Working Papers

[New May 2024!] LASH Risk and interest rates with Laura Alfaro (Harvard Business School), Saleem Bahaj (UCL & BoE), Robert Czech (BoE) and Jonathon Hazell (LSE) – Link

We introduce a framework to understand and quantify a form of liquidity risk that we dub Liquidity After Solvency Hedging or ‘LASH’ risk. Financial institutions take LASH risk when they hedge against losses, using strategies that lead to liquidity needs when the value of the hedge falls, even as solvency improves. We focus on LASH risk relating to interest rate movements. Our framework implies that institutions with longer duration liabilities than assets – eg pension funds and insurers – take more LASH risk as interest rates fall, because solvency concerns rise in a low rate environment. Using UK regulatory data from 2019–22 on the universe of sterling repo and swap transactions, we measure, in real time and at the institution level, LASH risk for the non‑bank sector. We find that at peak LASH risk, a 100 basis points increase in interest rates would have led to liquidity needs close to the cash holdings of the pension fund and insurance sector. Using a cross‑sectional identification strategy, we find that low interest rates caused increases in LASH risk. We then find that the pre‑crisis LASH risk of non‑banks predicts their bond sales during the September 2022 LDI crisis, contributing to the yield spike in the bond market.

Presented at (selected): Fed Board, Boston Fed, Bank of England, BIS*, IMF*, 10th Sovereign Bonds Market Conference, BIS Banks’ liquidity in volatile macroeconomic and market environments Conference*, Banco de Portugal & CEPR Conference on Financial Intermediation*, EFA*, BSE Summer Forum*

The Market for Sharing Interest Rate Risk: Quantities and Asset Prices with Umang Khetan (University of Iowa), Jane Li (Columbia Business School) and Ishita Sen (Harvard Business School)SSRN (latest version: March 2024)

We study interest rate risk sharing across the financial system using novel data on cross-sector interest rate swap positions. We show that pension funds and insurers (PF&I) are natural counterparties to banks and corporations: PF&I buy duration, whereas banks and corporations sell duration. However, demand is highly segmented across maturities, resulting in significant imbalances at various maturity points. We calibrate a preferred-habitat investors model with risk-averse arbitrageurs to study how demand imbalances interact with supply side constraints to impact swap spreads. Our framework helps quantify the spillover effects of demand shifts, which informs policy discussions on financial institutions’ hedging requirements.

Presented at (selected): 2023 – CFTC, Bank of Canada; 2024- AFA*, SFS Cavalcade*, OFR Rising Scholars Conference*, European Summer Symposium in Financial Markets*, Columbia Workshop in New Empirical Finance*, IBEFA-WEAI Summer Meeting, EFA

The Ring-Fencing Bonus (Oct 2022)with Irem Erten (Warwick Business School) and John Thanassoulis (Warwick Business School) – BoE Staff WP 999 (latest version: March 2024)

We study the impact of ring-fencing on risk-taking in the financial sector using short-term money markets. Ring-fencing is when the government restricts some activities to a subsidiary of the group whilst restricting intra-group transfers. Exploiting confidential data on sterling-denominated repo transactions, we document that banking groups subject to ring-fencing are perceived to be safer; repo investors lend to ring-fenced groups at lower rates. We show that ring-fenced groups reduce their risk-appetite and that the safety perception is amplified during times of market stress. Our paper suggests that structural reforms can create a ‘safe haven’ bank in the financial system.

Presented at (selected): FMA Applied Finance, FMA Annual Conference*, OCC Symposium on Emerging Risks in the Banking System*, ERMAS, EFMA*, IFABS*, NFA Annual Meeting

Media coverage: , Financial Times: Martin Wolf , Financial Times: Helen Thomas, The Banker

In public policy: The Edinburgh Reforms, His Majesty’s Treasury Call for Evidence

Banks’ internal capital allocation, the leverage ratio requirement and risk-taking (2021) – with Quynh-Anh Vo (BoE) – BoE Staff WP 956

This paper examines how banks’ asset risk is affected by the level (ie group or business unit) at which regulatory requirements are applied. We develop a theoretical model and calibrate it to UK banks. Our main finding is that the impact differs depending on which regulatory constraint is binding at the group level. If that is the leverage ratio requirement, then the allocation of regulatory constraints to business units either maintains or decreases the riskiness of banks’ investment portfolios. However, if the risk-weighted requirement is the binding constraint at the group level, applying regulatory requirements at the business unit level can lead to banks selecting riskier asset portfolios as optimal. We also find that the impact on banks’ asset risk differs across bank business models.

Presented at (selected): EFMA 2021, IFABS 2021, 37th Symposium on Money Banking and Finance BdF 2021*, WinE EEA 2021, 20th Annual FDCI/JFSR Bank Research Conference 2021*, ASSA 2022, ERMAS Romania 2022

Dormant projects

Risk-Taking, Competition and Uncertainty. Do CoCo Bonds Increase the Risk Appetite of Banks? BoE /CEPR WP Aug 2021 – with Mahmoud Fatouh (Bank of England) and Sweder van Wijnbergen (UvA)

Presented at (selected): Royal Economic Society Symposium 2021, IFABS 2021, Money Macro and Finance Society Annual Conference 2021, 19th Winter School of Mathematical Finance 2022

Multiple buffer CoCos and their impact on financial stability Tinbergen Institute WP Jan 2020 

Presented at: GSE Barcelona 2018, IFABS 2018, FMA European Conference 2018, INFER 2019, Queen Mary Economics and Finance PhD workshop 2019, ERMAS Romania 2019

(Updated: April 2024. * presentations by co-authors.)

error: Content is protected !!