Inside the Libra Ecosystem, Other Financial Products Could Arise” 8 Interview with Maik Schmeling

Newsletter Q4 2019

“Inside the Libra ecosystem, other financial products could arise”_8 Interview with Maik Schmeling

The long-term viability of sovereign bond-backed securities_10 Jan Pieter Krahnen • Christian Wilde

Do leveraged loans herald the next financial crisis?_14 Claudio Borio Imprint About SAFE Publisher: Prof. Dr. Wolfgang König • Executive Board Research Center SAFE House of Finance • Goethe University Theodor-W.-Adorno-Platz 3 The Research Center SAFE – “Sustainable Architecture for 60323 Frankfurt am Main • Germany Finance in Europe” – is a cooperation of the Center for Fi- [email protected] nancial Studies and Goethe University Frankfurt. It is funded by the LOEWE initiative of the State of Hessen (Landes- Editors: Offensive zur Entwicklung wissenschaftlich-ökonomischer Dr. Muriel Büsser Exzellenz). SAFE brings together more than 40 professors Prof. Dr. Wolfgang König and just as many junior researchers who are all dedicated Christopher Krämer to conducting research in support of a sustainable financial Laura Thomale architecture. The Center has two main pillars: the striving for excellent research on all important topics related to Internet: finance; and policy advice, including the dissemination of www.safe-frankfurt.de relevant research findings to European decision makers Twitter: https://twitter.com/SAFE_Frankfurt from the realms of politics, regulation and administration. LinkedIn: https://www.linkedin.com/company/ researchcentersafe In order to promote a fruitful exchange with interested par- ties from politics, academia, business and the media, SAFE issues a newsletter on a quarterly basis. This aims to provide Design: an overview of the Center‘s ongoing research and policy ac- Novensis Communication GmbH tivities. The SAFE Newsletter succeeds the House of Finance Bad Homburg Newsletter, which was published between 2009 and 2012.

4th Edition SAFE is based at Goethe University’s House of Finance, however extends beyond by drawing on scholars from other Copyright © by the Research Center SAFE, parts of Goethe University as well as from fellow research Frankfurt am Main institutions. The Center builds on the reputation of the House of Finance institutions, serving as an interdisciplinary think Printed in Germany tank on the issue of finance. SAFE • Editorial • Quarter 4/2019

Building bridges between disciplines, and within: the Content new Leibniz Institute for Financial Research SAFE

architecture, capital markets, and banking. Besides having researchers from different Research We plan to work on savings and investment disciplines – mainly economics, law and po- Regulating tail-risks: When and how decisions, on pension politics, as well as bond litical science –, there is also a diversity of prudential regulation should apply to markets and their relation to monetary pol- methods at SAFE, ranging from theory to shadow banking _4 icy. In the field of banking and regulation, we empirical work, and laboratory experiments. Matthias Thiemann • Tobias H. Tröger will look at supervision and resolution, and Different fields and methods under one topi- how to prepare for a resilient, innovative and cal roof open the door widely for interdisci- Jan Pieter Krahnen competitive banking architecture. plinary research, and SAFE will make all efforts How horizontal links between industries Director, SAFE to foster such cross-fertilization. At the same can help to predict stock returns_6 Apart from research, SAFE will also engage time, we will be careful enough to preserve a Christian Schlag • Kailin Zeng „Everything is interconnected“ – without doubt, in policy advice. The SAFE Policy Center aims strong research footprint in the main fields the view of the famous German scientist to overcome the usual separation between of our discipline. Interview Alexander von Humboldt (1769-1859) on the academia and politics by exchanging perspec- “Inside the Libra ecosystem, other interdependencies between the environment tives and insights with governments, super- Research-based, diverse and independent – financial products could arise”_8 and human activities is more relevant than visory and legislative bodies at all levels, in these are basic principles underlying SAFE’s Maik Schmeling ever. Likewise, Finance as a discipline studies Germany and throughout Europe. The general work, already practiced for the past seven how people and institutions connect contrac- idea is to support high economic standards years under the Hessian LOEWE program. This Policy Center tually across space and over time. Questions when questions of institutional design and brings us back to another giant of German The long-term viability of sovereign of allocational efficiency and intergenerational regulatory framework are concerned, streng- intellectual history, Gottfried Wilhelm Leibniz bond-backed securities_10 fairness, the vitality of banks and markets, thening a sense of “Ordnungspolitik” in finan- (1646-1716), the name patron of the Leibniz the importance of innovation and capital for- cial markets at large. Association. Leibniz once said: “The more Jan Pieter Krahnen • Christian Wilde mation, and the impact of monetary policy we act according to reason, the freer we are, on interest rates, growth and wealth – those As an institute with staying power, we will and the more we are enslaved, the more we Guest Commentary issues are all in the area of Finance, and they have the privilege and the responsibility to allow ourselves to be governed by passions.” Do leveraged loans herald the are also connected among each other. address big questions and to initiate long- For me, this is a fitting motto for starting next financial crisis?_14 term projects which will help to improve the the Leibniz Institute for Financial Research Claudio Borio As a Leibniz Institute from 2020 onwards, role research can play in our society. In this SAFE. SAFE will provide academic support for such spirit, the Data Center, an infrastructure area News_12 topics of high social and political relevance. within SAFE, will cooperate with partners in Selected Publications_13 The key research questions for the next years several countries, aiming for better European Kind regards, Events_15 will cover the main fields in Europe’s financial financial market data. Jan Pieter Krahnen

