Global Financial Crisis (GFC) seems to have been behaviour. For instance, early this year The Economist (2009, p. 65) saw human failings as the GFC’s underlying cause: ‘Ask people what caused the financial and economic crisis and most are likely to plump for some mix of greed and incompetence’. Whilst it is possible to explore the rationale and nature of actions by financial managers during 2007–2009 using surveys or even scrutiny of documents (including those supporting prosecutions), the validity of ex post responses is questionable and sanitized documents cannot be interrogated.

We make an important contribution to the literature on the GFC by reporting the ex ante rationale of financial managers’ governance-related decisions. Data come from our face-to-face interviews with 12 senior finance managers – all but one of them chief finance officers (CFOs) and treasurers of major listed Australian companies – in the 12 months preceding the GFC. Interviews were held between October 2007 and October 2008 as part of a broader study using surveys and interviews to probe finance executives’ decisions. We had deliberately sought the granularity of interviews that is common in the management discipline (where it yields excellent insights into managerial behaviour), anthropology and other social sciences; and – although governance and financial risk were not core to our research – we serendipitously included relevant questions to round out the analysis.

Thus we report here the results of interviews with senior finance executives conducted during the GFC as quotations from them in relation to governance and financial risk, but without any taint from hindsight. Results are particularly informative because several of the surveyed companies subsequently became embroiled in financial crisis.

The most significant of our findings is that the corporate executives we interviewed displayed perspectives simila...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• 1. Introduction: The global financial crisis: introduction and overview
• 2. What were they thinking? Reports from interviews with senior finance executives in the lead-up to the GFC
• 3. How did the Fed do? An empirical assessment of the Fed’s new initiatives in the financial crisis
• 4. The put problem with buying toxic assets
• 5. Global financial crisis and US interest rate swap spreads
• 6. Were there warning signals from banking sectors for the 2008/2009 global financial crisis?
• 7. Extreme value modelling for forecasting market crisis impacts
• 8. The correlation structure of FX option markets before and since the financial crisis
• 9. Global capital market interdependence and spillover effect of credit risk: evidence from the 2007–2009 global financial crisis
• 10. A simple model of trading and pricing risky assets under ambiguity: any lessons for policy-makers?
• 11. Comparing the performance of relative stock return differential and real exchange rate in two financial crises
• 12. Permanent and transitory dynamics in house prices and consumption: some implications for the real effects of the financial crisis
• 13. Another consequence of the economic crisis: a decrease in migrants’ remittances
• Index