Economic and Financial
Newsletter
2013-1
Newsletter
Economic and Financial
2014-4
Table 1: Key equity indices
Main equity indices
Maximum
10/12/14
10 yrs
DJIA
Change since
in past
Date
11/09/14 01/01/14
17,533.2
17,958.8 05/12/14
2.7%
5.8%
S&P 500
3,150.9
2,075.4 05/12/14
-2.9%
1.3%
NASDAQ
2,026.1
4,791.6 28/11/14
1.5%
9.6%
CAC 40
4,684.0
6,168.2 01/06/07
2.1%
12.1%
DAX 30
4,227.9
10,087.1 05/12/14
-5.0%
-1.6%
FTSE 100
9,799.7
6,878.5 14/05/14
1.0%
2.6%
FTSE MIB
6,500.0
44,364.4 18/05/07
-4.8%
-3.7%
DJ EURO STOXX 50
19,217.7
4,557.6 16/07/07
-9.1%
1.3%
NIKKEI 225
17,412.6
18,262.0 09/07/07
10.3%
6.9%
Table 2: Interest and exchange rates
10/12/14
11/09/14
13/06/14
15/03/14
Source: Thomson Reuters Datastream
Note: 1 Jan 2007 = 100; last observation: 10 Dec 2014
Key rates (%)
USA
0.25
0.25
0.25
0.25
Euro area
0.05
0.05
0.25
0.25
Japan
0.10
0.10
0.10
0.10
Monetary policy rates (%)
6
Money market rates (%)
%
Fed funds
0.12
0.09
0.09
0.08
EONIA
-0.04
-0.02
0.07
0.17
3-month Euribor
0.08
0.09
0.26
0.31
US T-Bond 10 yrs
2.22
2.53
2.63
2.79
CNO-TEC 10
0.97
1.37
1.86
2.20
Euroe area(1)
1.18
1.55
2.00
2.37
USD/EUR
1.24
1.29
1.35
1.39
EUR/GBP
1.26
1.25
1.24
1.20
YPN/USD
118.97
106.68
102.41
103.24
5
Long-term rates (%)
Exchange rates
6
US
UK
Japan
Euro area
4
4
3
3
2
2
1
1
0
(1) Average ten-year benchmark yields for euro area countries
weighted by economic importance (source: Datastream).
5
0
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: Thomson Reuters Datastream
Last observation: 10 Dec 2014
Contents
 Economic outlook and financial markets ..................................................................................................................... p. 2
 Risks – Synthetic indicators for measuring systemic stress ....................................................................................... p. 6
 Study – Asset management in a low interest rate environment ............................................................................... p. 13
Sent to press on 10 December 2014
DRAI – Research, Strategy and Risk Division
1
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Macroeconomic indicators
World growth
(Annual real GDP growth rate, %)
Economic growth: still awaiting a recovery
8
The euro area posted a sixth consecutive quarter of growth in the
third quarter of 2014 (after second quarter growth was revised to
0.1%). Even so, growth is disappointing. The European
Commission lowered its 2014 forecast to 0.8% (and 1.1% for
2015) in November, just when a combination of falling oil prices,
euro weakness against the dollar and low interest rates should
have been offering a cyclical lift. Adverse factors thus remain
significant, among them credit conditions in peripheral
economies, low levels of corporate profitability and, above all, the
limited ability of European labour markets to create jobs. Euro
area unemployment stood at 11.3% in December 2014,
compared with 11.8% a year earlier. Despite less pronounced
fiscal corrections in 2014 than in 2013 in most euro area
countries, persistent weak inflation (now forecast by the
Commission at 0.5% for 2014, versus 0.8% previously) is making
the deleveraging process for public and private agents both
costlier and slower. At the same time, deleveraging in both the
public and private sectors continues to hamper the recovery,
especially with inflation continuing to decelerate in the euro area
(0.3% year on year in November, compared with 0.5% at endMarch and end- June).
France
USA
Germany
United-Kingdom
Japan
Euro area
6
4
2
0
Q1 2008
Q4 2008
Q3 2009
Q2 2010
Q1 2011
Q4 2011
Q3 2012
Q2 2013
Q1 2014
-2
-4
-6
-8
-10
Sources: Datastream, national accounts. To December 2014
Economic sentiment indicator
120
115
110
105
100
German GDP – the driver of European growth since the crisis –
grew just 0.1% in the third quarter after contracting 0.1% in the
second. Construction spending, household consumption and
corporate investment all flattened out for the entire second
quarter of 2014, despite the favourable trend in unemployment.
In France, above-forecast third quarter growth of 0.3% was
largely driven by the positive change in inventories and a positive
contribution by public consumption. Conversely, investment by
households, non-financial companies and public authorities
continued its downward trend. The question therefore remains as
to whether long-term growth drivers will be restored in 2015. In
the rest of the euro area, Italy reported disappointing activity in
the third quarter, down 0.1%, in line with lacklustre private sector
investment and an ongoing deterioration in activity expectations
signalled by a fifth consecutive monthly decline in the economic
sentiment indicator. Spain and Portugal, on the other hand,
confirmed their return to positive growth in the third quarter,
posting GDP growth of 0.4% (after 0.3%) and 0.3% (after 0.3%)
respectively, while their economic sentiment indicators remained
above the 100-point mark.
95
90
Euro area
France
85
Germany
Italy
80
Spain
75
Portugal
70
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Sources: European Commission, Datastream.
Unemployment rates (%)
30
France
25
Germany
Italy
Portugal
Spain
20
Euro area
15
10
Rest of world: momentum renewed in the USA and
confirmed in the UK; backlash in Japan
5
0
2005
2006
2007
2008
2009
2010
2011
2012
The USA posted growth of 1.1% in the third quarter, confirming
the momentum seen in the second quarter with a rate of 1.0%.
The labour market nevertheless remained flat, with job creation
languishing. While the slower pace of deleveraging buoyed the
economy relative to 2013, stagnating salaries and spending
power threatened growth momentum. In the UK, third quarter
growth came in at 0.7% and job creation remained buoyant. In
Japan, the quarterly rally to 1%, which came after a particularly
adverse first half, is unlikely to have prevented a decline in fullyear GDP in 2014.
2013
Sources: Datastream, Eurostat, national accounts
France – Contributions to growth (%)
1,5
1,0
Household GFCF
Net exports
Inventories
Corporate GFCF
Public spending
Private consumption
GDP
0,5
0,0
-0,5
-1,0
Source: INSEE – quarterly national accounts
DRAI – Research, Strategy and Risk Division
2
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Credit markets
Sovereign debt: ten-year yields (%)
8
7
Euro area
France
Germany
Ireland
Italy
Japan
Spain
UK
USA
Greece (rhs)
Portugal (rhs)
20
Monetary policy easing set to continue in the euro area
15
6
10
5
5
4
0
3
-5
2
-10
1
-15
0
The ECB’s downward revision of growth and inflation forecasts in
the fourth quarter revived expectations that it would introduce
new quantitative easing measures in the euro area by purchasing
assets, particularly sovereign debt. Moreover, this option was
debated at the December meeting of the Governing Council. It
appears even more likely given the somewhat disappointing
participation in the second TLTRO (EUR 130 billion after
EUR 83 billion for the first TLTRO in September, giving a total of
EUR 213 billion out of the maximum target amount of
EUR 400 billion). Against this backdrop, sovereign yields
continued to ease, at an ever more sustained pace of around
30 basis points (bps) between end- September and midDecember for France – coming back to less than 1% at endDecember – Ireland, Spain and Italy, and around 20 bps for
Germany.
-20
Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
13 13 13 13 13 13 13 13 13 14 14 14 14 14 14 14 14 14 14 14
Source: Thomson Reuters Datastream
Change in the cost of bond issues in the USA and Europe
(basis points, at 11 Dec 2014)
700
In the USA, policy rates remained on hold. At its last meeting in
October, the Federal Reserve announced the end of its third
wave of quantitative easing, or QE3. Despite favourable growth
and employment numbers, the Fed continues to closely monitor
wage trends. However, at its 17 December meeting, the Fed’s
monetary policy committee suggested that interest rates should
stay on hold for some time to come.