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Regulating tail-risks: When and how prudential regulation should apply to shadow banking

In a new paper, we argue that supervi- provided by the regulated banking sector and supervision which focuses on the economic sors should prevent non-bank financial thus passing on tail-risks (i.e. very unlikely, but substance and the risk structure of NBFI trans- intermediation (NBFI) only viable due to severe events with highly negative market actions, rather than on their specific legal form. backing from public safety nets – cover- effects) to banks and, ultimately, into public In our view, the overarching policy objectives age which these institutions do not earn safety nets. Such access to public backstops underpinning prudential banking regulation Matthias Thiemann by complying with prudential banking distorts investors’ incentives, dulls market disci- are the same as those which should drive regula- Sciences Po & SAFE regulation. From this perspective, re- pline, and allows for risk-insensitive funding of tory intervention in NBFI: shadow banks which gulators should follow a normatively- shadow banking (see Adrian and Ashcraft, ultimately unload tail-risks onto public back- charged approach, looking deeper into 2012). Therefore, it is crucial that financial inter- stops should be regulated like banks, a change the transactional design of NBFI. If public mediaries who benefit from (indirect) access to which would remove the undue competitive safety nets carry tail-risks, prudential public safety nets also be subject to prudential advantages they derive from a lighter regula- rules should apply to NBFI just as they regulation as a counterbalance. tory burden. This approach would permit more would to regulated banks. Only supervi- efficient forms of financial intermediation, im- sors engaged in intense regulatory dia- Focusing on economic substance and risk peding regulatory arbitrage and thus enabling Tobias H. Tröger logue with the industry and gatekeepers structure beneficial innovation. Goethe University & SAFE will be able to arrive at informed and It follows that regulators should analyze the socially beneficial decisions. allocation of tail-risks involved in the trans- To understand the pivotal features of NBFI, i.e. actional structures of NBFI. For instance, banks the risk structure of financial innovation, we Shadow banking – now labeled NBFI by the pre-crisis carried the tail-risks of securitization suggest multipolar regulatory dialogues. These Financial Stability Board – maneuvers outside of transactions, but these transactions still provid- dialogues would bring together regulators, mar- the realm of prudential banking regulation. ed relief from regulatory capital requirements ket participants, and semi-public gatekeepers NBFI entities often refinance themselves on inasmuch as the securitized loan portfolios (lawyers, auditors, rating agencies). Efficient wholesale markets in a way that leads to fragili- were held by off-balance sheet vehicles and supervision of NBFI would require monitoring ties from leverage and liquidity/maturity trans- banks’ liquidity facilities were treated as low the production processes of financial innovation formation, just like in traditional banks. There- risk-weight exposures. We argue for a norma- and, in particular, learning about how nego- fore, NBFI also requires backstops, frequently tively-charged approach to prudential banking tiating regulated market participants and semi-

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public gatekeepers anticipate the regulatory of the regulator’s treatment of financial innova- Clearly, incentives need to be aligned to ensure approach, we use the recent contractual inno- treatment of new products. tions, have strong incentives to communicate that gatekeepers voluntarily provide relevant vations in European credit funds. Supervisors candidly about product developments. input. To create adequate motivations, super- in the EU embraced the basic structure of We argue that, in determining whether NBFI visors should help overcome the uncertainty in these funds as an alternative channel for credit implies tail-risks for public backstops, the bur- The important role of semi-public gatekeepers the regulatory treatment of specific forms of in 2015 (see figure 1). Over time, however, these den of proof should be reversed. To escape pru- Although respective gatekeepers are private bu- NBFI. Incentives aside, regulators must also hold funds have morphed to complex structures dential regulation, market participants would sinesses, their services directly affect public inter- gatekeepers accountable for the way in which which use higher leverage ratios to increase the need to show that the risk structure of their ests as they hedge regulatory compliance. They they share information, excluding them from profitabil ity of their business (see figure 2). transaction does not burden public backstops design financial innovations which, while formal- the interpretative community in case of mis- Therefore, fewer assets are available to service with tail-risks. Regulators, who lack in-depth ly compliant with the legal framework, still pro- behavior and depriving them of their ability to more debt, which makes the sudden exit of understanding of recent advances in transac- vide regulatory advantages. It therefore follows reduce uncertainty for their clients. investors more likely, thus increasing the risk of tional practices, and regulated institutions, who that regulators can gain a deeper un derstanding runs. To counter these fragi lities, funds now lack certainty about the pending decisions of relevant innovations from gatekeepers. To illustrate the potential benefits of our establish relationships with banks, meaning that public backstops may now have taken on the tail-risks investors are unwilling to bear. Asset liquidity coverage Asset Management Custodian Bank (subscription Foundation Manager credit facility) Company 100% loan notes loan notes loan notes equity (X% total Supervisors who want to understand the finan- (50% sub- (50% subordinated) fund capital) SubDebt cial stability implications of these developments ordinated) SubDebt Company Investor and determine an adequate regulatory reaction

