Working Papers

Unexpected changes in interest rates, often observed through the course of monetary policy, can have a significant effect on corporate credit risk. Using high frequency measures of interest rate surprises surrounding Federal Open Market Committee announcements and daily credit default swap (CDS) spreads, this paper finds a positive, significant relationship between monetary policy shocks and corporate credit risk over the last two decades. One component of the spread affected is compensation related to expected losses in default. The other affected component is the credit risk premium, which measures additional compensation for default risk. Riskier firms, with higher CDS spreads or leverage, or lower market capitalization, are much more sensitive to monetary policy shocks. Among the three measures of firm risk, CDS spreads appear to capture this sensitivity best. High frequency and daily equity returns also exhibit a significant and asymmetric response to policy announcements. (Working Paper no. 20-05)

This paper examines how a central counterparty (CCP) uses a default waterfall to manage and allocate resources to cover defaults of clearing members and clients. A resilient waterfall ensures cleared payments are paid in full and on-time, reducing the threat to financial stability from losses and their spillovers. However, the amount of resources collected and their allocation affect clearing incentives. This paper models and evaluates the trade-offs between resiliency and participation in a credit default swaps market. It finds that the benefits of greater central clearing rates generally dominate the benefits of increased waterfall resources. (Working Paper no. 20-4)

This paper examines whether hedge funds’ returns include a premium that compensates investors for accepting the risk from illiquid asset holdings. It finds that the premium is large and a significant share of risk-adjusted returns. The size of the premium matters for financial stability because it signals investors’ view of the importance of illiquidity risk. (Working Paper no. 20-03)

This paper examines the relationship between hedge funds’ use of leverage and their portfolio risk. It finds that more leveraged funds tend to have less volatile returns and less chance of an extreme negative return. More leveraged funds also tend to hold higher quality and more liquid assets. (Working Paper no. 20-02)

This paper shows that hedge fund industry gross assets were $8.5 trillion, and net assets were $5.2 trillion, at year-end 2016. This estimate is 40 percent larger than the next largest estimate. This paper also shows that funds reporting publicly available data have much lower returns, and much higher net flows, than funds reporting only non-public regulatory data. The outperformance of the non-publicly reporting funds appears to arise entirely from alpha rather than greater exposure to systematic risk factors. (Working Paper no. 20-01)

This paper examines the complex intra-day linkages between the U.S. equity securities market and the equity derivatives market. The paper finds a positive, but short-lived, relationship between the two markets’ order flow activities, which relate to the supply, demand, and withdrawal of liquidity between the two markets. The paper also finds that cross-asset market order flow is a key component of liquidity and price discovery, particularly during periods of market volatility. (Working Paper no. 19-04)

This paper shows the post-crisis hedge fund-prime broker credit network is concentrated among 10 percent of participants. The average fund borrows from three brokers, and the brokers lending the most are highly connected. The paper finds that a liquidity shock to a prime broker results in reduced borrowing by hedge funds due to the broker reducing its supply of credit. Larger, more connected, and better-performing funds, and those that do less over-the-counter trading, are better able to compensate for the reduction in credit from the broker. (Working Paper no. 19-03)

This paper examines the impact of the Volcker rule, which bans proprietary trading by commercial banks and their affiliates, with some exceptions. It finds evidence that the rule has increased the cost of liquidity provided by firms it covers, but not decreased the firms’ exposure to liquidity risk. It also finds that the rule has decreased the market share of covered firms. Customers appear to be trading more with non-bank dealers, who are exempt from the Volcker rule but also cannot borrow at the Federal Reserve's discount window. (Working Paper no. 19-02)

This paper examines whether liquidity deteriorated in the single-name credit default swaps market due to regulatory reforms after the 2007-09 financial crisis. It finds evidence of both increased spreads and lower volumes, consistent with the reforms increasing the cost of market-making for bank-dealers. It also finds that transaction prices between dealers and clients have become more dependent on the inventories of individual dealers as interdealer trade has declined. (Working Paper no. 19-01)