200
180
600
160
500
140
120
400
100
300
80
Europe - High Yield Bonds
100
0
Differing trends in corporate credit conditions on either side
of the Atlantic
60
200
40
US - High Yield Bonds
Europe - Investment Grade Bonds (RHS)
The cost of borrowing on corporate bond markets continued to
rise in the USA in the fourth quarter, across all ratings. Yields in
the high-yield segment rose by as much as 100 bps between the
beginning of October and mid-December, compared with 30 bps
for investment grade corporates. Conversely, they held steady in
Europe. Meanwhile, premiums on CDS on corporate bonds
differed substantially: they did indeed head upwards, but only in
the high-yield segment, with the rise also more pronounced in
Europe, reflecting a significant rerating of default risk premiums.
20
US - Investment Grade Bonds (RHS)
0
Source: Bloomberg
Change in CDS indices for private issuers in Europe and the USA
(basis points, at 11 Dec 2014)
800
200
180
700
160
600
Despite a less favourable second half, primary market
activity increased further in 2014
140
500
120
400
100
On the primary markets, the slowdown in corporate bond issues
observed in the third quarter of 2014 did not continue into the
fourth, when a slight rally could even be seen in the USA.
Conversely, activity continued to decline in the high-yield
segment in both the USA and Europe. Despite a less favourable
second half, corporate bond issues in full year 2014 should thus
show a significant rise on both sides of the Atlantic (including in
the highest-risk segment) of around 5% for the USA and 15% for
Europe.
80
300
60
200
100
Europe : ITRX XOVER
États-Unis : CDX High Yield
Europe : ITRX MAIN (RHS)
US : CDX Investment Grade (RHS)
40
20
0
0
Source: Bloomberg
Corporate issuance (USD billion, at 11 Dec 2014)
2,500
Total
o/w high yield
2,000
1,500
1,000
0,500
0,000
Etats-Unis
Europe
Source: Bloomberg
DRAI – Research, Strategy and Risk Division
3
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Equity markets
Change in MSCI indices over time (at 11 Dec 2014)
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
Tensions ease on equity markets
World index
Developed countries
Equity markets posted mixed performances between endSeptember and mid-December 2014, exposed in particular to the
consequences of the Russian crisis. Areas of uncertainty
remained, including deflation risk in the euro area, changes in
monetary policy and their impact on asset prices, and geopolitical
risk. However, the prospect of game-changing news eased
market jitters somewhat, as illustrated by the sharp fall in implied
volatility on key equity indices from the second half of October
onwards. Those prospects included the end of quantitative
easing in the USA; the results of the Asset Quality Review in
Europe, broadly in line with expectations; and the release of
better than forecast macroeconomic indicators in the USA.
Buoyed by the favourable growth outlook, US equity indices
climbed to record highs at the beginning of December 2014.
Meanwhile, the Nikkei index notably bounced back 19% between
mid-October (when it bottomed out) and mid-December; this
trend was connected with further monetary easing by the Bank of
Japan, which expanded its asset purchase programme, and
followed the announcement by Japan’s leading pension fund,
GPIF, of its intention to significantly increase the proportion of
equities in its portfolio.
Since 30/09/2014
Since the beginning of 2014
2013
USA
Europe
Euro Area
Pacific ex-Japan
Japan
Emerging markets
Asia
Latin America
Eastern Europe
Source: Thomson Reuters Datastream
Implied volatility (%)
60
50
S&P500
DJ EURO STOXX 50
40
30
20
Slowdown takes hold in primary markets
10
On primary markets, the slowdown in activity observed on the
IPO market in the third quarter continued in the autumn, in a less
favourable financial environment. IPO volumes remained high,
with capital-raising in the fourth quarter approaching
USD 54 billion globally by mid-December, down almost 20% on
the previous quarter. Based on this criterion, the New York Stock
Exchange once again proved the most active market, with
USD 8.5 billion raised. The market also remained buoyant in
most financial centres in the Asia-Pacific region, particularly in
Australia and, to a lesser extent, Japan. Trends in Europe
appeared very mixed: the amount of capital raised continued to
decline in London, while the Paris market shut down during the
fourth quarter. Conversely, the Frankfurt market reopened and
activity firmed up in Amsterdam. In all, capital raised through
IPOs across virtually the whole of 2014 is expected to exceed
USD 235 billion globally, up more than 40% on 2013.
10/12/14
10/10/14
10/08/14
10/06/14
10/04/14
10/02/14
10/12/13
10/10/13
10/08/13
10/06/13
10/04/13
10/02/13
10/12/12
10/10/12
10/08/12
10/06/12
10/04/12
10/02/12
10/12/11
10/10/11
10/08/11
10/06/11
10/04/11
10/02/11
10/12/10
10/10/10
10/08/10
10/06/10
10/04/10
10/02/10
10/12/09
0
Source: Thomson Reuters Datastream
World share issuance (USD billion)
700
600
IPOs
500
Secondary issuances
400
300
200
100
0
As regards equity offerings by existing listed companies, the
slowdown that began in the spring continued in the autumn,
albeit at a more moderate pace as activity stabilised in the USA
and Europe. Consequently, capital raised globally in the fourth
quarter was down 10% relative to the previous quarter, following
a 40% decline in the third quarter.
Source: Bloomberg, AMF calculations
1,200
1,000
Merger & acquisitions volume (USD billion)
Africa and Middle East
Eastern Europe
Latin America and Caribbean
Asia Pacific (developed)
Asia Pacific (emerging)
Western Europe
Significant dip in M&A activity
North America
Mergers and acquisitions slowed again in the fourth quarter of
2014, with volumes totalling USD 800 billion at mid-December,
well below the spring high but still comfortably higher than the
medium-term average. The pharmaceutical industry continues to
be one of the most active sectors; in particular, mid-November
saw Actavis announce its USD 66 billion takeover of US group
Allergan, which makes Botox.
800
600
400
200
0
Source: Bloomberg, AMF calculations
DRAI – Research, Strategy and Risk Division
4
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Saving and investment funds in France
Household financial investment flows
 Over 2 years (EUR billion)
2012
Q4 Total
7
57
1
4
-3 -6
7
24
0
-3
-1 -8
2
5
0
-5
0
0
0
5
Cash and deposits
Debt securities
Listed shares
Other shares
Funds:
Money market
Non money market
- Equity
- Bond
- Diversified and alternative
- Employee investment funds
-1
(FCPE)
- Other
3
Life insurance and
8
pension funds:
- Non-unit linked
9
- Unit-linked
-1
Total
21
2
Q1
12
-2
-1
8
-2
-2
0
-1
-1
-1
Q2
12
-2
-1
-1
1
-1
2
0
0
-2
-1
3
Uplift in investment flows into life insurance
2013
Q3 Q4 Total Q1
7 3
33
9
-2 -1 -6 -2
0 -3 -5 -1
9 8
24
4
-6 -2 -10 -4
-2 -1 -6 -3
-5 -1 -4 -2
0 0
0
0
0 0
-1
0
-2 -2 -7 -1
-2
-2
-2
2014
The rally in household financial investment flows in the first
quarter of 2014 extended into the second quarter
(EUR 19 billion), consisting mainly of bank deposits and
new investments in non unit-linked life insurance.
Q2 Q3*
7
-3
0
2
1
-1
1
0
0
0
4
-
-1
4
-
-3
-
5
3
1
0
2
6
1
21
14
8
10
7
38
14 11 13
25
-4
97
13 7 9 6
1 1 1 1
29 17 16 12
35
3
75
12 10 11
2 2 2
20 19 -
Nevertheless, provisional data published by the Banque de
France on 30 October suggests that investment flows
declined in the third quarter as a result of a lesser
contribution from bank deposits (EUR 4 billion). The
underlying reasons are a rise in sight deposits, up from
EUR 2.4 billion to EUR 5.4 billion between the second and
third quarters of 2014, combined with a drop in deposits in
passbook savings accounts. Outflows from the latter,
including home savings accounts, were reportedly around
EUR 6.5 billion in the third quarter, compared with barely
positive inflows of EUR 0.3 billion in the previous quarter,
according to the provisional data.
After beginning the year with declining but positive inflows of
EUR 3.8 billion in the first half of 2014, Livret A and
sustainable development passbook savings accounts
shifted back to a net outflow position from May onwards.
This trend became more marked when interest rates on
these accounts were once again lowered in August 2014.
