Contemporary Issues in Financial Institutions and Markets

Volume II

Claudia Girardone, Philip Hamill, John Wilson

• Publisher: Routledge
• Year: 2016
• eBook ISBN: 9781317610038
• Edition: 1
• Topic: Economía
• Subtopic: Teoría económica

This book showcases recent academic work on contemporary issues in financial institutions and markets. It covers a broad range of topics, highlighting the diverse nature of academic research in banking and finance. As a consequence the contributions cover a wide range of issues across a broad spectrum, including: capital structure arbitrage, credit rating agencies, credit default swap spreads, market power in the banking industry and stock returns. This timely collection offers fresh insights and understandings into the ongoing debates within and between the academic and professional finance communities.

This book was originally published as a special issue of the European Journal of Finance.

Introduction

Contemporary issues in financial markets and institutions

The second Emerging Scholars Conference in Banking and Finance took place at Cass Business School, City University, London, on 9 December 2010. It was jointly organised by The British Accounting and Finance Association’s Financial Markets and Institutions-Special Interest Group (FMI-SIG) and the Centre for Banking Research at Cass Business School. A key objective of the FMI-SIG is to provide opportunities for emerging scholars to debate their work in a constructive collegial environment and to support early-career scholar’s transition into the academic community. To that end, the emerging scholars’ conference was accompanied by a special issue of the European Journal of Finance. The theme for the conference was contemporary issues in financial institutions and markets. It was deliberately general to reflect the diversity of research across FMI, and to encourage as broad a submission as possible from emerging scholars with the overriding objective of promoting the best work at the conference and in the special issue.

Two excellent plenary sessions complemented the emerging scholar’s papers. Dr Peter Hahn (City University) opened the proceedings with a critique of evolving remuneration policy in the financial services sector entitled Regulation of Executive Compensation. Professor Thorsten Beck’s (European Banking Centre; Tilburg University) keynote address – Villain or Solution? Cross-border Banking and the Global Crisis – discussed the contribution of cross-border banking to the financial crisis and concluded by arguing that the geographic outreach of banks should be matched with a corresponding regulatory and resolution framework. From over 50 submitted papers, 12 were chosen from the refereeing process for presentation at the conference with 5 published in this special issue. The first three selected papers share credit as a common over-arching theme; the first paper investigates the returns from investing in naked credit default swaps (CDS), the second introduces a new test of credit rating agency’s performance, while the third paper evaluates the determinants of CDS spreads and whether CDS spreads can be considered a good proxy for bank risk. The fourth paper investigates the implications of market power and funding strategies for bank interest margins for emerging and developing countries. The final paper assesses how a range of sentiment proxies affects returns of value and growth stocks, and aggregate markets returns, across G7 economies. The remainder of this editorial summarises the key insights from each paper.

Because of its speculative nature, trading in naked CDS has been subject of intense debate over the last few years, and not just in relation to the 2007–2009 financial turmoil but also for the more recent Eurozone crisis.¹ An interesting insight into CDS and capital structure arbitrage is given by Giovanni Calice, Jing Chen and Julian Williams in the article entitled: ‘Are there benefits to being naked? The Returns and Diversification Impact of Capital Structure Arbitrage’. The study proposes a novel testing framework to establish whether the inclusion of naked CDS positions in an optimised portfolio is replicable by a large set of alternative assets. More specifically, the method uses first and second moments and co-moments to assess replicability of asset returns under different portfolio optimisation regimes. The data sample spans from January 2004 to August 2010 and most estimated results are divided over two sample periods (pre- and post-2007) to account for the recent financial crisis. The empirical analysis reveals that investing in naked CDS yields significant excess returns of approximately 28% per annum. It also suggests that these systematic abnormal returns are inherently unstable and could potentially initiate a bubble in CDS prices. On the one hand, this study gives solid evidence that that there are considerable potential gains for speculative traders and investors for trading in naked CDS. On the other hand, it raises concerns about the potential economic and social benefits deriving from naked CDS contracts.