This paper examines the impact of double liability on bank risks and depositor safety before and during the Great Depression. Under double liability, shareholders of failing banks lost their initial investments and had to pay up to the par value of their stock to compensate depositors. The paper finds that double liability did not reduce bank risk before the Great Depression, but that deposits were less susceptible to runs. (Working Paper no. 18-06)

This paper estimates the systemic effects of exit by a key over-the-counter (OTC) intermediary. In the model, risk-averse traders are connected by a core-periphery network. If traders are also averse to concentrated bilateral exposures, then the incomplete network prevents full risk sharing. The impact of the network structure on prices is quantified using proprietary data on all credit default swap transactions in the United States from 2010 to 2013. There are a small number of key OTC intermediaries whose exit can move markets dramatically. Eliminating one of these intermediaries leads to over a 20 percent increase in credit spreads. The Internet Appendix includes extensions of the model. (Working Paper no. 18-05)

This paper develops a model of a downward spiral of falling prices and increasing redemptions that can lead to the failure of a mutual fund. It shows how mutual funds can best design swing pricing for effectiveness at preventing runs, even under extreme market stress. (Working Paper no. 18-04)

This paper studies the role of learning and reputation in economic networks, such as interbank lending and derivatives trading networks, in times of market distress or financial crisis. The model demonstrates the importance of maintaining firm anonymity and identifies network structures that offer increased resilience. (Working Paper no. 18-03)

This paper assesses whether compensation plans can drive excessive risk-taking. It develops a model showing that principals offer contracts incentivizing less risky behavior when the market for managers is sluggish. But hot labor markets result in contracts that incentivize risk-taking. The market for executive talent heats up for larger projects and during financial bubbles, when debt funding increases. The results suggest policymakers should consider the impacts of compensation and corporate governance policies on competition for managers. (Working Paper no. 18-02)

This paper describes the purpose, construction, interpretation, and use of the OFR Financial System Vulnerabilities Monitor. The monitor, a heat map of 58 quantitative indicators, is a starting point for assessing vulnerabilities in the U.S. financial system. The OFR launched the monitor in 2017 to help fulfill its mandate to measure and monitor risks to U.S. financial stability. (Working Paper no. 18-01)

Some hedge funds have a few large investors. Such a concentrated investor base can make a fund vulnerable to unexpected requests for large redemptions. This paper shows that U.S. hedge funds in part account for that risk by holding more cash and liquid assets. These holdings help funds accommodate large outflows, but also result in lower risk-adjusted returns. The Internet Appendix includes methodology details. (Working Paper no. 17-07)

How likely is a central counterparty, or CCP, to default after a severe credit shock? This working paper uses credit default swap data to estimate the direct and indirect impacts of a default by CCP counterparties in derivatives trades. It finds that a CCP could be more vulnerable to failure than conventional stress tests have shown. (Working Paper no. 17-06)

After the financial crisis, reforms of money market funds and changes to banks’ liquidity requirements had an unintended consequence of increased Federal Home Loan Banks’ reliance on short-term funding from money market funds to finance longer-term loans and other assets. This increase could make the financial system more vulnerable and pose risks to financial stability. (Working Paper no. 17-05)

The 2007-09 financial crisis showed that stress in the financial system can have devastating effects on the economy. To measure such stress, the OFR has developed a Financial Stress Index. This working paper describes how the index is constructed and how the OFR uses it to monitor financial stability. (Working Paper no. 17-04)

Some bank holding companies are very complex, with hundreds or thousands of subsidiaries. This complexity complicates the job of unwinding a failed bank holding company. In this working paper, OFR researchers propose a new way to measure complexity that can support the resolution process after a bank holding company fails. (Working Paper no. 17-03)

European banks issue contingent convertible bonds. These bonds can force investors to absorb losses when a bank is under stress. The authors find that heightened uncertainty about discretion by banks on when to make payments to investors and by regulators on when to trigger a loss absorption mechanism worsened price declines in a stressed market. (Working Paper no. 17-02)

This paper describes how to set margin levels for derivatives contracts so that margin calls do not add to market stress during times of instability. Price volatility varies by asset class. Certain qualities of volatility should be taken into account to set the most effective margin levels without adding to market stress. (Working Paper no. 17-01)

