Finance: Research, Policy and Anecdotes

Frontier research in macro-pru

The Ieke van den Burg Prize (for outstanding research conducted by young scholars on a topic related to the ESRB’s mission) was today awarded in Frankfurt and I am very happy to report that I have a link to one of the two prize-winning papers.*  My former PhD student Andre Silva (now at the Federal Reserve Board in Washington DC) won the prize for his job market paper Strategic Liquidity Mismatch and Financial Sector Stability, forthcoming in the Review of Financial Studies. Andre shows the importance of the systemic dimension of liquidity. Specifically, he finds that banks strategically incorporate their competitors’ liquidity mismatch policies when determining their own liquidity position. While it is typically difficult to identify such peer effects due to the reflection problem and unobserved effects, he uses network structures and cross-border ownership linkages to construct a valid IV to account for potential correlated effects.  He also shows that such peer effects in liquidity positions are driven by asset- rather than liability-side effects and asymmetric, with individual banks mimicking their respective peers only when competitors are increasing funding liquidity risk.  And these effects also have important stability implications, with correlated riskier liquidity positions resulting in lower idiosyncratic and systemic bank stability. Together, these results emphasize the importance of regulating liquidity risk from a macroprudential perspective; while Basel III has introduced micro-prudential liquidity requirements, Andre’s paper shows the importance of moving to a more systemic approach.



The other paper awarded the price is by Guillaume Vuillemey and is forthcoming in the Journal of Finance. The Value of Central Clearing assesses the effect of the first Central Clearing Counterparty House (CCP) in 1882 in Le Havre for coffee futures.  This new contractual institution allowed coffee traders to insulate themselves against counterparty risk.  The effect on coffee trade were significant, with more coffee imports channelled through Le Havre, even if subsequently sold to other European countries. There was also a smoothing effect on coffee consumption!  Guillaume shows that the CCP helped complete the market, both reducing asymmetric information between traders and offering insurance against counterparty default (as this is taken by the CCP). The success of this first CCP was soon replicated in other European exchanges. This quite insightful historic study shows that financial innovations such as a clearing house can have positive effects on the real economy.   After the Global Financial Crisis there was another global push to bring more derivatives onto CCPs, though this was mostly for transparency and stability reasons. However, one important lesson from this and one of Guillaume’s other papers is that high equity, high margin requirements, and good governance are critical for the success of a CCP – in a paper with Vincent Bignon, published in the Review of Finance (with me as responsible editor) he analyses the failure of a CCP for sugar futures in Paris in 1974, related to poor risk management and weak governance structures.


Together, these papers show the importance of specific regulations and institutions for systemic stability.  They also show the diversity of tools being used in modern finance research – on the one hand, bank-level data with a carefully constructed instruments; on the other hand, a historical study offering important insights for the present!


*Important clarification – these prize winners are chosen by ASC members; I did not participate in the final voting round given my link to Andre’s paper!