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Journal Article
Market discipline and subordinated debt: a review of some salient issues
Requiring banks to issue subordinated debt is one proposal to bring market discipline to bear in aiding regulatory supervision. This article explores the frictions that produce a need for discipline (agency problems) and the mechanisms markets have evolved for dealing with these frictions. Following an examination of the rationales and assumptions underlying subordinated debt proposals, the article concludes that the case tying regulatory intervention to subordinated debt spreads is not clear-cut, and that use of all available information, including equity returns and debt yields, when ...
Journal Article
A comparison of U.S. corporate and bank insolvency resolution
In the U.S., the insolvency resolution of most corporations is governed by the federal bankruptcy code and is administered by special bankruptcy courts. Most large corporate bankruptcies are resolved under Chapter 11 reorganization proceedings. However, commercial bank insolvencies are governed by the Federal Deposit Insurance Act and are administered by the FDIC. These two resolution processes?corporate bankruptcy and bank receiverships?differ in a number of significant ways, including the type of proceeding (judicial versus administrative); the rights of managers, stockholders, and ...
Working Paper
The stability of interest rate processes
This paper presents a careful reexamination of Chan, Karolyi, Longstaff, and Sanders (CKLS 1992). By redefining the possible regime shift period in line with evidence from known policy changes and past empirical research, we find evidence that contradicts the major results in their paper. The widely cited conclusion of their paper is that the elasticity of interest rate volatility is 1.5. CKLS also concluded that there was no structural shift in the interest rate process after October 1979. When the structural shift period is defined to be temporary and coincident with the Federal Reserve ...
Working Paper
The pitfalls in inferring risk from financial market data
This paper examines two qualitative rules of thumb, frequently invoked in discussions of bank regulatory policy. The first, that equity holders prefer more risk to less, derives from a result in option pricing theory, that an option's value increases monotonically with the riskiness of the underlying asset. This result is shown to depend on very restrictive assumptions regarding the underlying assets return distribution and the type of option being considered. These restrictive assumptions do not generally obtain in practice. The second rule of thumb is that bondholders' and deposit insurers' ...
Journal Article
Movements in the term structure of interest rates
Bond prices tend to move together. Stocks tend to go their own way. This distinction requires completely different approaches to managing risks for these securities. For equities the emphasis is on reducing idiosyncratic risk through portfolio diversification. For interest rate-sensitive securities it is on precisely balancing a portfolio to achieve the desired exposure to systematic risk factors. ; Hedging to reduce or eliminate the common factors influencing an interest rate-sensitive portfolio's value requires a model of interest rate behavior. This article reviews and extends previous ...
Working Paper
Resolution of large complex financial organizations
The resolution of a large complex financial organization (LCFO) presents numerous problems, including organizational complexity, opacity of positions, and conflicting legal jurisdictions. Of particular concern is the potential impact of large derivatives books. Widespread adoption of laws permitting close-out of derivatives contracts exempts these contracts from the usual stays that provide time for the orderly resolution of claims by the courts. Thus, a potentially significant part of the LCFO's assets and liabilities are exempted from normal bankruptcy procedures, creating the potential for ...
Newsletter
Common sense about executive stock options
Journal Article
Bankruptcy law and large complex financial organizations: a primer
Large complex financial organization (LCFOs) are exposed to multiple problems when they become insolvent. They operate in countries with different approaches to bankruptcy and, within the U.S., multiple insolvency administrators. The special financial instruments that comprise a substantial portion of LCFO assets are exempted from the usual "time out" that permits the orderly resolution of creditor claims. This situation is complicated by the opacity of LCFIs' positions, which may make them difficult to sell or unwind in times of financial crisis. This article discusses these issues and their ...
Journal Article
Policy essay - risk-based bank capital: issues and solutions
Market risk has become an integral consideration in bank business. Derivatives are increasingly used as a means of risk management, and bank involvement in derivatives trading represents a new, different, and very important line of business. Existing regulations for the determination of bank capital, based on the quality of assets held, are not appropriate for trading portfolio assets where exposure to market risk factors is of primary importance. ; This essay discusses three major proposals for dealing with market risk in determining banks' risk-based capital. The standard and internal model ...