The authors create an agent-based model that can help regulators understand risk in the interbank funding market. Tests of the model against actual bank failures before, during, and after the 2007-09 financial crisis suggest that the market has become more resilient to asset write-downs and liquidity shocks. The model uses balance sheet data from more than 6,600 U.S. banks. (Working Paper no. 16-14)

This paper uses unique data to analyze how the national banking acts in 1863 and 1864 reshaped the U.S. bank network in the 1860s. The laws concentrated reserves in New York and regional cities, creating systemically important banks. The paper shows this concentration made contagion more likely if big banks faced economic shocks. (Working Paper no. 16-13)

This paper assesses the risk of contagion in the credit default swap (CDS) market. This risk emerges through the inability of CDS counterparties to make payments during systemic stress. The authors find that the central counterparty contributes significantly less to network contagion than do several peripheral firms that are large net sellers of CDS protection. (Working Paper no. 16-12)

This paper examines how risk-taking in the repurchase agreement, or repo, market changed after regulators introduced the supplementary leverage ratio for banks. The paper finds that broker-dealers owned by U.S. bank holding companies now borrow less in the repo market overall after the change, but a larger percentage of the borrowing is backed by more risky collateral. (Working Paper no. 16-11)

This paper assesses the likelihood of European government support in distressed banks. To measure market expectations of these events, the authors study the credit spread between old credit default swap contracts and new ones with a definition of default linked to government intervention. (Working Paper no. 16-10)

This working paper shows how network analysis can facilitate the monitoring of movements by stocks in the global financial system over time. The paper analyzes nearly 4,000 stocks in 15 countries. It concludes that stock returns tend to move together within regions — but not across them — in times of stability, but move in sync globally in times of crisis. (Working Paper no. 16-09)

A new securities lending survey sheds light on these transactions that help underpin smooth-functioning capital markets. The pilot project by the OFR, Federal Reserve, and staff of the Securities and Exchange Commission shows that participating agents facilitated about $1 trillion in daily securities loans during a three-day period in 2015. Collecting these data on a permanent basis could help regulators identify potential vulnerabilities in a key component of our financial system. (Working Paper no. 16-08)

The requirement that standardized over-the-counter derivatives be cleared through central counterparties, or CCPs, is intended in part to create a cost incentive favoring central clearing. This working paper shows that the cost incentive does not necessarily favor central clearing, and when it does, it might be because of insufficient levels of guarantee funds, which banks provide to protect CCPs in the event of CCP member default. (Working Paper no. 16-07)

Collateral is exchanged among market participants to support financial activities, including secured funding, securities lending, securities exchanges, margin lending, derivatives, and clearing. This working paper creates a collateral map to show how collateral moves among bilateral counterparties, triparty banks, and central counterparties, and can spread stress through the financial system. The paper also discusses the recent increase in collateral demand, effects of post-crisis regulation, and collateral-related stress scenarios. (Working Paper no. 16-06)

This paper describes how mortgage lending standards, as measured by responses to the Federal Reserve's quarterly Senior Loan Officer Opinion Survey, relate to changes in the availability of mortgage loans at banks from 1990 to 2013. The research suggests that the survey's reported changes in credit standards are a leading indicator of the financial industry's vulnerability to shocks. (Working Paper no. 16-05)

This paper investigates the use of automated text analysis by computers as a tool for monitoring financial stability. The authors find negative sentiment extracted from tens of thousands of news articles about 50 large financial services companies is useful in forecasting volatility in the stock market. The method, which also considers the "unusualness" of news, may help anticipate stress in the financial system. (Working Paper no. 16-04)

This working paper examines how a bailout orchestrated by New York Clearinghouse member banks stopped financial contagion during the Panic of 1884. The private-sector assistance to Metropolitan National Bank, an important correspondent bank for many banks outside New York City, prevented a minor financial crisis in New York from becoming a broad, systemic event, according to the authors' analysis. (Working Paper no. 16-03)

This paper examines the precision of Form PF in measuring the risk hedge funds pose to the financial system. Hedge funds and other private funds now file Form PF with the Securities and Exchange Commission. The paper extends the methodology of a 2015 OFR working paper and finds that options significantly weaken the risk-measurement tolerances in Form PF. (Working Paper no. 16-02)

