Appendix I. Major Financial Stress Episodes Identified in the Literature
Appendix II. Data and Methodology
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We would like to thank Charles Collyns, Joerg Decressin, Tim Lane and Hyun Song Shin for helpful comments and suggestions. We also thank Gavin Asdorian and Angela Espiritu for excellent research assistance.
The countries included in this study are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, and the United States.
This broader approach complements other recent research on the empirical relationship between asset prices— such as for equity and house prices and bond spreads—and the dynamics of output during the course of the business cycle (see, for example., Cihak and Koeva, 2008 or Claessens, Kose, and Terrones, 2008) or between bank capital, lending and output (see Bayoumi and Melander, 2008, and Kashyap and others, 2008, in the context of the United States).
See Kindleberger, Aliber, and Solow (2005) for a history of financial crises. A well known exposition of this procyclical feature of financial systems is Minsky’s Financial Instability Hypothesis (Minsky, 1992).
Overall, of the 113 episodes of financial stress identified in the sample, 87 episodes simultaneously affected two or more countries.
Furthermore, the FSI captures 100 percent of all episodes identified in the literature if the duration of episodes is interpreted more broadly, that is, if the window around the quarter of financial stress identified by the FSI is expanded by a few quarters.
Mirroring the definition of financial stress episodes, oil price or labor productivity shocks are defined as cases where changes in the oil price or labor productivity are one standard deviation above trend; fiscal policy shocks are defined as episodes where the government net lending/borrowing ratio to GDP is one standard deviation above trend; and finally monetary policy shocks are defined as cases where the inverse term spread is one standard deviation above trend. In all cases, the deviations from trend are calculated using Hodrick-Prescott filters.
For example, many shocks may affect both the financial system and the economy, and while the financial system may amplify the shock, it would be hard to disentangle the direct effect of the shock from the amplification effect.
For example, in the United States, the most recent recession was in 2001while the most recent slowdown was when GDP fell below trend during 2007:Q4–2008:Q1.
The turning point dates were compared with Morsink, Helbling, and Tokarick (2002), as well as dates identified by the Economic Cycle Research Institute (www.businesscycle.com)—dates used in this paper are available from authors upon request.
As a window of 12 quarters is used in the charts, only “complete” episodes (i.e., those episodes preceded and followed by at least 12 quarters) are considered in this chart. This amounts to consider only those downturns and recessions episodes that started between 1983:Q1 and 2005:Q1.
Also, as indicated in Table 2, the duration and cumulative losses between the downturns is statistically significant at least at the 10 percent level.
The cost of capital is defined here as a weighted average of the real cost of equity, the real cost of debt, and real lending rates, using as weights the relative shares of equity, bonds, and loans in non financial corporate liabilities. See Appendix II for details.
Asset prices, namely real house and stock prices, are measured as deviations from their respective Hodrick-Prescott trends in line with many studies in the literature, especially those focusing on credit booms—see for example, Cardarelli, Igan, and Rebucci (2008) for a recent overview regarding house prices, and Mendoza and Terrones (2008) regarding credit booms.
Net lending (or borrowing) of a sector is a standard national accounts concept and can be measured either through incomes and expenditures or through financial transactions. Under the income and expenditure approach, net lending is the difference between internally generated funds and outlays on nonfinancial capital. A sector’s net lending equals its saving, plus its capital consumption allowance and net capital transfers from nonresidents, less its investment in fixed capital and inventories (the excess of net acquisitions of financial assets by transactions over their net incurrences of liabilities). Net lending (or borrowing) is also referred to as sector surplus (or deficit).
Slowdown severity is measured using the cumulative output loss during the period that output is below trend, see Table 1 for further details; recession severity is measured by losses until recovery.
While we do not want to repeat this point too many times, it is important to underscore that large discrepancies shown in the figures are statistically different. For example, in the bottom panel of Figure 8, the differences between slowdowns preceded by banking-related financial stress and slowdowns not preceded by financial stress is significant at a minimum of 10 percent for t – 6 to t + 6.
Banks increasingly depend on market-based funding sources to finance their assets (such as through their CD and off-balance sheet CP programs). Conversely, investment and now increasingly commercial banks also remain at the center of the originate-to-distribute model of securitized financing, and provide credit to hedge funds and other leveraged intermediaries through repurchase facilities to invest in securities markets.
The role of relationships is likely to be weaker in a system where banks pose greater competitive challenges to each other and where inside information about borrowers is much more limited.
This is in line with Minsky’s Financial Instability Hypothesis.
It is important to note that in a systemic crisis it will still be difficult for all banks to adjust their leverage simultaneously, as there would be few buyers for these assets among other banks, unless other cash-rich investors who do not rely on bank leverage to fund their positions emerge.
This is consistent with the findings in Paper 3 of the October 2008 GFSR, showing that fair value accounting tends to lead to more procyclical movements in financial intermediaries’ balance sheets.
Contrasting experiences with economic cycles may also reflect divergences in other areas, notably in the degree of flexibility in labor and product markets and the social welfare systems, between economies characterized by arm’s-length as opposed to relationship based financial systems (see Lall, Cardarelli, and Tytell, 2006).
While not indicated in Figure 15, top panel, the difference between growth rates in the first year after financial stress is statistically significant at the 10 percent level.
Furthermore, in August, a major stock market decline began, with Dow and S&P falling by 16 percent and 15 percent, respectively. A likely source of financial stress was the very weak conditions of depository institutions. The S&L bailout required a bailout of $150 billion, while loan losses were increasing and commercial bank failures had risen to over 200 a year by late 1980s.
The fallout from the scandal quickly extended beyond Enron and all those formerly associated with it. The trial of Arthur Andersen on charges of obstruction of justice related to Enron helped to expose accounting fraud at WorldCom (see below), and set off a wave of other accounting scandals.
On September 4, 2003, a major investment bank, Goldman Sachs, admitted that it had violated anti-fraud laws. Specifically, the firm misused material, nonpublic information that the U.S. Treasury would suspend issuance of the 30-year bond. The firm agreed to pay over $9.3 million in penalties—for a total of 120 million.