Net outflows from these two types of accounts in the third
quarter thus totalled EUR 4.6 billion and EUR 3.8 billion
respectively in October.
Low nominal interest rates on regulated passbook savings
accounts continued to benefit sight deposits, whose
opportunity cost fell amid weak inflation.
* Provisional data – data not available
Source: Banque de France, national financial accounts, base = 2005

Over seven years
(Cumulative flows over four quarters, EUR billion)
Currency and deposits
Debt securities
Mutual funds shares
Life insurance & pension fund
Quoted shares
160
110
60
Continued net purchases of shares/units in CIS
The net outflows from shares/units in collective investment
schemes (CIS) observed in the first quarter of 2014
(EUR 4 billion) gave way to modest inflows of
EUR 0.6 billion in the second quarter. With low interest rates
crimping available returns, outflows from money market CIS
slowed in the second quarter of 2014, totalling
EUR 0.8 billion, compared with EUR 2.5 billion the previous
quarter. Reflecting product switches and investment
behaviours, non money market CIS reported weak inflows in
the second quarter, resulting from an upturn in net inflows
into employee investment funds (EUR 3.5 billion), as in the
second quarter of 2014.
10
-40
Mar-07Sep-07Mar-08Sep-08Mar-09Sep-09Mar-10Sep-10Mar-11Sep-11Mar-12Sep-12Mar-13Sep-13Mar-14
Source: Banque de France, national financial accounts, base = 2005
Yields on investments (%)
5
Passbooks savings accounts
Time deposits < 2 years
Money market funds shares
10-year government bonds yield
4
3
2
Life insurance holds steady
Benefiting from the decline in interest rates on regulated
savings accounts, net investment in life insurance policies
across all products remained relatively buoyant in the third
quarter of 2014. According to provisional data, net new
investments in non unit-linked life insurance policies totalled
EUR 11.3 billion in the third quarter, compared with
EUR 9.8 billion the previous quarter. Net investment in unitlinked policies continued to rise, benefiting from relatively
strong market performance, up from EUR 1.8 billion to
EUR 1.9 billion in the third quarter. Nevertheless, according
to the French insurers' federation, FFSA, year-to-date net
inflows stood at EUR 19.5 billion at end-October, compared
with EUR 11.8 billion for the same period in 2013,
highlighting the significant recovery in life insurance.
1
0
Dec-06 Aug-07 Apr-08
Dec-08 Aug-09 Apr-10
Dec-10 Aug-11 Apr-12
Dec-12 Aug-13 Apr-14
Sources: Banque de France and Datastream
Net investment in life insurance and pension funds
(Cumulative flows over four quarters, EUR billion)
100
Unit linked contracts
Euros contracts
80
60
40
20
0
-20
Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar- Sep- Mar07
07
08
08
09
09
10
10
11
11
12
12
13
13
14
Source: Banque de France, national financial accounts, base = 2005
DRAI – Research, Strategy and Risk Division
5
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Risks – Synthetic indicators for measuring systemic financial stress
Box:
Macroprudential policies:
Definition and implementation6
Systemic risk defies easy definition because it is multifaceted
and thus difficult to measure with a single indicator. In fact
1
there are several different definitions that are nevertheless
similar in substance: systemic risks refer collectively to all
risks of imbalances or shocks affecting the financial system if
2
they significantly undermine economic activity . Their scope
can be determined using the concepts of macroprudential
policies and financial stability, which are closely tied to
systemic risk.
Definition
In a 2011 joint report, the Financial Stability Board (FSB), International Monetary
Fund (IMF) and Bank for International Settlements (BIS) defined
macroprudential policy as “a policy that uses primarily prudential tools to limit
systemic or system-wide financial risk, thereby limiting the incidence of
disruptions in the provision of key financial services that can have serious
consequences for the real economy”.7
Operational implementation of macroprudential policies:
New institutions have been created since 2009 specifically to conduct
macroprudential policies. These include the European Systemic Risk Board
(ESRB), set up in Europe in 2011, and the Haut Conseil de Stabilité Financière
(High Council for Financial Stability) in France, formed in 2013 to replace the
Conseil de régulation financière et du risque systémique (Council for Financial
Regulation and Systemic Risk), which dated from end-2010.
In Europe, macroprudential policies resulted in the enforcement as of 1 January
2014 of the Fourth Capital Requirements Directive (CRD IV) and the Capital
Requirements Regulation (CRR). CRD IV mainly introduces rules for dynamic
provisioning, such as the countercyclical buffer, the systemic risk buffer, and the
capital buffers for systemically important institutions. In addition to minimum
capital requirements, the CRR establishes short-term liquidity requirements
(liquidity coverage ratio, LCR) as from 2015 and a long-term structural liquidity
ratio (the net stable funding ratio, NSFR).
Financial stability means “a condition in which the financial
system – intermediaries, markets and market infrastructures –
can withstand shocks without major disruption in financial
intermediation and in the effective allocation of savings to
productive investment” (ECB (2013)). Until 2007, there was a
3
degree of consensus that financial stability, which ensures
steady economic growth, arose from the concurrent
implementation of the right monetary, fiscal and
microprudential policies.
The global financial crisis that began in 2007 clearly showed
that even when inflation is under control and fiscal positions
seem sound, certain risks to the financial system may disrupt
the system when they materialise. They can go so far as to
undermine financial stability and affect the real economy by
stunting economic growth and social welfare.
Macroprudential versus microprudential policies
In contrast to their microprudential counterparts, macroprudential policies
specifically concern not the prudential instruments on which they rely but their
objective and analytical scope8. While microprudential policies aim to protect
individual financial institutions and maintain their soundness, macroprudential
policies seek to prevent systemic risk by analysing of the financial system as a
whole, including interconnections, and its interactions with the real economy.
Monetary and fiscal policies and microfinancial supervision
tools have proved inadequate for dealing with these risks,
dubbed systemic because they impact heavily on economic
activity. It thus became necessary to give a macroeconomic
dimension to microprudential policy, which aims to ensure the
stability of individual financial institutions. The aim of this
addition is to account firstly for the interconnections between
the components of the financial system and secondly for the
interactions between the real and financial economy. Such is
4
the aim of macroprudential policies .
An additional capital requirement is typically both a microprudential and
macroprudential instrument. Only the levels are set differently: a microprudential
capital requirement is based on the level of capital needed to ensure that
financial intermediaries remain resilient, even after they have absorbed losses
caused by potential shocks. The macroprudential capital requirement
incorporates negative externalities resulting from the disorderly failure of an
institution and their effect on the entire economy.
The financial system's regulatory bodies have made
macroprudential policies a core concern since 2009; they are
working to specify the scope of those policies and to ensure
they are implemented operationally (see box). The resulting
macroprudential instruments have been designed to make the
financial system more resilient and prevent it from
5
encouraging an ex ante build-up of stress , which is fertile
ground for systemic risk.
Macroprudential policies are therefore deeply rooted in the
concept of systemic risk, the origins of which need to be
understood in order to develop measurement indicators that
can be used to guide these policies. Indicators with the
potential to predict financial crises can be designed only
through detailed knowledge of the vulnerabilities that underlie
systemic risk.
Harmonised processes for identifying systemic risk at
international level
Identifying systemic risk requires detailed knowledge of the
entire financial system and how it interacts with the real
economy, in order to detect financial failures and
vulnerabilities that might foster systemic crises.
Of the various definitions, those used by the G20 (shared by the FSB, IMF and BIS)
and the European Systemic Risk Board (ESRB) compel recognition. They read as
follows:
“a risk of disruption to financial services that is (i) caused by an impairment of all or
parts of the financial system and (ii) has the potential to have serious negative
consequences for the real economy” (FSB, IMF, BIS (2009) p.5-6).
“a risk of disruption in the financial system with the potential to have serious negative
consequences for the internal market and the real economy”, according to Article 2 of
European Regulation No. 1092/2010 (European Union (2010)).
2 See Noyer (2014), p. 7.
3 See Caruana, J. and B. H. Cohen (2014), p. 16.
4 While use of the term “macroprudential” became more widespread after the 20072009 financial crisis, the archives of the Bank for International Settlements date the
first appearance of this term to 1979, when it was used in the minutes of a meeting on
international bank lending held by the Cooke committee, the forerunner to the Basel
Committee. Its use in public documents reportedly dates from 1986. See Clement
(2010) for a historical perspective.