This paper applies the Federal Reserve's supervisory stress test scenarios to examine the impacts on banks — and the banking system as a whole — from default of their largest counterparties in the credit derivatives markets. The authors find higher loss concentrations for the banking system than for individual firms and potential for large indirect losses when a major counterparty defaults. (Working Paper no. 16-01)

This paper examines the systemic implications of the supply of liquid safe assets, such as Treasury bills. The paper explores how liquid safe assets facilitate the trades of risky assets. The paper finds that financial markets may be remarkably resilient to changes in the stock of liquid assets. (Working Paper no. 15-23)

This paper documents a pattern of foreign-owned broker-dealers reducing their borrowing in the U.S. triparty repo market, a key source of short-term funding in the financial system, at quarter end and immediately returning to the market when a new quarter begins. This activity reduces their capital requirements under the leverage ratio. (Working Paper no. 15-22)

This paper surveys the rapidly growing literature about interconnectedness and financial stability. The paper focuses on insights in the literature on the relationship between network structure and the vulnerability of the financial system to contagion. (Working Paper no. 15-21)

Bank regulators adopted a new requirement called the Liquidity Coverage Ratio after the financial crisis to help ensure banks maintain enough liquid assets to cover their financial obligations during times of stress. This paper uses a series of increasingly complex examples to demonstrate issues in analyzing this new liquidity metric. (Working Paper no. 15-20)

Uncertainty is a crucial factor in financial stability, but it is notoriously difficult to measure. This working paper extends techniques from engineering to quantify fundamental economic uncertainty, and applies the method to an example of portfolio stress testing. By this measure, uncertainty peaked in late 2008. (Working Paper no. 15-19)

This paper presents an agent-based model for examining price impacts and liquidity dynamics during financial crises, which are often characterized by sharp reductions in liquidity followed by cascades of falling prices. The model highlights the implications of changes in market makers' ability to provide intermediation services and the decision cycles of liquidity demanders versus liquidity suppliers during a crisis. (Working Paper no. 15-18)

This paper is a reference guide on U.S. repo and securities lending markets. It discusses the main institutional features of these markets, their vulnerabilities, and data gaps that prevent market participants and regulators from addressing known vulnerabilities. (Working Paper no. 15-17)

This paper proposes a new method for bounding the impact of "wrong-way risk" on counterparty credit risk measurement for a portfolio of derivatives. Wrong-way risk refers to the possibility that a counterparty's default risk increases with the market value of the exposure. (Working Paper no. 15-16)

This paper explores how the increasing correlation among intraday stock returns affects the possibility to diversify investment risk and potentially may affect market stability. (Working Paper no. 15-15)

This paper investigates the dynamics of commodity futures volatility and analyzes the impact of increased emerging market demand on commodity markets. (Working Paper no. 15-14)

This paper examines the precision of Form PF, a regulatory filing introduced after the financial crisis to measure risk exposures for private funds, including hedge funds. The paper finds that Form PF's measurement tolerances are large enough to allow private funds with dissimilar risk profiles to report similar risk measurements to regulators. (Working Paper no. 15-13)

This paper presents a dynamic bipartite network model for a stress test of a banking system's sensitivity to external shocks in individual asset classes. As a case study, the model is applied to investigate the Venezuelan banking system from 1998 to 2013. The model quantifies the sensitivity of bank portfolios to different shock scenarios and identifies systemic vulnerabilities that stem from connectivity and network effects, and their time evolution. The model provides a framework for dynamical macroprudential stress testing. (Working Paper no. 15-12)

This paper identifies hidden liquidity regimes (high, medium and low) across a broad range of financial markets that can be used for characterizing periods of market stress and identifying underlying predictors of liquidity shocks. This regime could have provided meaningful predictions of liquidity disruptions up to 15 trading days in advance of the 2008 financial crisis. These methods offer a potential framework for monitoring and predicting a systemwide collapse in market liquidity, which could signal a collapse of liquidity in the funding markets as experienced in the financial crisis. (Working Paper no. 15-11)