Alternative 50% equity

loan origination 50% equity pledge of HoldCo shares sale of Investment fund need to scrutinize the allocation of tail-risks in Fund sale of loan portfolio Holding Company loan shares a multipolar regulatory dialogue. portfolio shareholder debt 100% equity (subordinated) loan notes (X% total fund capital) Loan Mezzanine References Bank Investor Operating Company portfolio Debt Investor pledge of Adrian, T. and A. B. Ashcraft (2012), loan portfolio upstream 100% equity “Shadow Banking Regulation”, Federal Reserve origi- and guarantee funding commercial paper nation of FinCo CP (X% total fund capital) of NY Staff Report No. 559. Loan Financing Company Commercial portfolio priority in bankruptcy Paper Investor The paper “It’s the Tail-risk, Stupid!” was

Figure 1: Basic transaction structure of European credit Figure 2: Advanced transaction structure of European credit funds illustrating the increasing complexity and incre- published as SAFE Working Paper No.260 and is funds. mental leverage not present in the funds’ initial design depicted in figure 1. available at: www.safe-frankfurt.de/tail-risk

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How horizontal links between industries can help to predict stock returns

It is well documented that vertical We consider industries to be related when they macroeconomic quantities. As an example, customer-supplier links between indus- operate in similar business environments and security brokers are increasingly confronted tries are the basis for strong cross-sec- are therefore likely to be exposed to similar with competition from other financial interme- tional stock return predictability. In a kinds of economic shocks. Relative to the exist- diaries, such as real estate agencies, insurance new study, we show that robust predict- ing literature, we add a new dimension to the companies, or money market funds, which all Christian Schlag ability also arises from horizontal links analysis of information flow between industries provide certain types of financial services. Goethe University & SAFE between industries – i.e. industries which over time. We show empirically that it generates are competitors or offer products which return predictability above and beyond that The fact that we find strong evidence in favor of function as substitutes for one another. documented in previous studies. In earlier work horizontally-linked industries exhibiting posi- These horizontally-linked industries ex- (e.g., Menzly and Ozbas, 2010), the focus is on tively-correlated fundamentals provides sup- hibit positively-correlated fundamentals. ‘vertical’ customer-supplier relationships be- port for this notion of connectedness between This has an impact on investment strate- tween industries. industries. Based on our empirical analysis, we Kailin Zeng gies, as informed investors take this suggest that this horizontal relationship be- Goethe University & information into account when they A plausible channel for robust return predict- tween industries is a plausible channel for robust Jiangxi University of form their portfolios. ability return predictability not captured by other types Science and Technology We label the new direction of the connection of links. Concerning the underlying economic What does the stock return of one industry tell between two industries ‘horizontal’. The basic mechanism, we argue that there are at least two us about the return of another, related one? idea is that firms in different industries can be channels through which horizontal lead-lag In this paper, we investigate the flow of infor- competitors, or their products can be substi- relations between firms in different industries mation between related industries over time tutes. Substitute industries can be closely re- can arise. The first channel is related to product and the question of whether this transmission lated concerning the operating business. More substitution. Even though firms belong to dif- of information is also visible in financial market precisely, equity prices in horizontally-related ferent industries, they may still produce goods prices. Does it generate return predictability? industries are driven by shocks to the demand of which are seen as close enough substitutes by We focus specifically on interdependencies joint down-stream customers, to the cost of customers. However, it may take time until between industries which are generated by supply materials purchased from joint up- news regarding a given industry is finally also economic links. stream suppliers, and to generally important processed by investors of firms in the substitute

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industry, meaning that a lagged return reaction stock price of the firms in the substitute indus- Compustat segment data. More precisely, for strongly suggests that the information con- may be observed in the substitute industry. try since, there, the news is only relevant for a a given industry, we count how often it is men- tained in the signal is less valuable for firms less important business segment. tioned together with another industry in the with a larger share of informed investors in The second channel is related to what might Compustat segment reports for the firms in their ownership. be called ‘segment momentum’. Firms belong- Technically, we generate our return predictor our sample (and then normalize this number ing to substitute industries will have their own based on horizontal connectivity in two main appropriately). Finally, we also investigate if institutional inves- distinct main business segments, but are also steps. First, we compute what we call the com- tors take the relatedness between firms into likely to have overlaps in segments of lesser im- bined predictor; then we regress this combined Long-lasting economic effects account when it comes to portfolio rebalancing. portance. An item of news regarding the respec- predictor on the vertical predictor, yielding We find that horizontal return predictability is We find that the presumably better-informed tive main segment may be processed very quick- the horizontal predictor as the residual. In our statistically and economically significant. Fur- investors indeed adjust their holdings of a ly by investors due to its pronounced relevance. paper, we directly compute the combined pre- thermore, the economic effects of horizontal certain stock by either the contemporaneous On the other hand, it may take investors longer dictive signal as a weighted sum of return-based predictability are long-lasting since we find that change of their holdings in the signal-producing to incorporate the same piece of news into the quantities, where the weight is calculated using the returns of our associated portfolio strategy firms (i.e., the firms in the related industries) or do not revert over horizons of up to twelve the contemporaneous signals based on factor 2.0 months (see figure). model residuals (and after controlling for other 1.8 1.6 return predictors). Moreover, the effect is more 1.4 Motivated by the analysis in Menzly and Ozbas pronounced for horizontally than for vertically- 1.2 1.0 (2010), we further investigate the role of in- related firms. 0.8 formed investors since they form the group 0.6 of market participants who presumably recog- References Cumulative Returns Cumulative 0.4 0.2 nize the relevance of the predictive signal and Menzly, L. and O. Ozbas (2010), 0 “Market segmentation and cross-predictability 0 2 4 6 8 10 12 form their portfolios accordingly. We find that, Month for firms with a very high degree of institutional of returns”, Journal of Finance, Vol. 65, pp. 1555-