5 Macroprudential policies are, by definition, preventative. They aim to prevent crises
rather than manage them.
1
DRAI – Research, Strategy and Risk division
In comparison, the financial sector is seriously strained by the
presence of information asymmetries and externalities
resulting from its unique characteristics. These include, among
others, the specific balance sheet structure of financial
6
See the April 2014 special issue of the Banque de France Financial Stability Review
on macroprudential policies, IMF (2013) and the recommendations of the IMF (2014).
7 See FSB, IMF and BIS (2011) p. 2.
8 Andrew Crockett presented a visionary view of macroprudential policies in 2000 in a
speech to the Eleventh International Conference of Banking Supervisors, entitled
“Marrying the Micro- and Macro-prudential Dimensions of Financial Stability” (Crockett
(2000)).
6
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
intermediaries, mainly in terms of maturity mismatches and
high leverage, and the high degree of interdependence
between markets and institutions, primarily through strategic
complementarities that lead to correlated exposures and risks
(ECB (2009)).
reflecting financial vulnerabilities. The IMF recently published
a Staff Guidance Note on macroprudential policy listing a set
of indicators for monitoring vulnerabilities that could be a
source of systemic risk, differentiating between the
vulnerabilities that come under the procyclical dimension and
14
those that come under interconnectedness (IMF (2014)) .
In addition to individual indicators, each covering specific
aspects of systemic stress in the financial system, synthetic
indicators have been developed on both sides of the Atlantic,
15
mainly by the central banks .
An analysis of past crises has gradually made it possible to
identify a number of market failures and vulnerabilities that are
9
of particular importance in preventing systemic risk , including:
 excessive credit growth;
 high leverage;
 excessive maturity mismatches and insufficient
consideration given to asset or market illiquidity risks;
 overly concentrated exposures, both direct and indirect;
 misaligned incentives that cause excessive risk-taking
and moral hazard;
 significant development of OTC derivatives and offbalance sheet transactions;
 financial infrastructures that are not resilient enough to
withstand operational shocks.
Overview of indicators of systemic financial stress
Constructing synthetic indicators is a three-fold process that
involves selecting a number of sub-indices reflecting a variety
of financial vulnerabilities; standardising the sub-indices so
they can be compared with a single set of values; and
aggregating the standardised sub-indices to obtain a single
synthetic indicator (Figure 1).
This analysis of advantages and limitations has been
deliberately confined to the construction of three synthetic
indicators. They have been selected to represent a range of
methods likely to be used and are recognised for their ability
to identify previous crises in hindsight.
The essence of the failures and vulnerabilities that underlie
systemic risk are diverse in origin but can generally be found
in one of two dimensions: interconnectedness or procyclicality.
10
In general, interconnectedness has a cross-sectional,
structural dimension. It refers to all the unique characteristics
of the financial system that may or are likely to propagate risks
at a given point in time and to trigger a domino effect. More
specifically, interconnectedness refers to markets' and
participants' common exposures, risk concentration, and the
relationships and interdependencies between entities and
sectors within the financial system at a given point in time.
Incorporating
this
cross-sectional
dimension
into
macroprudential policies has tightened the focus on
11
systemically important institutions and sectors .
Figure 1: Principle for constructing synthetic indicators of
systemic financial stress
While interconnectedness is based on a snapshot of the
financial system's vulnerabilities at a specific time,
12
procyclicality is assessed on a dynamic basis . This time
dimension refers to the gradual accumulation of financial
imbalances due to the existence of financial cycles that, for
example, produce potentially excessive credit growth and
heightened leverage during up-phases and unfavourable
financial conditions during downturns. Incorporating the time
dimension into macroprudential instruments makes it possible
to develop so-called lean-against-the-wind measures that can
be calibrated over time to adjust to the cyclical nature of
financial markets or their participants.
Source: AMF
Given the extent and variety of the failures and vulnerabilities
that might encourage a build-up of systemic risks, the
authorities in charge of macroprudential policies have
13
developed risk dashboards to identify measurement tools for
9
See Noyer (2014) and ESRB (2013).
This cross-sectional dimension arises from the need to consider all participants and
markets in the financial system in order to identify interconnectedness.
11 Some of the principal criteria cited for identifying the systemic weight of markets
and institutions include the size of the financial entity, “substitutability (the ability of
the other components of the system to provide the same services in the event of
failure)”, interconnectedness, cross-jurisdictional activity and complexity. See BCBS
(2013).
12 Interconnectedness does indeed evolve over time but can be assessed at any
given moment based on detailed, immediate knowledge of the financial system, like a
snapshot. Cyclicality can be perceived only over a financial cycle, i.e. over time like a
short film.
13 Since September 2012, the ESRB has published a quarterly risk dashboard
composed of some 50 quantitative indicators for 29 countries (27 EU countries, the
10
DRAI – Research, Strategy and Risk Division
USA and Japan) and the euro area, covering six categories: interlinkages and
composite measures of systemic risk, macro risk, credit risk, funding and liquidity risk,
market risk, and profitability and solvency of banks and insurers. See ESRB (2014).
14 The IMF (2014) recommends monitoring the vulnerabilities of the procyclical
dimension with indicators that have been divided into four groups: (i) vulnerabilities
affecting the entire economy that result from credit growth; (ii) sector vulnerabilities
resulting from growing credit to households; (iii) sector vulnerabilities resulting from
businesses' credit exposure; and (iv) vulnerabilities arising from excessive
asymmetries in foreign exchange positions and in the maturity mismatch in the
financial sector (IMF (2014) p.12).
15 See de Bandt et al. (2013), Bisias et al. (2012) and Brunnermeier et al. (2012) for
reviews of the literature.
7
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Figure 2: Composite Indicator of Systemic Stress (CISS)
The three synthetic indicators chosen are:
16
 The Composite Indicator of Systemic Stress (CISS) ,
developed in 2012 by the European Central Bank (ECB),
reflecting systemic financial stress in the euro area
(Figure 2);
17
 The Kansas City Financial Stress Index (KCFSI) ,
developed in 2009 by the Federal Reserve Bank of
Kansas City to report on financial stress in the USA
(FigureFigure 3).
 The credit weighting-aggregated Financial Stress Index
18
(FSI) for Canada, developed in 2003 by the Bank of
Canada (Figure 4). The FSI for Canada differs from the
CISS and the KCFSI in two ways. First, it broke new
ground when it was developed in 2003. Second, it stems
from a selection process. Based on 15 synthetic
indicators designed by standardising the sub-indices with
different methods and using different aggregation
processes, the credit weighting-aggregated FSI (see
below) has proven better at tracking previous crises. A
comparison of the synthetic indicators proposed by Bank
of Canada reveals the contrasting methodologies used
by the CISS and KCFSI with the same data.
Source: ECB data.
Figure 3: Kansas City Financial Stress Index (KCFSI)
The construction of a synthetic indicator raises several
questions. Which sub-indices should be selected to capture
existing stress in the financial sector? How can sub-indices
that use different scales be harmonised and compared? And
how can these indices be aggregated to retain the maximum
amount of key information?
Source: Federal Reserve Bank of Kansas City data.
Selecting the sub-indices
Whichever synthetic indicator of systemic financial stress is
considered, it is always constructed from a set of sub-indices
that share some similarities.
Figure 4: Two of the 15 financial stress indices for the Canada
FSI
In an effort to measure stress-indicating factors such as flight
to quality, search for liquidity or economic agents' uncertainty,
the sub-indices interpret stress by using measures of trends,
volatility and replacement strategy that reflect financial market
activity and participant behaviour.
Certain basic sub-indices are common to the majority of
synthetic indicators: volatility in money-market securities, debt
securities, stock indices and exchange rates, and the spread
between risky and non-risky assets or between assets with
equivalent ratings on different markets.
Source: Illing and Liu (2006).
Some synthetic indicators also group their sub-indices by
market or participant. That is the case with the CISS, which
uses five groups: financial intermediaries, the equity market,
the bond market, the money market and the foreign exchange
market (Figure 5).