This paper examines evidence of a too-big-to-fail subsidy for large financial firms by comparing borrowing costs of large and small firms across industries. The paper finds that larger firms borrow more cheaply in many industries, and this size effect is often largest in nonfinancial industries. These results challenge the notion that expected government bailouts are behind borrowing cost advantages enjoyed by the largest financial firms. (Working Paper no. 15-10)

This paper examines credit default swap (CDS) spreads in a sample of international banks for evidence of a benefit related to possible measures of systemic importance. The authors find a consistent, statistically significant negative relationship between five-year CDS spreads of banks and nine different systemic importance indicators. The paper shows that the benefit is most pronounced for banks within a certain asset range. Such evidence is weaker for banks identified by regulators as global systemically important banks. (Working Paper no. 15-09)

This paper develops a model for concentration risks that clearing members pose to central counterparties. Over time, larger clearing members crowd out smaller clearing members. Systemic risk is created because high clearing member concentration results in relatively lower lending, higher cost of capital, and increasingly costly hedging. To address this risk, the paper proposes a self-funding systemic risk charge. (Working Paper no. 15-08)

This paper focuses on the systemic risks in markets cleared by multiple central counterparties (CCPs). Each CCP charges margins based on the potential impact from the default of a clearing member and subsequent liquidation of a large position. Swaps dealers can split their positions among multiple CCPs, effectively "hiding" potential liquidation costs. A lack of coordination among CCPs can lead to a "race to the bottom" because CCPs with lower perceived liquidation costs can drive competitors out of the market. (Working Paper no. 15-07)

This paper uses data from the Home Affordable Modification Program to examine the impact of principal forgiveness on mortgage default. On average 3.1 percent of loans become delinquent and exit the program each quarter. The authors estimate that the rate would have been 3.8 percent absent principal forgiveness, which averaged 28 percent of the initial mortgage balance. (Working Paper no. 15-06)

The Federal Reserve System was created to reduce risks related to seasonal swings in loan demand and to stabilize fluctuations in interest rates. Many state-chartered banks chose not to join the system because of the cost of the Federal Reserve's reserve requirements. The inability to attract many state-chartered banks created indirect access to government protection (lender of last resort) without federal regulation. (Working Paper no. 15-05)

This paper shows that the fundamental legal structure of a well-written financial contract follows a logic that can be formalized mathematically as a "deterministic finite automaton." This allows, for example, automated reasoning to determine whether a contract is internally coherent and complete. The paper illustrates the process by representing a simple loan agreement as an automaton. (Working Paper no. 15-04)

This paper presents a model of market liquidity in which those who need to sell come into the market with a greater need for immediacy than those who are willing to buy. This is a critical market dynamic behind the illiquidity that arises during market dislocations and crises, when some are in forced-selling mode while others are hesitant to come in and take the other side of the trade. (Working Paper no. 15-03)

This paper examines the results of four rounds of stress testing of the largest U.S. bank holding companies, starting in 2009. The data reveal a growing correlation in results from one year to the next, highlighting whether the stress tests in their current form may be losing some of their information value over time. The authors discuss the implications of these patterns and recommend greater diversity in the stress scenarios analyzed. (Working Paper no. 15-02)

This paper demonstrates the value of signed directional graphs, a modeling methodology used for risk detection in process engineering, in tracing the path of potential instabilities and feedback loops within the financial system. This approach expands the usefulness of network models of the financial system by including critical information on the direction of influence and the points of control between the various nodes of the network. (Working Paper no. 15-01)

This paper uses proprietary credit default swap (CDS) data for 2010 to 2014 to show that capital fluctuations for sellers of CDS protection are an important determinant of CDS spread movements. (Working Paper no. 14-10)

This paper uses an agent-based model of the limit order book to explore how the levels of information available to participants, exchanges, and regulators can be used for insights on the stability and resiliency of a market. (Working Paper no. 14-09)

This paper discusses optimal strategies for financial institutions in selling large blocks of securities and in hedging the resulting market risk. (Working Paper no. 14-08)