Vertical signal Horizontal signal Combined signal ownership, the predictive signal becomes less 1580. important. Furthermore, the interaction term between the quintile dummy for institutional The paper “Horizontal Industry Relationships and Average cumulative returns of long-short portfolio strategies over the long horizon: Average cumulative returns for the long-short portfolio strategies based on the vertical, horizontal, or combined residual signal, for 1 month to 12 months ownership and the predictor becomes insignif- Return Predictability” was published in the Jour- after portfolio formation. Long-short strategy denotes the portfolio long the quintile of stocks with the highest signal icant for the 20 percent of firms with the high- nal of Empirical Finance, Vol. 53, September 2019, value and short the quintile of stocks with the lowest signal value. est degree of institutional ownership. This pp. 310-330.

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“Inside the Libra ecosystem, other ﬁnancial products could arise”

Facebook is planning to introduce a global digi- Similar to a central bank, a currency board issues nies support the project and are part of the foun- tal currency in 2020. How does Libra differ from domestic currencies; where it differs from a cen- dation, and the Libra reserve is not subject to other blockchain-based payment methods, such tral bank, however, is that for each unit of domes- access by Facebook. A run on the currency by Libra as Bitcoin? tic currency, a certain amount of another cur- investors as a result of Facebook encountering Maik Schmeling rency is put into a reserve and can be paid out if difficulties would probably be more the result of a Goethe University As a stablecoin version of a blockchain currency, necessary. Hong Kong is a good example: If the psychological effect than of anything else. How- & SAFE Libra is intended to hold the value of a coin stable Hong Kong Monetary Authority creates 7.8 Hong ever, the details of the system are not yet clear, so in relation to a benchmark: Libra would be an Kong dollars (HKD), one US dollar is put in the re- it is hard to say how influential Facebook will be. electronic means of payment whose value would serve. Thus, a currency board can guarantee that be kept stable against a basket of currencies, the exchange rate between the US dollar and the What opportunities does the project offer? although we do not yet know exactly how the Hong Kong dollar always remains 7.8. If the value basket will be structured. The other difference is of the HKD falls below the fixed exchange rate, I expect Libra to be attractive for users in certain that Bitcoin is decentralized while Libra will be you can buy HKD and exchange them for US dol- countries, especially those with un stable curren- managed by a group of big companies. There are lars at the higher rate and make a profit. The Libra cies. In these countries, it might be attractive to already other stablecoins such as Tether, for idea is similar. The biggest difference would be switch to Libra and thereby hold a basket of for- example: the idea is that for every Tether created, that there is a currency basket. The reserve con- eign, stable currencies. Holding a share of one’s one dollar is held in a reserve to back it; this tains several currencies – but this does not guar- assets in safe currencies, such as US dollars or In this interview about Facebook’s plan- should serve to keep the price of one Tether equal antee a fixed exchange rate to any particular cur- Swiss francs, for example, is not uncommon ned digital currency Libra, Maik Schmel- to one dollar. Where the idea behind Libra di- rency. At this point, it is also not clear whether the nowadays and Libra would be a relatively easy ing looks at its possible implications for verges is that the currency will be stable against a composition of the reserve can change over time. way to hold such foreign currencies, especially monetary policy and the banking sys- basket of various currencies – i.e. one Libra will be for smaller investors – and use these assets as a tem. A professor at Goethe University equivalent to the value of these other currencies. Would Libra’s stability also depend on Face- means of payment, too. since 2018, Schmeling holds the chair book’s reputation? for Finance. The focus of his research lies In SAFE Policy Letter No. 76, you compare Libra What would Libra mean for banks? on empirical asset pricing, international with a currency board. What are the similarities According to the proposals, the Libra Foundation finance, and monetary policy. and differences? will be independent of Facebook; many compa- If Libra is used extensively, banks’ payment

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transaction business would diminish. For exam- become important as a way of avoiding ex- In your assessment, how severe are the poten- How Libra is classified seems to depend very ple, a bank that grants consumer credits and change rate risks. Credit products such as loans tial risks to the financial system? much on the country: is it considered an elec- manages customer accounts learns a lot about are also needed to construct derivatives against tronic currency, a means of payment, or a type its customers from observing payments. Banks exchange rate risks; in short, if Libra were ad- Libra could become an extremely large cash of security? The latter would be subject to would lose this source of information and, in adopted to a significant extent, there would be a pool which contains a lot of short-term govern- different regulations, so it is hard to say at dition, parts of their cheapest funding. If cus- great demand for (credit) products not yet ment securities and be able to negotiate the the moment how Libra will be regulated. A fast tomers withdraw money from banks and con- planned. Problems would arise, how ever, be- terms of investments with large banks on equal and cheap global payment system would have vert it to Libra, banks would have to rely more cause no one would be responsible for those terms. This would put pressure on banks’ mar- advantages, of course, but a key question is on other sources of funding, which tend to be products: as it will be a global currency, which is gins, yet if there were a run on Libra, large sums who would be responsible for regulating this more expensive. Inside the Libra ecosystem, only subject to varying national sets of regula- could then be withdrawn at short notice. This system. Central banks would no longer have other financial products could arise. If many tion, there is no single natural regulator – no state of affairs would, of course, have implica- direct influence on a key part of the payment end-users rely on Libra for payments, for in- central bank to provide liquidity in the event of tions for the financial markets. There would be a system, leading to a weakening of their control stance, consumer or supplier credits will likely a crisis, for example. whole array of unregulated credit products, for over the financial system. If a high volume instance, because, even if there were tight of transactions takes place in a currency that regulation in place, these areas often migrate is not controlled, this can become a problem Libra into shadow systems – to countries with fewer for the transmission and the conduct of mone- Reserve regulations, for instance. It was a similar devel- tary policy. opment which lead to the creation of the Euro- dollar market, so if Libra were adopted on References