Canada's FSIs are based on seven standard sub-indices, in
which financial series have already been mathematical
transformed, plus four refined sub-indices produced, for
example, by regressing standard sub-indices or introducing
econometric models to measure the volatility of certain
financial securities or exchange rates. This fine-tuning shows
how difficult it is to reflect potential stress in the financial
system through simple quantitative measurements.
In addition, as pointed out by Hollo et al. (2012), the process
of selecting sub-indices is inevitably constrained by the
availability of data and the frequency with which they are
19
updated . In practice, it is generally preferable to use subindices constructed from weekly or monthly data so as to
Developed in 2012 (Hollo, Kremer and Lo Duca (2012)), the composite indicator of
systemic stress, or CISS (pronounced “kiss”), has since been regularly updated by
the ECB and used by the European Systemic Risk Board in its risk monitoring
dashboard (ESRB (2014)). The European Securities and Markets Authority (ESMA)
used it to develop an ESMA-CISS, published on a quarterly basis in its risk monitoring
dashboard (ESMA (2014)).
17 Designed in 2009 (Hakkio and Keeton (2009)), the Kansas City Financial Stress
Index, or KCFSI, has since been regularly updated by the Federal Reserve Bank of
Kansas City. See http://www.kc.frb.org/research/indicatorsdata/kcfsi/index.cfm.
18 Developed in 2003 (Illing and Liu (2006)), the 15 Financial Stress Indices (FSI) are
no longer publicly updated.
16
DRAI – Research, Strategy and Risk Division
It is particularly difficult to use data from on-transparent financial sectors, such as
shadow banking, which is why the latter is not currently taking into account in
synthetic indicators. Similarly, financial innovations for which statistical information is
not available cannot be incorporated.
19
8
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
regularly monitor changing patterns of systemic financial
stress.
sub-indices reduces their volatility by making their variance
24
constant , which can result in underestimating the extent of
financial stress.
Standardising the sub-indices
Once the sub-indices have been selected, they are
harmonised before being aggregated. This gives them the
same weight in the synthetic index despite their differing initial
scales. The sub-indices are standardised to prevent any one
of them being unduly overweighed in the synthetic indicator.
Aggregating the sub-indices
Once the sub-indices have been standardised, they still have
to be aggregated to produce the synthetic indicators. There
are two main ways to do this:
 a weighting system, possibly matched with a correlation
matrix, as is the case with the CISS and some FSIs.
 a principal component analysis, as is the case with the
KCFSI and some FSIs.
The sub-indices selected to represent systemic financial
stress can use very different units, such as percentages,
currency units or basis points. Aggregating indices with
different initial scales would give some of them more weight
20
than others in the synthetic index .
Two main methods are generally used to standardise the subindices:
 relying on the cumulative distribution function, primarily
in the CISS and some FSIs;
 standardising sub-indices, through normal distribution,
performed mainly in the KCFSI and some FSIs.
Technicality aside, this step is sometimes used to strengthen
the systemic nature of the synthetic indicator.
That is the case with the CISS. Two specific steps in the
aggregation process help to better reflect the systemic
financial stress observed in the financial system: using an
inter-market and inter-participant correlation matrix and
working out a weighting matrix that reflects the impact of the
financial system on the real economy.
Using the cumulative distribution function for a given subindex over a reference period consists in assigning a
21
cumulative frequency to each index value . This same
method is applied beyond the reference period by gradually
expanding this period. Thus the value of a sub-index at a
given date after the reference period is determined by its
cumulative frequency within the set of values that pre-date it,
22
without revising the previous standardised values . The
advantage of standardising the sub-index values using the
cumulative distribution function is that present values can be
aligned with past values without revising the assessment of
the prior values which, once determined, remain fixed over
time. In other words, this method offers a view of financial
stress as perceived in real time, not as it would be perceived
today with hindsight. This ensures that no stress events are
underestimated. Typically, WorldCom's bankruptcy is now
seen to pale in comparison with the failure of Lehman
Brothers, while in 2002 it was viewed completely differently
(Figure 2).
However, aggregating the sub-indices in the CISS is a more
complex exercise, consisting of four steps (Figure 5):
 compiling the 15 standardised sub-indices, through a
simple arithmetic mean, into five intermediate indices,
each characteristic of a market or participant.
 computing an inter-market and inter-participant
25
correlation matrix .
26
 determining a weighting matrix that assigns a weight to
each intermediate index based on its impact on euro
area industrial production.
 computing the CISS by aggregating the intermediate
indices using the correlation and weighting matrices.
As noted above, the CISS has two key advantages because it
takes into account:
 the interdependencies within the financial system via the
correlation matrix and hence the potentially systemic
nature of a market as a result of the contagion effect;
 the impact of the financial system on the real economy
via the weighting matrix, more closely approximating the
theoretical definition of systemic risk.
Moreover, this method places no preconditions on the subindices before standardisation, particularly in terms of
normality. It nevertheless alters the variance of the subindices.
Calculating the CISS is nevertheless complex and numerous
econometric tests have to be carried out before applying the
VAR model that is used to determine the weighting matrix.
Moreover, the weighting matrix is fixed. However, although the
stability of the weights may be warranted over a short- or
medium-term period, given that the industrial production
model and its dependence on different markets are probably
slow to change, a lack of change in the structure of the
27
economy over the longer term is more doubtful .
The other method used in the KCFSI and some FSIs to
harmonise the sub-indices is to normalise them through
23
normal distribution . Though fairly simple, this method has its
drawbacks. In particular, each of the sub-indices constructed
has to follow a normal distribution. Moreover, normalising the
Without standardisation, an index representing bank lending will typically
overshadow any measure of stock index volatility.
21 With the CISS, all n values for each of the 15 sub-indices between 1999 and 2002
are arranged in ascending order, then each value, xt, is assigned a ranking, rxt, based
on which the cumulative frequency value, zt, is computed as follows:
rx
z t  Fn ( x t )  t . Beyond 2002, at date 2002+T, the cumulative frequency
n
rx
value, zn+T, is: z n T  Fn T ( x n T )  n T , where r xn T is the ranking of value
n T
xn+T within the set of n+T values.
22 Progressively expanding the calculation period for the cumulative distribution
function beyond the reference period is equivalent to adding each new value
individually and ranking them all in real time.
23 Over a specified period of time, after first computing the means and variances for
each sub-index, normalisation consists merely in centring and reducing them.
20
DRAI – Research, Strategy and Risk Division
Normalising a magnitude reduces its heteroscedasticity.
The correlation matrix computation is not based on the usual formulas but on
exponentially weighted moving averages, which make it possible to compute each
contemporaneous correlation as a function of all past correlations. The weight
assigned in the past versus the present is determined arbitrarily with the smoothing
parameter, set at 0.93 in the CISS (Hollo et al. (2012), p. 19).
26 The weighting matrix is obtained using VAR model impulse response functions
describing the impact of the various intermediate indices on industrial production
growth in euro-area. The weights used are 30% for financial intermediaries, 25% for
the equity market and 15% for the money market, bond market and foreign exchange
market (Hollo et al. (2012), p. 18).
27 However, using variable weights that are recalculated for each period can cause
the synthetic indicator to fluctuate without increasing systemic financial stress but just
24
25
9
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
28
Figure 5: CISS methodology
different weighting systems . These FSI indicators can be
29
compared using a loss function , which reflects the indicator's
failure to clearly identify periods of stress and calm. This
comparison shows the weighting method, based on the
markets' contribution to the financing of the economy, to be
the most effective (Figure 7), while PCA seems the least
effective method.
Assessing the effectiveness of synthetic indicators in
predicting crises is a complex process, and it can only be
done indirectly in hindsight since there is no universally
acknowledged measure to reflect financial stress. With that in
mind, estimates are made to determine whether the sharp
variations in these indicators are associated with periods of
greater financial stress. These estimates show that the CISS
is consistent with historically identified periods of financial
stress: the WorldCom bankruptcy (2002), the onset of the
subprime crisis (mid-2007), the collapse of Lehman Brothers
(15 September 2008), and the start of the sovereign debt
crisis in Europe. The same holds true for the KCFSI and
Canada's FSI, where each “peak” is linked to a major financial
event in the geographic areas covered (i.e. the USA and
Canada). In addition, the KCFSI statistically tests the
correlation between the synthetic indicator and an indicator of
30
economic activity to ascertain the KCFSI's ability to predict
economic activity.