Normally, rating agencies play a pivotal role in financial markets globally through the production and dissemination of credit information. Their ability to produce timely and accurate ratings is valued by investors while at the same time enhancing the credibility of the best performing agencies in a competitive market (Güttler and Wahrenburg 2007; Alsakka and ap Gwilym 2010). Soon after the onset of the financial crisis in 2007, it became clear that many credit ratings were suspect. There is no doubt that overly optimistic ratings, due to unrealistic model inputs and the conflict of interest that arose as rating agencies received relatively higher fees from issuers for rating structured products, exacerbated the banking crisis (Crouhy, Jarrow, and Turnbull 2008; Brunnermeier 2009). Given this backdrop, the paper The Path to Impairment: Do Credit Rating Agencies Anticipate Default Events of Structured Finance Transactions? by Matthias Bodenstedt, Daniel Rösch and Harald Scheule assesses the ability of credit rating agencies to adjust their ratings prior to impairment of structured finance transactions, and develop a new metric – the anticipation coefficient – which quantifies a rating agency’s performance in advance of defaults. The advantage of the anticipation coefficient is its ability to incorporate ratings information for a 1-year period which contrasts with the typical focus on ratings at origination or at the beginning of the year. Utilising ratings by Moody’s Investor Service for 13,679 structured finance transactions with impairments between 2001 and 2008, the authors show that Moody’s ability to identify higher levels of impairment risk deteriorated significantly in the global financial crisis. And that differences in Moody’s performance could be partially explained by deal-specific and macroeconomic factors. Overall, the findings from this paper suggest that ratings do not consistently reflect increased risk prior to impairments and factors including deal volume, asset type, time since origination and the overall economic situation should be considered in tandem with ratings.

CDS are thought to have played a significant role during the recent financial crisis (Stulz 2010). CDS are contracts that make it possible to isolate and transfer credit risk, and as such have become useful as indicators of an organisation’s credit risk (Hull, Predescu, and White 2004). These instruments have also led to investors to bet on the likelihood of bankruptcy or default of a given organisation and in some cases led to contagion effects within the financial system (Jorion and Zhang 2007). Recent evidence suggests that CDS spreads could provide regulators and investors with important information with respect to the risk of individual financial institutions (Völz and Wedow 2011). The paper The Determinants of Bank CDS spreads: Evidence from the financial crisis by Laura Chiaramonte and Barbara Casu investigate the determinants of CDS spreads for a sample of large international banks over three time periods comprising: a pre-crisis period; a crisis period; and a less acute crisis. The results of the empirical analysis conducted by the authors suggest that bank CDS spreads reflect the risk captured by bank balance sheet ratios. Furthermore, the determinants of bank CDS spreads vary through time with general economic and bank-specific conditions (such as liquidity).

Market failure or anti-competitive behaviour on the part of banks has far-reaching implications for productive efficiency, consumer welfare and economic growth. In recent years, a literature that is largely confined to developed countries has sought to explain the importance of competition (or market power) for bank performance (Carbó Valverde and Rodriguez Fernandez 2007; Goddard et al. forthcoming). The paper entitled The impact of market power and funding strategy on bank interest margins by Mohammed Amidu and Simon Wolfe examines the implications of market power and funding strategies for bank interest margins (net interest margin, NIM). Utilising a large sample of banks located in emerging and developing countries over the period 2000–2007, the authors find a negative relationship between size and cost to income ratio and NIM, and a positive relationship between credit risk and NIM. Furthermore, the type of funding plays an important role in explaining variations in NIM.

An ongoing debate within, and between, the academic and professional finance communities is the extent to which stock returns and well-documented anomalies can be explained by the traditional risk-return trade-off paradigm or explanations offered by behavioural finance. Mostly, the US centric empirical evidence identifies factors unrelated to fundamentals as important determinants of stock returns (Baker and Wurgler 2006; Barber and Odean 2008; Green and Hwang 2009; Tetlock 2011). Understanding the influence of relevant factors across markets is important for global investors. The paper An Examination of Investor Sentiment Effect on G7 Stock Market Returns by Deven Bathia and Don Bredin investigates how sentiment proxies (consumer confidence index, equity fund flow, closed-end equity fund (CEEF) discount and the equity put-call ratio) affect value and growth stock returns, and aggregate market returns for G7 (US, Canada, UK, France, Germany, Italy and Japan) capital markets from January 1995 to December 2007. Assessing how a range of sentiment proxies affects returns, not only for aggregate markets returns, but also value and growth stocks across markets in a noticeable gap in the literature motivates this paper. The first insight reported is the disproportionate influence of survey sentiment on value stocks relative to growth. The authors also provide evidence of price pressure on value stocks and the market due to an increase in equity fund flow. In contrast to the US evidence, the authors also report that CEFF discount enters into the returns generating process with a narrowing of the CEFF discount associated with an increase (decrease) in value (growth) stocks returns. Collectively, these findings confirm the efficacy of both variables as valid sentiment proxies and highlight the significant influence of individual investors in affecting returns. The final sentiment variable, the equity put-call ratio, was only significantly correlated with value stocks. The authors conclude by arguing that their findings support the contention that investors’ behaviour is consistent with the adaptive expectations hypothesis.

This collection of papers reflects the work of emerging scholars who are completing their doctoral studies or have been in an academic post for 3 years or less. Julian Williams, Matthias Bodenstedt, Laura Chiramonte, Mohammed Amidu, Deven Bathia and their co-authors address important issues in the FMIs literature. We look forward to reading further contributions as their careers develop.