New libra units Basket of assets a large scale, a kind of shadow Libra system Lettau, M. and A. Madhavan (2018), might form. “Exchange-traded funds 101 for economists”, Journal of Economic Perspectives, Vol. 32, pp. How should financial supervision react? And 135-154. Currency Currency Foreign Authorized what does Libra mean for central banks and the Libra user exchange Reseller Money Market effectiveness of the monetary policy? The paper “What is Libra? Understanding Face- Libra coins Assets book’s Currency” was published as SAFE Policy Let- Depending on which legislation is applied, its ter No. 76 and is available at: www.safe-frankfurt. How money is made: Potential mechanism for Libra creation. Adapted from Lettau and Madhavan (2018). use as a means of payment can be prohibited. de/understanding-libra

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The long-term viability of sovereign bond-backed securities

backed by a portfolio of government as a risk for financial stability. The relative scar- up this proposal, recently has issued its version bonds. We argue that a relatively large city of safe assets in the Eurozone is believed to of SBBS securities in a proposal for a regulation junior bond, a minimum free-float of worsen if the volume of outstanding govern- (European Parliament, 2019). In the SBBS model, sovereign bonds, and a limit on total ment debt is decreasing, like in the case of Ger- the pooling and tranching of a portfolio of gov- SBBS volume, are key for ensuring the many or the Netherlands, now at or below 60 ernment bonds generate two new asset classes, Jan Pieter Krahnen long-term viability of the proposed safe percent and 50 percent of GDP, respectively. This one safe – the senior bond – and the other risky Goethe University & SAFE asset regime. Moreover, governance rules trend has reinforced the search for safe assets. – the junior bond. The attractive and perhaps need to be credible to achieve accep- surprising feature of it is that, due to the tech- tance in the market. “Eurobonds” never really took off nique of securitization, the safe bond does not The first generation of policy proposals champi- need a government backing, nor an explicit risk- The severity of the European debt crisis be- oned “Eurobonds”. Those bonds have a fiscal sharing among participating countries. The tween 2008 and 2012 is widely attributed to the backstop underwritten by all issuer govern- authors of the SBBS proposal argue that SBBS doom loop between the sovereign debt of a ments jointly. However, the idea never really do not imply debt mutualization, neither directly country and the stability of its banks, which was took off since some countries, including Ger- nor indirectly. Christian Wilde fuelled by banks holding own sovereign debt in- many, rejected Eurobonds as a path to debt Goethe University & SAFE stead of safe assets. Safe assets play an impor- mutualization in Europe, because of moral Our paper focuses on the potential for moral tant role in modern financial markets: they are hazard concerns (Kotz et.al., 2011). hazard in these new instruments, and on design used as collateral in derivative markets, for re- features that may mitigate these unwelcome In a new SAFE White Paper, we discuss purchase agreement transactions in interbank Brunnermeier et.al. (2011) propose a private risks. The first important design element is the sovereign bond-backed securities (SBBS) markets, and in transactions with the lender of market solution to safe asset scarcity by sug- credit enhancement condition, describing a recently proposed by the European Par- last resort. gesting a way to create senior financial instru- minimum size of the subordinate, first loss part liament. SBBS are intended to mitigate a ments, based on the pooling and subsequent of the SBBS scheme. The junior SBBS bonds will shortage of safe assets in Europe, there- German government bonds are the preferred tranching of Euro area government bonds. Their absorb almost all losses that may accrue in the by enhancing financial stability. The pro- collateral asset class in Europe, while US trea- proposal for Sovereign Bond-Backed Securities underlying portfolio of sovereign bonds ensur- posal suggests issuing a new type of se- sury bills play a similar role worldwide. A short- (SBBS) has caught considerable attention from ing AAA-rating quality for senior SBBS bonds at curities with different levels of seniority, age of safe assets in the markets is widely seen policymakers. The European Parliament, taking issuance. Figure 1 shows how an increase in the