Recently, the synthetic indicators have shown – to a greater
extent in Europe than in the USA – that financial stress began
to increase moderately and fluctuate in May 2013 with the
announcement of the tapering pullback by the Federal
Reserve.
.
Source: AMF.
Figure 6: KCFSI methodology
Source: AMF.
Figure 7: FSI methodology
Table 1: Comparison of synthetic indicators
Sub-indices
Methods for
standardising
sub-indices
Methods for
aggregating
sub-indices
CISS
- 15 subindices
- 5 intermediate
indices
Cumulative
distribution
function
Arithmetic
mean,
correlation and
weighting
KCFSI
- 11 subindices
Normalisation
Principal
component
analysis
FSI
- 7 sub-indices
Cumulative
distribution function
and normalisation
Principal component
analysis, arithmetic,
geometric and
weighted means
Source: AMF.
A comparison of these three synthetic indicators shows that
progress has been made since 2003 on constructing them to
better reflect systemic stress in the financial system. They are
now based on higher-quality sub-indices. The number of
possible aggregation methods has also increased and some
are now better able to account for the systemic dimension of
the financial system by using correlation and weighting
matrices. As shown in Figure 8, while each intermediate index
reflects the financial stress specific to the participants or
markets to which it refers, the CISS offers a more
comprehensive view. The CISS is more than the sector- and
market-weighted sum of certain stresses; it also reflects the
Source: AMF.
The other oft-used method adopted by the KCFSI is principal
component analysis (PCA) (FigureFigure 6). PCA is a
statistical method that uses linear combination to transform
several sub-indices into one factor that best replicates the
variance of these indices. But the drawback of this method is
that a considerable amount of information may be lost,
particularly when there is a large number of sub-indices. PCA
is also harder to interpret than a weighting system.
The construction of 15 synthetic indicators provides an opportunity to test a number
of combinations of standardisation and aggregation methods, including the following:
normalisation of sub-indices and PCA; normalisation and different means (arithmetic
or geometric); use of the cumulative distribution function and different means; and
use of an average weighted by the percentage of funding each sector provides to the
Canadian economy.
29 The loss function minimises type 1 errors, which consist of failing to signal existing
stress, and type 2 errors, which signal non-existent stress.
30 This test consists of regressing each indicator on its own lagged values and the
lagged values of the other variable.
28
The FSI provides the ideal framework for comparing the
previous two methodologies as it constructs 15 synthetic
indicators, some of which use PCA, while others employ
by increasing the weight of certain intermediate indices. This makes it harder to
interpret changes in the synthetic indicator.
DRAI – Research, Strategy and Risk Division
10
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
References
interconnectedness between markets and sectors inside the
financial system.
de Bandt O., J.-C. Héam, C. Labonne and S. Tavolaro (2013)
Measuring Systemic Risk in a Post-Crisis World, Autorité de
Contrôle Prudentiel, Débats économiques et financiers, No. 6,
June.
Figure 8: Standardised intermediate indices relative to the
CISS
8.1 Financial intermediaries
8.2 Equity market
1
1
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0
0
1
Basel Committee on Banking Supervision (BCBS) (2013) “Global
systemically
important
banks:
updated
assessment
methodology and the higher loss absorbency requirement”,
BIS, July.
1
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0
Bisias D., M. Flood, A. Lo and S. Valavanis (2012), “A Survey of
Systemic Risk Analytics”, Annual Review of Financial
Economics, 4, 2012, p. 255-296.
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
8.3 Bond market
Brunnermeier, M., G. Gorton and A. Krishnamurthy (2012) “Risk
topography”, NBER Macroeconomics Annual 2011, vol. 26, p.
149-176.
8.4 Money market
1
1
1
1
0.9
0.8
0.8
0.8
0.6
0.6
0.6
0.8
Caruana, J. and B. H. Cohen (2014) “Five questions and six answers
about macroprudential policy”, Financial Stability Review,
Banque de France, no. 18, April, p. 15-24.
0.7
0.6
0.5
0.4
0.4
0.4
0.2
0.2
0.2
0.4
0.3
Clement, P. (2010) “The term ‘macroprudential’: origins and
evolution”, Quarterly Review, BIS, p. 59-67, March.
0.2
0.1
0
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
0
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Crockett, A. D., (2000) “Marrying the Micro- and Macro-prudential
Dimensions of Financial Stability”, Speech before the Eleventh
International Conference of Banking Supervisors, 20-21
September.http://www.bis.org/review/rr000921b.pdf
8.5 Foreign exchange market
1
1
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
European Central Bank (2013) Financial Stability Review, November.
0
European Central Bank (2009) “The Concept of Systemic Risk”,
Financial Stability Review, December, p. 134-142.
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
European Securities and Markets Authority (2014) ESMA Risk
Dashboard, No. 4-2014, November.
Note: The right-hand scale is the CISS scale, in dark blue in each figure.
Source: ECB data.
European Systemic Risk Board (2014) ESRB Risk Dashboard, issue
9, 25 September.
There are some drawbacks, however. Because they are
sophisticated, synthetic indicators are difficult to compute, and
sometimes even difficult to replicate on the basis of published
descriptions, because the calculation requires multiple steps
that are specific to each sub-index. There are, however,
possible ways to simplify the selection of the sub-indices and
the design of the correlation matrix. It is especially important to
encourage simplification because the structure of the most
recent synthetic indicators, such as the CISS, has proven
flexible enough to incorporate new data derived either from
developments in finance or from greater efforts to make
information available.
European Systemic Risk Board (2013) Recommendation
(ESRB/2013/1) of the European Systemic Risk Board on
intermediate objectives and instruments of macro-prudential
policy, Official Journal of the European Union, April.
European Union (2010) Regulation (EU) no. 1092/2010 of the
European Parliament and of the Council on European Union
macro-prudential oversight of the financial system and
establishing a European Systemic Risk Board, Official Journal
of the European Union.
Financial Stability Board, International Monetary Fund and Bank for
International Settlements (2011) “Macroprudential policy tools
and frameworks: update to G20 finance ministers and central
bank governors”, February.
Despite the progress made thus far, the benefits of these
indicators in terms of interpretation should not be overrated.
They do provide an overall measure of systemic financial
stress, interpreted mostly on a relative basis, but it is still
necessary to concurrently monitor a broader range of nonsynthetic financial indicators, such as risk monitoring
dashboards. Furthermore, the macroprudential contribution of
synthetic indicators lies party in their ease of interpretation.
31
From that perspective, introducing early warning thresholds
alongside the synthetic indicator charts is a promising
development because it endows these indicators with a
forward-looking capability that is most opportune (Figure 2).
Financial Stability Board, International Monetary Fund and Bank for
International Settlements (2009) “Guidance to Assess the
Systemic importance of financial institutions, markets and
instruments”, October.
Hakkio, C. S., and W. R. Keeton (2009) “Financial stress: what is it,
how can it be measured, and why does it matter?”, Economic
Review, 94(2), p. 5-50.
Hollo, D., Kremer, M. and Lo Duca, M. (2012) “CISS-a composite
indicator of systemic stress in the financial system”, ECB
Working Paper Series, No. 1426, March.
Illing, M., and Y. Liu (2006) “Measuring financial stress in a developed
country: An application to Canada”, Journal of Financial
Stability, 2(3), p. 243-265.
V. Janod and N. Mosson
The CISS threshold is derived from a threshold VAR (TVAR) model, which, when
applied to the CISS and to annual growth in industrial production, identifies two
regimes: a low financial stress regime located below the threshold and a high
financial stress regime above it. The threshold separating these two regimes is
determined by the TVAR model so as to optimise the areas where industrial
production and the CISS co-evolve. Adequacy tests show a statistically significant
ability to correctly identify periods of high and low financial stress.
International Monetary Fund (2014), “Staff Guidance Note on
Macroprudential Policy”, IMF Policy Paper, forthcoming.
31
DRAI – Research, Strategy and Risk Division
International Monetary Fund (2013) “Key aspects of macroprudential
policy”, IMF Policy Paper, June.