This paper proposes a new model of volatility featuring a "leverage multiplier" by which financial leverage amplifies equity volatility. The model estimates daily asset returns and asset volatility. (Working Paper no. 14-07)

This paper investigates the design of risk weights used in setting minimum levels of regulatory capital for banks and presents a formula for regulators to set those weights by analyzing bank portfolios. (Working Paper no. 14-06)

This paper develops an agent-based model that uses a map of funding and collateral flows to analyze the financial system's vulnerability to fire sales and runs. (Working Paper no. 14-05)

This paper presents an accounting framework for measuring the sources and uses of short-term funding in the global financial system and introduces a dynamic map of global funding flows. (Working Paper no. 14-04)

This paper features a funding map to illustrate the flow of funding from its initial providers through the bank/dealers to the end-users. In addition to showing the plumbing of the system, the paper also shows the processes for transforming funding liquidity, credit quality, and tenor. The paper then applies the funding map to track risk through various types of financial institutions, and to identify gaps in data needed for financial stability monitoring. (Working Paper no. 14-03)

This paper provides an overview of visual analytics - the science of analytical reasoning enhanced by interactive visualizations produced by data analytics software - and discusses potential benefits in monitoring financial stability. (Working Paper no. 14-02)

This paper explores the relationship between the quality of corporate credit ratings and competition in lending between the public bond market and banks. It finds that the quality of credit ratings plays a role in financial stability because the behavior of rating agencies can reduce the impact of macroeconomic shocks. (Working Paper no. 14-01)

The U.S. mortgage finance system is a critical part of our nation's financial system, representing 70 percent of U.S. household liabilities. The establishment of a single, cradle‐to‐grave, universal mortgage identifier that cannot be linked to individuals using publicly‐available data would significantly benefit regulators and researchers. (Working Paper no. 13-12)

This paper explores tradeoffs between transparency and confidentiality in financial regulation and discusses new techniques from the fields of secure computation and statistical data privacy that can facilitate the secure sharing of financial information. (Working Paper no. 13-11)

Stress testing of large bank holding companies in the United States - a valuable exercise used to determine regulatory capital and liquidity planning at these institutions - should be adapted to be made more useful for financial stability monitoring. (Working Paper no. 13-10)

This paper estimates how much interconnections among financial institutions - potential channels for contagion and amplification of shocks to the financial system - can increase expected losses from a wide range of shocks. (Working Paper no. 13-09)

This paper presents a survey and historical narrative of policies to smooth the credit cycle in light of their potential future application as "macroprudential" policies to reduce the build-up of risks in U.S. financial markets. (Working Paper no. 13-08)

This paper develops a method for selecting and analyzing stress-testing scenarios for financial risk assessment. (Working Paper no. 13-07)

This paper uses a flexible framework to analyze two important phenomena influencing the hedge fund industry - contagion and time variation in risk-adjusted return. (Working Paper no. 13-06)

This paper offers a technique for selecting multidimensional shock scenarios for use in financial stress testing. The technique uses a grid search of sparse, well distributed stress-test scenarios that are considered a middle ground between traditional stress testing and reverse stress testing. (Working Paper no. 13-05)

This paper develops a capital structure model of a bank to analyze the incentives created by contingent convertibles (CoCos) and bail-in debt, which convert to equity when a bank approaches insolvency. These two forms of contingent capital have been proposed as potential mechanisms to enhance financial stability. (Working Paper no. 13-04)

This paper discusses the concepts and research related to agent-based models and explores how the dynamics of a flock of birds in flight, a group of drivers in a traffic jam, or a panicked crowd of stampeding people might inform our analysis of threats to financial stability. (Working Paper no. 12-03)

This paper assesses risk management practices and how risk management can be improved. The paper approaches risk management from three perspectives: (1) risk measurement by individual firms, (2) governance and incentives, and (3) systemic concerns. The paper evaluates each approach separately and also discusses the importance of considering them as interrelated. (Working Paper no. 12-02)

The paper focuses on quantitative tools to assess threats to financial stability. It gives a broad overview of the state of the art in measuring systemic risk by focusing on a key set of 31 specific measurements outlined elsewhere in peer-reviewed articles or working papers. (Working Paper no. 12-01)