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size of the junior bond reduces the remaining markets, and by calling in ESMA to define suit- may need to bail out the insolvent sovereign to conditions: sufficient credit enhancement, mini- default risk of the senior bond. However, ab- able standards and to monitor subsequently. stabilize the safe asset status of the senior mum free-float, and an upper limit for the size sorption of expected losses per se may not be While liquidity is related to informativeness, the bonds. A size limitation on the total SBBS mar- of SBBS schemes altogether. On top of this, enough to preserve the AAA-status of a safe as- two concepts are not identical. ket is an appropriate way to mitigate the risk of the long-term viability of SBBS as safe assets set at all times, particularly if large losses ‘bite’ bailouts and hold-up situations. will require appropriate SBBS governance, in- into the junior bond. This would preliminarily A further moral hazard situation may arise cluding a type of self-commitment of all par- leave the senior bond untouched, but with an when senior SBBS tranches become the domi- Policy discussion ticipants to leave the rules governing SBBS- increased default expectation, endangering its nant collateral-type used in financial markets. The SBBS regime, as envisaged by the Commis- construction untouched, even in financially dif- AAA-status. Therefore, the calibration of the To see how moral hazard can creep in through sion and the European Parliament, will require ficult times. size of the junior SBBS tranche needs to consider the use of SBBS safe assets, imagine a default of coordination by a designated public authority, dynamic safety, i.e. ensure the ongoing AAA- one larger country’s sovereign debt. Because of e.g. ESMA. The challenges for the mandated References status of senior SBBS tranches which is the basis the expected negative consequences on the rat- authority will be to operationalize solid SBBS Brunnermeier, M., Garicano, L., Lane, P., Pagano, for its use as a safe asset. ing of all senior SBBS tranches other countries construction rules containing three minimum M., Reis, R., Santos, T., Thesmar, D., Van Nieuw- erburgh, S. and D. Vayanos (2011), The second important design element we are Expected loss rate of senior tranche Price informativeness European safe bonds (esbies), Working paper. 3.5% stressing is the impact an SBBS portfolio may exert on the pricing of sovereign bonds in the 3.0% European Parliament, Committee of Economic secondary market. The free-float of these bonds and Monetary Affairs (2019), 2.5% needs to be large enough to allow for unbiased “Report on the proposal for a regulation of pricing of each of them, despite their reduced 2.0% the European Parliament and of the Council on circulation due to SBBS issuance. Figure 2 illus- sovereign bond-backed securities” http://www. 1.5% trates the relationship between free-float and europarl.europa.eu/doceo/document/A-8- Experted loss rate the informativeness of market prices. Price in- 1.0% informativeness Price 2019-0180_EN. html formativeness is essential for the proper func- 0.5% tioning of market discipline, reducing moral Kotz, H. H., Krahnen, J. P., Leuz, C. and H. Siek- 0.0% hazard and keeping debt levels of sovereigns in mann (2011), 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 check. As a consequence, the minimum market Eurobonds zur Bewältigung der europäischen Size of junior tranche Share of free-float size of free-floating securities is needed to Krise? Wegweisung zu einer modernen Entwick- ensure the viability of the concept. lungsunion, SAFE White Paper No. 7. Credit enhancement and free-float: Figure 1 on the left depicts graphically how the 5-year expected loss rate of the senior SBBS tranche depends on the size of the junior SBBS (credit enhancement). The numbers on the expected loss The proposal of the European Parliament ad- rate base on a portfolio of Euro-area sovereign bonds to be included in the SBBS scheme. Figure 2 on the right displays The paper “The long-term viability of Sovereign dresses this issue indirectly by setting a mini- the positive relationship between the size of the secondary market (measured by free-float to total issue Bond-Backed Securities“ will be published as mum standard for liquidity in secondary bond volume, x-axis) and the level of price informativeness (y-axis). SAFE White Paper No. 64.

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News

Experts from the House of Finance appointed Simone Wies receives DFG funding for a new to advisory bodies research project

Nicola Fuchs-Schündeln has been appointed to the new Franco-German Council of SAFE researcher Simone Wies has re- stock exchange and their innovation efforts; specifi- Economic Experts; the new body was launched at the end of September in Paris. A ceived a positive funding decision for cally, she will examine whether there are companies Professor of Macroeconomics and Development at Goethe University Frankfurt since her new research project from the which continue to introduce innovations after IPO and, 2009, Fuchs-Schündeln is also a principal investigator at SAFE. Furthermore, Peter German Research Foundation (Deut- if so, which factors are decisive. Wies has held the Alt maier, the Federal Minister for Economic Affairs and Energy, has appointed Christine sche Forschungsgemeinschaft, DFG). SAFE Junior Professorship for Marketing and Finance Zulehner as a new member of the Scientific Advisory Board of the Federal Ministry. The title of her research project is at Goethe University Frankfurt since 2014. Previously, Zulehner has held a professorship at the Department of Economics of the University “Combatting the Wall Street Curse on Firm Product she was a post-doctoral researcher at the Fuqua of Vienna since 2017; from 2013 to 2017, she held the SAFE Professorship for Industrial Innovation”. The DFG will fund the project over the School of Business at Duke University in Durham. Organization and Financial Markets at Goethe University. next three years. In her project, Wies will be dealing Wies’ research interests lie in the interactions be- with the interplay between firms floating on the tween capital markets and management decisions.

Klaus Regling: Need for further reforms in the 7th Frankfurt Conference on Financial Market Policy: European Monetary Union European Banking – Too much competition?