11
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Study – Asset management in a low interest rate environment
The fact that asset portfolios are sensitive to a hiatus in the
current extended period of low interest rates is causing
concern or alarm among a broad swathe of global
institutions, national and international regulators, and market
participants. All and sundry are expecting significant periods
of reallocation that will adversely affect less liquid or riskier
assets, especially corporate bonds, which have attracted
substantial investment flows recently. These periods would
occur if or when nominal yields undergo an upside shock
caused either by monetary policy adjustments (including
unforeseen or miscalculated adjustments on both sides of
the Atlantic) or by a reassessment of risk premia, now at an
all-time low. Moreover, the consequences of these
reallocations might be heightened by a structural decline in
liquidity on secondary fixed income markets. Under these
circumstances, the quality of the procedures that asset
managers use to cope with liquidity risk is crucial both for
financial stability and for investor protection.
Federal Reserve's policy tapering announcement in May
2013 triggered sharp corrections in HY bonds and emerging
assets, resulting in temporary reversals of investment flows.
Spreads on US HY corporate debt pushed out between 8
and 16 basis points around the announcements on 22 May
and 19 June 2013 that asset purchases were being scaled
down. During the following quarters, however, investor
appetite for the HY segment showed no signs of waning.
Some institutions actually conjectured that yield-seeking
behaviour might become more acute during the first half of
1
2015. According to the Bank for International Settlements,
the reaction of yields on these asset classes was quickly
absorbed and the search for yield resumed in second-half
2013. It continued in 2014 on the back of positive
announcements concerning the US macroeconomic
situation as well as reassuring language from the Federal
Reserve, the Bank of England and the European Central
Bank. As regards HY corporate debt, the Fed's tapering talk
did indeed leave its mark on US and European interest rates
and investment flows, but the impact proved short-lived and
markets seem to have regained their wind in the second half
of 2013 and during 2014.
Yield-seeking behaviour is compressing risk premia
Risk free nominal interest rates have been anchored at
record lows by the accommodative policies adopted by
central banks in response to the negative shocks to the
GDP growth trajectory. The shocks were caused in
succession by the 2007-2008 financial crisis and the euro
area sovereign debt crisis. In addition, the banks' asset
purchase and refinancing policies, visible in their bloated
balance sheets, caused these lower rates to spread to
lesser-quality sovereigns, corporate bonds and equities.
Low returns on the least risky assets prompted a search for
yield. Investors' greater propensity to expose themselves to
risk factors – notably market, credit, liquidity and volatility
risk – compressed risk premia not just on sovereigns but
also on corporate bonds in the USA and, to a lesser extent,
Europe. As a result, credit risk valuation on corporate bonds
in both areas, as well as on some corporate bonds in
emerging economies, is now at historically low levels.
Spreads on triple-C rated European debt plummeted 30%
between October 2013 and May 2014, compared with Arated and higher securities, possibly reflecting a steeper
underweight to high yield (HY) corporate segments than to
investment grade (IG) segments. Additional signs of this
trend can be seen in substantial investment flows into debt
securities that are less legally safe, such as convertible and
cov-lite bonds. Equities have also been buoyed by the
newfound appetite for market risk, displaying lofty
price/earnings ratios in recent months. Declining risk premia
on US and European IG and HY corporate bonds point to a
low valuation of liquidity risk. Moreover, option prices are
consistent with persistently low volatility expectations. The
hunt for yield pickup is also visible in investment flows from
developed economies into emerging bonds and equities.
Note that demand-side pressure for assets has prompted a
response on the supply side. Governments and the private
sector have issued larger amounts of long-dated paper in
order to safeguard the ability to pay off their long-term
interest expense.
Admittedly, none of these signals in itself poses a potential
or actual risk to financial stability. Nevertheless, a broad
consensus is forming around the idea that the corporate
debt situation, particularly for HY debt, combines signs of
undervalued liquidity and credit risk with an investordemand driven rise in volumes.
Investors are certainly aware that asset valuation
assumptions hinge on central banks maintaining a highly
accommodative stance. An indication of this came when the
DRAI – Research, Strategy and Risk division
Asset managers' portfolios also mirror investors' yieldseeking behaviour
The job of asset managers is to help investors adjust their
portfolios to market conditions at the lowest possible cost,
so it is only natural that those conditions should make their
mark on investments in this sector, in several ways.
First, flows into US and global HY debt funds have surged.
However, the increase in the assets of corporate bond funds
should be viewed with caution. Without further details about
the precise composition of their portfolios, the increase is
not necessarily a relevant indicator insofar as liquidity
conditions, the degree of legal certainty, and interest rate
sensitivity can vary across the corporate bond asset class.
Second, measured by the change in assets under
management (AuM) in alternative investment funds, we see
an apparent increase both in exposure to less liquid assets
and in liquidity transformation. Although the market shares
of alternative funds are still modest, from 2007 to 2013 their
aggregate global AuM rose from USD 4 trillion to
2
USD 7 trillion . Allocations by US emerging equity funds
increased from USD 667 billion to USD 911 billion between
2011 and 2012, while emerging bond allocations went from
3
USD 246 billion to USD 457 billion during the same period .
Among regulated funds, alternative strategy funds are
increasingly popular. The AuM of American alternative
mutual funds rose from USD 258 billion at end-2011 to
USD 465 billion in May 2014, while in Europe the AuM of
alternative UCITS swelled from USD 113 billion to
4
USD 155 billion between end-2011 and May 2013 .
It thus seems certain that low money market rates and the
search for yield have distorted asset managers' portfolios,
especially in the USA, where most of the research has been
carried out. That said, the actual scope of these changes
should be viewed with caution because it is very hard to
determine precisely what percentage of portfolios is
invested in assets with a proven risk of illiquidity. In addition,
the funds' exposure, both aggregated and by asset subBIS Annual report, April 2014.
Source: BCG Global Asset Management, AuM including captive insurers and
pension funds in 42 countries.
3 Source: Investment Company Institute
4 Source: Blackrock
1
2
12
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
class, is difficult to quantify with finer granularity, especially
due to lack of harmonisation between the definitions used
by regulators and their scope of action.
As is the case for aggregate levels, it is hard to identify the
direction in which managers' portfolios have moved in terms
of these asset classes, which yield-seekers have focused on
in recent months. Emerging asset AuM rallied globally in
first-half 2014, although not to the May 2013 level.
Meanwhile, the total assets invested by US mutual funds in
HY debt exceeded that same level.
some USD 20 billion compared with USD 80 billion in 2008.
This is equivalent to 0.2% of a total market worth
USD 9.8 trillion, or one day's trading at present volumes.
Daily trading volume in US corporate bonds has also slowed
sharply, whereas the total stock of underlying assets has
risen on robust issuance. In Europe, the percentage of
corporate debt securities held by monetary and financial
institutions outside the European System of Central Banks
has also fallen steeply. Regarding trading volume in
7
secondary bond markets, ICMA estimates that in 2013 a
European corporate bond changed hands once a day on
8
average, whereas Biais and Declerck , using the same data
for 2005, calculated an average of five trades per day.
Further, estimates by the Bank of England suggest investors
are significantly under-rewarded for the liquidity risk in their
portfolios. For example, the estimated risk premium on HY
corporate bonds halved to 80bp between July 2013 and July
2014, close to the all-time low of 50-60bp seen in 2007.
The systemic potential of asset reallocation periods has
risen sharply because secondary markets are less liquid
Successive phases of portfolio adjustment can jeopardise
financial stability if they coincide with fire sales, especially
when liquidity is scarce in secondary asset markets,
because they contribute to spreading or heightening the
impact made by interest rate shocks on asset prices. Where
several market participants or categories of participant try
simultaneously to sell assets, the resulting price decline is
accentuated by an increase in the risk premium demanded
by the sale counterparties. The stronger demand for liquidity
that occurs during a fire sale, and its impact on prices, can
spread among asset classes and financial institutions,
especially where market participants are indebted either
explicitly or implicitly (through derivatives exposure or
because of consolidated off-balance sheet commitments).
This type of chain reaction is especially likely to occur when
secondary markets are shallow.
If the low interest rate environment were to continue, that in
itself may generate financial pressures, particularly for
institutions offering guaranteed rates of return on liabilities.
In addition, an interest rate hike prompted by an
unfavourable macroeconomic scenario or a monetary policy
shift – notably if unexpected or wrongly forecast – might
show that the last two years' asset valuations are not robust.
