Funding Frictions after the Global Financial Crisis

Project Information

FuFri

Grant agreement ID: 101040188

DOI

10.3030/101040188

EC signature date 23 February 2022

Start date 1 May 2022

End date 31 August 2027

Funded under

• European Research Council (ERC)

Total cost

€ 1 500 000,00

EU contribution

€ 1 500 000,00

Coordinated by

FRANKFURT SCHOOL OF FINANCE & MANAGEMENT GEMEINNUTZIGE GMBH
Germany

Periodic Reporting for period 1 - FuFri (Funding Frictions after the Global Financial Crisis)

Reporting period: 2022-05-01 to 2024-10-31

Summary of the context and overall objectives of the project

Funding frictions are tensions in financial markets that can preclude institutions from borrowing money or rolling over debt. In extreme situations, such as the 2007-2009 global financial crisis (GFC) or the market turmoil in March 2020 during the Covid-19 pandemic, funding frictions can destabilize the entire financial system. While earlier research (pre-GFC) tends to disregard funding frictions, the enormous risk associated with these market tensions highlights that a deeper understanding of funding frictions is crucial – it can guide policy makers to determine their optimal responses to future crises and help institutions to reduce their funding risk.

In this project, I investigate how funding frictions affect financing conditions for banks, companies, countries, and pension plans. While funding frictions can, in the most extreme cases, lead to the bankruptcy of otherwise healthy entities, they usually first manifest through elevated costs for external financing, shorter debt maturities, or a lack of access to certain credit markets. Focusing on these aspects, I investigate the following question: How did the market developments since the GFC affect funding frictions for countries, banks, pension funds, and insurance companies? More specifically, I examine four post-crisis changes in financial markets – (i) tighter bank regulation (as implemented in the Basel III capital accords), (ii) more stringent regulation of Money Market Mutual funds, (iii) ballooning deficits in most developed economies, (iv) pension risk transfers with firms transferring their defined benefit (DB) pension plans to life insurance companies – and study their impact on funding costs and access to credit markets. The results can inform policy makers about the (potentially unintended) consequences of regulatory changes and help sovereigns with managing their increasing debt levels.

Work performed from the beginning of the project to the end of the period covered by the report and main results achieved so far

I have so far focused my attention on the following three steps: Hypothesis development, data collection, and re-assessment of hypothesis.

Hypotheses development: I have developed a set of hypotheses that allows me to examine funding frictions for countries, banks, pension funds, and insurance companies. In developing the hypotheses, I have given priority to the most topical issues, which were (i) funding frictions and corporate pension plans and (ii) funding frictions in money markets. By examining funding frictions money markets, I did discover a critical knowledge gap: The transition away from LIBOR toward alternative reference rates has a first-order impact on funding conditions for floating-rate debt markets. Hence, in addition to examining the more stringent regulation of Money Market Mutual Funds, I have tested an additional hypothesis: Does the LIBOR-SOFR transition increase borrowing costs?

Data collection: Data collection for the developed hypotheses went mostly as planned. In collecting data to examine the role of tighter bank regulation, I have discovered that it is possible to access data on interest rate derivatives through a central bank rather than purchasing them from a third-party vendor. This finding has enabled me to expand my analysis by purchasing another data set on foreign exchange derivatives, which was not available to researchers prior to our purchase and will shed more light on the role of banks’ funding constraints in derivatives markets.

Re-assessment of hypotheses and next steps: Initially, my main concern was that tighter bank regulation has an adverse effect on the liquidity of derivatives markets. In investigating this hypothesis, I found that one main concern is not that liquidity affects derivatives pricing but that using derivatives can have the unintended consequence of exposing derivatives users to funding risk. I have therefore expanded my analysis examining this issue. Both data collection and hypotheses developments focusing on the ballooning deficits in developed economies are an ongoing effort. I have hired a post-doctoral researcher who will help me with these issues.

Progress beyond the state of the art and expected potential impact (including the socio-economic impact and the wider societal implications of the project so far)

At this stage of the research plan it is difficult to assess if and how I have advanced the field. It will be possible to give a more detailed answer after some of the research papers are submitted and evaluated by academic journals. However, at this early stage, two contributions are worth highlighting that will potentially change our perception:
1. The common sense in academic research is that the transition from LIBOR to alternative reference rates has an adverse impact on funding conditions. In “The SOFR Discount”, my co-author Olav Syrstad and I show that the opposite is true, when examining floating rate notes. This is a key contribution showing that the LIBOR transition (which is arguably the biggest change in financial markets over the last decades) has unintended positive effects.
2. The paper “Pension Liquidity Risk” fundamentally changes our perception of pension funds. Traditionally, pension funds are viewed as stable long-term investors. Our research challenges this notion by showing that liquidity risk from derivatives positions exposes pension funds to funding risk.

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