At a SAFE Policy Panel in September, Klaus Regling, the first Managing In mid-November, academics, mar- Three panels addressed different aspects of the Director of the European Stability Mechanism (ESM), reviewed the begin- ket participants, and regulators dis- question of whether the European banking market nings and necessity of the European backstop institution. With Benoît cussed what impact competition in is overbanked. The panelists such as Ignazio Ange- Cœuré, Member of the Executive Board of the European Central Bank (ECB), the banking market has on both loni (Single Resolution Board), Jan Krahnen (Goethe and SAFE Director Jan Krahnen, Regling discussed the future role of the financial stability and banks’ profit- University and SAFE), and Isabel Schnabel (Univer- ESM. In his view, the ESM has been crucial to stabilizing the European ability. Member of the Supervisory sity of Bonn) agreed that since the financial crisis Monetary Union (EMU) in the financial crisis. Although the ESM is planned to be extended Board of the Single Supervisory Mechanism, Kerstin of 2008, instabilities at the financial market have 2020, Regling sees the need for further reforms, advocating more fiscal risk-sharing among af Jochnick, said in her keynote that a sustainably declined. They also addressed issues such as con- the member states; national governments have lost both monetary and exchange rate stable financial market can only be reached by har- tinued low profitability, the digitization of financial policy as an instrument to respond to macroeconomic shocks, he argued. Cœuré monizing regulation and completing the Banking services, and new competitors as current challenges recommended integrating the ESM into the community framework to make it formally Union; in her view, progress on the third pillar, a for supervision. accountable to the European Parliament. common deposit insurance, is particularly necessary.

12 SAFE • Selected Publications • Quarter 4/2019

Selected Publications

Baums, T. (2019) Clapham, B., Siering, M. and P. Gomber (2019) Recent SAFE Working Papers “Ein neuer Schleichweg? Zur Auslegung des “Popular News Are Relevant News! § 38 WpHG”, How Investor Attention Affects Algorithmic Begmann, A., Hoffmann-Becking, M. and Decision-Making and Decision Support in Ai, H., Li, J. E., Li, K. and C. Schlag (2019) Thiemann, M. and T. Tröger (2019) U. Noack (eds.), Recht und Gesetz. Festschrift Financial Markets”, “The Collateralizability Premium”, “It’s the Tail-Risk, Stupid!”, für Ulrich Seibert, pp. 31-44. forthcoming in Information Systems Frontiers. SAFE Working Paper No. 264. SAFE Working Paper No. 260.

Blaseg, D., Schulze, C. and B. Skiera (2019) Schlag, C. and K. Zeng (2019) Horneff, V., Liebler, D., Maurer, R. Aldasoro, I., Balke, F., Barth, A. and “Consumer Protection on Kickstarter”, “Horizontal Industry Relationships and Return and O. S. Mitchell (2019) E. Eren (2019) forthcoming in Marketing Science. Predictability”, “Implications of Money-Back Guarantees “Spillovers of Funding Dry-ups”, Journal of Empirical Finance, Vol. 53, pp. 310-330. for Individual Retirement Accounts: SAFE Working Paper No. 259. D’Hoir, J. and K. Langenbucher (2019) Protection Then and Now”, “Regulation of digital assets – How France and Tröger, T. (2019) SAFE Working Paper No.263. Grajales-Olarte, A., Uras, B. and Germany are paving the way for an EU reform”, “Toward a Better Bail-in Tool: Observations N. Vellekoop (2019) Revue Trimestrielle de Droit Financier. from a European Perspective”, Bedin, A., Billio, M., Costola, M. “Rigid Wages and Contracts: in: Arner, D., Avgouleas, E., Busch, D. and S. and L. Pelizzon (2019) Time- versus State-Dependent Wages Schwarcz (eds.), Systemic Risk in the Financial “Credit Scoring in SME Asset-Backed in the Netherlands”, Sector: Ten Years After the Great Crash, Securities: An Italian Case Study”, SAFE Working Paper No. 258. McGill-Queen’s University Press. SAFE Working Paper No. 262. Massenot, B. and G. Nghiem (2019) Billio, M., Costola, M., Pelizzon, L. “Depressed Demand and Supply”, and M. Riedel (2019) SAFE Working Paper No. 257. “Buildings’ Energy Efficiency and the Probability of Mortgage Default: The Dutch Case”, SAFE Working Paper No. 261.

The SAFE Working Papers can be downloaded at http://safe-frankfurt.de/working-papers

13 SAFE • Guest Commentary • Quarter 4/2019

Do leveraged loans herald the next ﬁnancial crisis?