Although it is hard to make an exhaustive list of effects, a
monetary policy adjustment, say in the USA, could
automatically trigger an immediate fall in the price of both
sovereign and corporate bonds, with the depth of the
decline increasing with the length of the maturity. According
5
to the Bank of England , a 100bp increase in US policy
rates would mechanically imply a decline of between 5%
and 8% in the market value of US, UK and European
corporate bonds. Reallocation could occur in the sovereign
bond segment, due both to the revision of relative yields
(between US and core euro area bonds) with equal or
comparable credit quality and to the comparative risk on
bonds with higher yields (between US bonds and those
issued in the euro area periphery or emerging economies).
A rise or fall in money market rates or a sudden swing in risk
appetite could cause a swingeing price correction for
corporate bonds, notably the riskier ones, together with
disinvestment flows. In addition, this kind of episode would
probably see a fall in the price of equities, notably the least
liquid shares.
Can asset management
financial instability?
6
ICMA, European Corporate Bond Trading – The Role of the Buy Side in Trading
and Liquidity Provision, 2013.
8 Biais, B. and Declerck, F., Liquidity and Price Discovery in the European
Corporate Bond Market, 2006.
7
Bank of England, Financial Stability Report, June 2014.
Source: Royal Bank of Scotland, Credit Research and Strategy
DRAI – Research, Strategy and Risk Division
to accentuating
At first glance, investment funds are simply conduits for
investors' allocation choices. Their managers are appointed
by the end-investors, whether institutions or individuals, who
bear the valuation and liquidity risks regardless of whether
the chosen vehicle is a collective investment scheme or an
investment management mandate. Managers allocate
assets tactically under the investment mandates received
from their clients, complying with the organisational and risk
management rules set by the institution they work for.
Exposures are both taken and unwound on the basis of the
preferences expressed by investors. Where returns are not
guaranteed, managers do not expose their capital to
changes in the prices of portfolio assets.
Under these assumptions, final price adjustments and the
onset of illiquidity spirals during fire sales are ultimately due
to variables that do not depend on funds or their managers,
namely the volumes that investors wish to reallocate and the
depth of secondary asset markets. Accordingly, while it is
safe to say that the asset management sector can be a
transmission channel for bond price corrections, it is much
harder to ascertain its role in triggering or intensifying
financial instability.
More importantly, although the volume of fund-managed
assets has been substantial and rising recently, it should be
seen from a broader perspective by comparing it both with
the volumes held by other market participants and with
issuance volumes. In the US market, the aggregate position
of funds (excluding money market funds) in corporate bonds
has apparently been stable over the long run. According to
estimates by the Investment Company Institute, the share of
global financial assets held by long-term mutual funds has
been steady at around 14.5% since 2005 (USD 22 billion
out of USD 151.6 billion at end-2012). Meanwhile, the share
of US bonds held by fixed income mutual funds has risen
from 6.2% to 8.8% (USD 1.4 trillion to USD 3.3 trillion) since
2005, while staying at a relatively modest level. True, US
and European funds have increased their exposure to
emerging assets, but these holdings still accounted for just
8.9% of equity capitalisation at end-2012 (7.2% in 2009) and
4.4% for bonds (1.4% in 2009). As a result, these
developments are not conclusive evidence that funds have
a growing hold on the markets in the underlying assets,
According to several estimates, which admittedly vary in
reliability, the secondary corporate bond market has
become much less liquid since the onset of the financial
crisis. For instance, inventories of corporate bonds and
mortgage-backed securities (MBS) held by US primary
dealers, i.e. the main banks that trade in the secondary
market, have fallen to USD 80 billion from their 2007 peak of
6
USD 250 billion . The decline mainly concerns MBS, but
inventories of IG and HY corporate bonds now stand at
5
contribute
13
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
even though the holdings are proportionally much higher for
certain securities.
In addition, the orders of magnitude should be compared
with those for issuance. In the US market, for example, HY
corporate bond issuance amounted to USD 118 billion on
average between 2002 and 2007, versus USD 224 billion
9
from 2008 to 2013 , with a total of USD 1.344 trillion.
Accordingly, this second period shows an "issuance
surplus" of USD 639 billion compared with the first. At the
same time, US HY mutual funds attracted USD 111 billion.
This means that more than 90% of issuance and over 80%
of the surplus relative to 2002-2007 were attributable to
other market participants.
Although it is too early to generalise, what has happened in
US bond segment gives grounds for a cautious view of the
possible risk to financial stability from asset managers as a
whole, particularly since not all European markets are as
liquid as their US counterpart. There is no certainty that the
systemic risks from sharp swings in fixed income prices
would be confined specifically to the asset management
sector; rather, the cross-sector impact would affect
everyone holding these assets. By contrast, shifts in the
supply of liquidity in secondary bond markets seem largely
structural and may make it harder to cope with substantial
waves of selling on the liabilities side. Managers must
therefore keep a close eye on the liquidity risk in their
portfolios. This may involve incorporating (or fine-tuning)
modules designed especially for that purpose into
managers' stress tests. Accordingly, the quality of liquidity
risk management hinges on the assumptions made for the
liabilities side (selling volumes for fund shares/units) and for
the asset side (the prices at which managers could unwind
their least liquid positions). Stress tests should also be
carried out at appropriate intervals. On this issue, the EU
Alternative Investment Fund Managers Directive has
strengthened risk monitoring requirements and regulatory
oversight for alternative investment funds.
9
In sum, recent trends in asset managers' exposures and in
the way they can unwind secondary market positions,
especially in bonds, require special vigilance when it comes
to managing liquidity risk. It is up to managers to ensure
they have effective and reliable procedure for dealing with
this risk and that their clients understand it very clearly. At
this juncture, however, a more accurate diagnosis is needed
to determine whether the risks borne by the sector as a
whole are likely to intensify. Thus is because quantitative
developments as well as regulations and supervisory
practices can vary from one jurisdiction to another.
L. Goupil
Source: JP Morgan.
DRAI – Research, Strategy and Risk Division
14
Autorité des Marchés Financiers
Economic
and Financial Newsletter
2014-4
Recent editions of the Economic and Financial Newsletter
October 2014 No 3
Recent developments on the contingent convertible bond market – Risks – A. Demartini, P. Garrau and O. Rocamora
Green bonds and the AMF's role in the segment– Study – P. Garrau, O. Rocamora, C. Matissart, N. Aissaoui
July 2014 No 2
Virtual currencies: risk or opportunity? – Risks – L. de Batz
Financial market infrastructure resilience – Study – O. Vigna
April 2014 No 1
Sustainability of government debt in developed economies – Risks – C. Bouillet
Impact of interest rates on French asset management – Study – A. Baranger and V. Janod
December 2013 No 4
The challenges of regulating and supervising high-frequency trading – Risks – O. Vigna
What share does private placement occupy in bond issuance by French companies? – Study – A. Demartini
September 2013 No 3
Measuring the quality of financial market regulation (more) effectively? – Risks – M. Morand and O. Vigna
Historical estimates of asset returns and risk premia – Study – H. Bluet
June 2013 No 2
Financing of non-financial companies: is there an optimal capital structure? – Risks – A. Demartini and O. Vigna
Portfolio structure: an international comparison – Study – M. Duchez
March 2013 No 1
Towards better supervision of "shadow banking"? – Risks – L. de Batz
What are the costs-benefits of impact assessment? – Study – L. Grillet-Aubert
______________________________________________
The Economic and Financial Newsletter is published by the Analysis, Strategy and Risk Division of the AMF Regulatory
Policy and International Affairs Directorate
Publication Director
Olivier Vigna
[email protected]
+33(0)153.45.63.57
Editorial team
Laure de Batz
[email protected]
Anne Demartini
+33(0)153.45.64.56
[email protected]
Luc Goupil
+33(0)153.45.63.39
[email protected]
Véronique Janod
+33(0)153.45.64.41
[email protected]
Natacha Mosson
+33(0)153.45.61.21
[email protected]
Carine Romey
+33(0)153.45.58.91
[email protected]
+33(0)153.45.63.41
Secretariat
Muriel Visage
[email protected]
+33(0)153.45.63.35
The Economic and Financial Newsletter reflects the personal opinions of its authors and does not necessarily express the position of the AMF
______________________________________________
DRAI – Research, Strategy and Risk Division
15
Autorité des Marchés Financiers