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Final Report Summary - EMAIFAP (EXPLOITING MACRO-ACCOUNTING INFORMATION FOR ASSET PRICING, SYSTEMIC RISK AND MONETARY POLICY ANALYSIS)

The objective of this project was to study the dynamic structuring of balance sheet positions of banks and institutional investors and its impact on the financial sector and the real economy. The project specifically aimed to achieve three objectives: (a) An understanding and measurement of the impact of the bank leverage and asset risk position on their stock market valuation; (b) The identification of balance sheet variables that are key in enhancing or mitigating systemic risk in the financial system, and the policy implications of the findings; and (c) An adequate understanding and evaluation of the transmission mechanism of monetary policy into banks’ balance sheets.

The research work done during these years can be synthesized in four points. First, we examine the impact of leverage and connectedness among the bank-dealers on European contagion in the CDS market. We specifically create a simple measure of commonality in the quotes that dealers give for Sovereign European CDS and show that it is a powerful predictor of cross-sectional variation in CDS return correlation, controlling for liquidity and default risks, and other country-pair characteristics and macro variables. These results are consistent with a non-fundamental price pressure mechanism in two different ways. First, the predicting effect of the commonality is stronger for dealers that experience selling pressure, and secondly, we show that the effect comes primarily from uninformed dealers. The Tier 1 Capital ratio is the key instrumental variable that we use, to address endogeneity concerns, which help us confirm that our findings reflect indeed a causal relation between commonality in quotes and CDS return comovement. These results are enlightening from a regulatory perspective, as they ask for a central clearing house in the CDS market, and other OTC markets, to mitigate the contagion effects that arise from the high concentration of dealers.

Second, we examine the impact that bank-specific factors have on an institution’s solvency risk and its contribution to systemic risk. We focus on the five categories that the Basel Committee on Banking Supervision has recently proposed as indicators of systemic importance, and our findings suggest that unstable funding is the main factor driving systemic risk. Furthermore, the combination of significant trading activities with global presence appears to exacerbate spillover risks to the global financial system. Interestingly, whereas trading activities contribute to the build-up of correlated or ‘wrong-way’ risk they help to mitigate individual solvency risk – that is why we labeled this paper “Good for One, Bad for All”. The findings of this part of the project suggest clearly that a macro-prudential approach to financial regulation should focus not only on scaling up micro-prudential measures but also on enabling the efficient transfer of risk between financial institutions.

Third, we examine the impact of commonality in mutual fund holdings on the contagion in stock market, where we measure contagion again as excess correlation beyond fundamentals. By connecting stocks through the mutual fund owners they have in common, we show that the degree of shared ownership forecasts cross-sectional variation in return correlation, controlling for exposure to systematic return factors, style and sector similarity, and many other pair characteristics. We argue that shared ownership causes this excess comovement based on evidence from a quasi-natural experiment—the 2003 mutual fund trading scandal. These results motivate a novel cross-stock reversal trading strategy exploiting information in ownership connections. Finally, we show that the returns on a long/short hedge fund index covary negatively with this strategy, arguably exacerbating the comovement we document.

Finally, we examine the impact of common ownership in firms’ balance sheets, and show that it has strong implications for corporate policies, such as compensation of top managers. In standard models of corporate finance, shareholders invest their entire wealth in one single firm; the optimal incentive contract features pay for performance relative to industry peers. In reality, CEOs get paid for other firms’ performance as much as for their own. We propose that a key reason for the failure of relative performance evaluation is that, in reality, many industry peers are commonly owned by the same investors. We show theoretically and empirically that CEOs are (optimally) paid less for own performance and more for peer performance when the industry is more commonly owned.

Collectively, the results of the project suggest that the connectedness of key players in stock and credit markets exacerbate the presence of systemic risk, or fragility of the financial system as a whole. The evidence in the research papers generated in this project also shows that we can identify these connections, and their impact on valuation of financial assets, and thus design better solutions to mitigate those effects. More specifically, in the second big agenda of the project, we show that common ownership is a key factor to understand better corporate policies and economic interactions among firms.

My objective is that by 2016 this project will keep shaping the ongoing debate on the causes of systemic risk and the way to alleviate them, both in academia and among market participants and regulators. Specifically, I hope the remaining work will contribute to the understanding of how monetary policy is transmitted to banks, and from banks to SMEs and end consumers; and how the money management industry evolves to a more efficient and sustainable equilibrium. This research path is of clear importance, considering the increased interest on macro-prudential regulation in the aftermath of the financial crisis.

The funding received from the Marie Curie Career Integration Grant has been of great help to the researcher to develop and continue the productive research started with the PhD in the London School of Economics.

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Reported by

UNIVERSIDAD DE NAVARRA
Spain
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