subprime mortgage market in the lead-up to diversification, as an increasing volume of structure should make it easier to assess the risk Claudio Borio the crisis. Then, collateralized debt obligations invested capital was exposed to a relatively nar- of losses and their timing. Moreover, larger Head of the (CDOs) were the focus. Both are asset-backed row set of assets. Moreover, CDO complexity junior tranches mean senior CLO tranches are Monetary and Economic securities which transform illiquid assets into made it difficult to gauge the risk that the un- better insulated from losses. Department marketable securities. Both are structured in derlying assets could default in quick succession. at the Bank of tranches of different seniority, with the more When the housing market faced a downturn, A key difference between pre-crisis CDOs and International Settlements junior tranches earning the highest yields, but investors panicked over mounting and synchro- current CLOs is that direct bank exposure is now being the first to absorb credit losses. Con- nized credit losses, amplifying financial stress. more visible, not least owing to regulatory versely, the most senior tranche receives the changes. That said, holdings tend to be concen- lowest yield, but is the last to absorb losses. Banks suffered significant losses because they trated in a few institutions and the indirect, held large amounts of CDOs, sometimes through more opaque exposures could still create vulner- Concerns have increased over the complexity off-balance sheet vehicles which masked their abilities. Banks provide large amounts of credit Since the 2008 financial crisis, the lever- and funding arrangements of CLOs, as well as exposure. Often, those vehicles funded them- to leveraged investors in CLOs, like hedge funds. aged loan market has doubled in size the direct and indirect exposure of banks and selves in the wholesale short-term markets, A significant share of this lending takes place to about 1.4 trillion dollars. The rapid other financial intermediaries. In particular, can making them and their sponsoring banks vulner- through “synthetic prime brokerage”, which growth was fuelled in part by collate - all these features interact in ways which would able to liquidity squeezes; despite the fact that involves heavy use of derivatives. Derivatives ralized loan obligations (CLOs), a type of magnify financial distress? banks held mostly senior CDO tranches, credit reintroduce an element of complexity which securitization which accounts for about losses occurred because the CDO portfolios were could muddle the assessment of indirect bank 50 percent of outstanding leveraged CDOs were very complex structures, investing very poorly diversified. exposure to CLO losses. loans, as well as by declining lending mainly in subprime mortgage-backed securities. standards. Investors’ appetite for subprime mortgage ex- In comparison, CLOs are typically backed by rela- Improved post-crisis practices and regulations posure outpaced actual issuance in the early tively well diversified pools of leveraged loans. mean that CLOs only partly resemble CDOs. The role CLOs have played in sustaining the 2000s. In response, CDO portfolio managers in- Currently, they largely avoid investing in credit Nonetheless, the opaque links between banks growth of risky debt has drawn the attention of creasingly invested in other CDOs, or even credit default swaps and other securitizations, and and leveraged CLO investors mean that CLOs regulators and policymakers alike, not least default swaps, which replicated the pay-off of funding by short-term borrowing is not as preva- could still turn into the Achilles heel of the finan- because it echoes developments in the US securitized mortgages. The cost was a loss of lent as it was for CDOs. In principle, the simpler cial system.

14 SAFE • Events • Quarter 4/2019

Events

December January 29 January Finance Brown Bag Seminar 2.00 – 3.00 pm Speaker: Christine Laudenbach, 16 December CFS Lecture with IBF 14 January Finance Seminar – Joint with SAFE Goethe University Der deutsche Wohnungsmarkt in Geschichte 12.00 am – 1.15 pm Speaker: Martin Brown, University of St. Gallen 29 January CFS Lecture with IBF und Gegenwart: eine historisch-vergleichende 14 January Frankfurt Macro Seminar – Joint with SAFE 5.30 – 7.00 pm Speaker: Matthias Morys, University of York Perspektive 2.15 – 3.45 pm Speaker: Vincent Sterk, Speaker: Sebastian Kohl, Max Planck Institut University College London für Gesellschaftsforschung February 15 January Finance Brown Bag Seminar 16 December CFS Book Presentation 04 February Finance Seminar – Joint with SAFE 2.00 – 3.00 pm The “Google Effect”: Linking Organic Search 12.00 am – 1.45 pm The Long Journey of Central Bank 12.00 am – 1.15 pm Speaker: Doron Avramov, Visibility to Shareholder Value Communication Hebrew University of Jerusalem Speaker: Gabriela Alves Werb, Goethe University Speaker: Otmar Issing, CFS 04 February Frankfurt Macro Seminar – Joint with SAFE 21 January Finance Seminar – Joint with SAFE 17 December Finance Seminar – Joint with SAFE 2.15 – 3.45 pm Speaker: Alexander Chudik, 12.00 am – 1.15 pm Speaker: Hugues Langlois, HEC Paris 12.00 am – 1.15 pm Speaker: Giorgia Piacentino, Federal Reserve Bank of Dallas Columbia Business School 22 January Finance Brown Bag Seminar 11 February Finance Seminar – Joint with SAFE 2.00 – 3.00 pm Econlinguistics 17 December Frankfurt Macro Seminar – Joint with SAFE 12.00 am – 1.15 pm Speaker: Svetlana Bryzgalova, Speaker: Sasan Mansouri, Goethe University 2.15 – 3.45 pm Marriage Market and Labor Market Sorting London Business School Speaker: Ilse Lindenlaub, Yale University 23 January ICIR Talks on Insurance and Regulation 11 February Frankfurt Macro Seminar – Joint with SAFE 6.00 pm Liquidity Risk in Insurance: Academic, Industry 18 December Finance Brown Bag Seminar 2.15 – 3.45 pm Speaker: Philipp Harms, University of Mainz and Regulatory Perspectives 2.00 – 3.00 pm Speaker: Sigurd Anders Muus Steffensen, 12 February Finance Brown Bag Seminar Aarhus University 28 January Finance Seminar – Joint with SAFE 2.00 – 3.00 pm Counterparty Exposures and Collateral Require- 12.00 am – 1.15 pm Speaker: Thorsten Beck, Cass Business School ments under Bilateral and Central Clearing 28 January Frankfurt Macro Seminar – Joint with SAFE Speaker: Xu Liu, Goethe University 2.15 – 3.45 pm Investment slumps during financial crises:

The real effects of credit supply March Speaker: Plutarchos Sakellaris, Athens University of Economics and Business 12 March CFS Conference Management of non-financial risk

CFS Center for Financial Studies GBS Goethe Business School EFL E-Finance Lab Frankfurt am Main IBF Institut für Bank- und Finanzgeschichte Please note that for some events registration is compulsory. 15 SAFE | Sustainable Architecture for Finance in Europe A Cooperation of the Center for Financial Studies and Goethe University Frankfurt