Claudia Girardone

Essex Business School, University of Essex

Philip A. Hamill

Department of Business, Retail and Financial Services, University of Ulster

Acknowledgements

The Guest Editors thank the Editor, Professor Chris Adcock, for commissioning this special issue and for providing advice and guidance throughout the process and Pat Anderson at the European Journal of Finance for administrative assistance. They also thank Peter Hahn and Thorsten Beck for excellent plenary sessions, Peter for his opening plenary session debating the merits of regulation and executive compensation in the financial services sector and Thorsten Beck for his closing keynote address critiquing of the merits of cross-border banking and its contribution to the financial crisis. We are also indebted to the discussants: Anna Sarkisyan, Simon Wolfe, Francesca Arnaboldi, Elena Beccalli, Andreas Hoepner, Richard Payne, Phil Molyneux, Jonathan Williams, Meziane Lasfer Jerry Coakley and Steve Haberman for chairing the keynote session. Conference organisation was overseen by a scientific committee comprising, in addition to the Guest Editors of this special issue, Barbara Casu, Shelagh Heffernan, Phil Molyneux, Elena Kalotychou, David McMillan, Anna Sarkisyan and Sotris Staikouras. Without papers and presenters, a conference is not possible. It, therefore, remains for us to thank all of the presenters for sharing their work at the second Conference for Emerging Scholars in Banking and Finance. Finally, this event would not have been possible without generous financial assistance from the sponsors: Cass Business School, the British Accounting and Finance Association (BAFA), the Institute of Chartered Accountants of Scotland (ICAS), Bangor University, BNY Mellon and Citi. On behalf of everyone involved, the Guest Editors thank them for the support. The usual disclaimer applies.

Note

1.   At the time of writing (October 2011), European Union lawmakers are moving closer to a ban on naked CDS on sovereign debt.

References

Alsakka, R., and O. ap Gwilym. 2010. Leads and lag in sovereign credit rating. Journal of Banking & Finance 34: 2614–26.

Baker, M., and J. Wurgler. 2006. Investor sentiment and the cross-section of stock returns. Journal of Finance 61: 1645–80.

Barber, M.B., and T. Odean. 2008. All that glitters: The effect of attention and news on the buying behaviour of individual and institutional investors. Review of Financial Studies 21, no. 2: 785–818.

Brunnermeier, M. 2009. Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives 23: 77–100.

Carbó Valverde, S., and F. Rodriguez Fernandez. 2007. The determinants of bank margins in European banking. Journal of Banking & Finance 31: 2043–63.

Crouhy, M., R. Jarrow, and S. Turnbull. 2008. The subprime credit crisis of 07. Journal of Derivatives 16: 81–110.

Green, T.C., and B.H. Hwang. 2009. Price-based return co-movement. Journal of Financial Economics 93: 37–50.

Goddard, J., H. Liu, P. Molyneux, and J.O.S. Wilson. Forthcoming. Do bank profits converge? European Financial Management.

Güttler, A., and M. Wahrenburg. 2007. The adjustment of credit ratings in advance of defaults. Journal of Banking & Finance 31: 751–67.

Hull, J., M. Predescu, and A. White. 2004. The relationship between credit default swap spreads, bond yields, and credit rating announcements. Journal of Banking & Finance 28: 2789–811.

Jorion, P., and G. Zhang. 2007. Good and bad credit contagion: Evidence from credit default swaps. Journal of Financial Economics 84: 860–83.

Tetlock, P.C. 2011. All the news that’s fit to reprint: Do investors react to stale information? Review of Financial Studies 24: 1481–512.

Stulz, R.N. 2010. Credit default swaps and the credit crisis. Journal of Economic Perspectives 24: 73–92.

Völz, M., and M. Wedow. 2011. Market discipline and too-big-to-fail in the CDS market: Does banks‘ size reduce market discipline? Journal of Empirical Finance 18: 195–210.

Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage

Giovanni Calice^a, Jing Chen^b and Julian M. Williams^c

^aManagement School, University of Southampton, Southampton, UK; ^bSchool of Economics and Business, Swansea University, Swansea, UK; ^cBusiness School, Edward Wright Building, University of Aberdeen, Old Aberdeen, Aberdeen AB24 3QY, UK

In a naked credit defa...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Contents
• Citation Information
• Notes on Contributors
• 1. Introduction
• 2. Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage
• 3. The path to impairment: do credit-rating agencies anticipate default events of structured finance transactions?
• 4. The determinants of bank CDS spreads: evidence from the financial crisis
• 5. The impact of market power and funding strategy on bank-interest margins
• 6. An examination of investor sentiment effect on G7 stock market returns
• Index