Bank of England, Jan. 22, 2016.
The case for sovereign contingent debt
Stavros Zenios
University of Cyprus
Norwegian School of Economics
Senior Fellow, The Wharton School, USA
Joint work with Andrea Consiglio
University of Palermo
Bank of England, Jan. 22, 2016.
The devil is in the tails
Sovereign contingent debt: A proposal
www.voxeu.org
Bank of England, Jan. 22, 2016.
Sovereign contingent debt (S-CoCo)
A sovereign debt instrument, with (i) a built-in trigger to allow standstill of
payments(ii)activated when an indicator breaches
threshold(iii)invokes a precautionary credit line from the
IMF(iv)makes the triggered bond senior to
subsequently issued debt.
Bank of England, Jan. 22, 2016.
Outline
1. Debate on sovereign debt restructuring
2. Why S-CoCo3. S-CoCo designs 4. Risk management model with S-
CoCO5. Case study of Greece
Bank of England, Jan. 22, 2016.
Ongoing debate on sovereign debt restructuring
Bank of England, Jan. 22, 2016.
Some facts about sovereign debt
IMF 2013 mea culpa on Greece“Debt restructurings have often be too little and too late, failing to re-establish debt sustainability and market access in a durable way”
IMF Board 2013 Discuss legal and policy framework for sovereign debt restructuring
UN General Assembly 2014-2015 Negotiate legal framework for sovereign debt restructuring(124 in favor, 11 against, 41 abstain)Adopted draft resolution (136 in favor, 6 against and 41 abstained)
Bank of England, Jan. 22, 2016.
Some facts about sovereign debt
Data: Bank of Canada 2014.
Bank of England, Jan. 22, 2016.
Some facts about sovereign debt
Financial Stability Paper No. 27 – November 2013, Sovereign default and state-contingent debtMartin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor, Bank of England and Bank of Canada
Bank of England, Jan. 22, 2016.
Observations from the facts Sovereign debt restructuring is pervasiveAn equal opportunity malaiseSignificant amounts involved
Reminders of Hyman Minsky (1919—1996):
Debt is fragile
Bank of England, Jan. 22, 2016.
The issues in sovereign debt crises
To default or not to default?Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006),Benjamin-Wright (2009), De Grauwe (2012)
Is to forgive to forget? Bulow-Rogoff (1989), Arsanalp-Blaire (2005)Cruces-Trebesch (2013), B-W (above), Wright (2012)
Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013),
Delays in resolving crisis destroys value
Bank of England, Jan. 22, 2016.
Why S-CoCo
From ex post to ex ante solutions
Bank of England, Jan. 22, 2016.
Why S-CoCo Contingent contracts
(Bazerman and Gillespie, HBR, 1999)Avoid biasesSharing risks
Neglected risks(Gennaioli, Schleifer, Vishny, J. Financial Economics, 2012)
Bank of England, Jan. 22, 2016.
Why S-CoCo Early proposals
Weber, Ulbrich, Wendor, Frankfurt Allgemeine Zeitung, 2011Barkbu, Eichengreen, Mody, J. of International Economics, 2012Brooke, Mendes, Pienkowski, Santor, Bank of England, 2013.
French Aid Agency 2009 Insurance and re-insurance Rated firms for capital management Service firms for liability insurance Michelin, Swiss Re, MBIA
Bank of England, Jan. 22, 2016.
Why S-CoCo Bank contingent capital
(Mark Flannery 2005) 2009-2013: $70bn 2014: $208bn, 187 instruments, 68
banks (Avdjeiv et al., BIS, 2015).
Bank of England, Jan. 22, 2016.
S-CoCo designs
Bank of England, Jan. 22, 2016.
S-CoCo designs: Trigger Accurate Timely Comprehensive in valuation of entity PredictableX Accounting data or institutional triggers
Bank of England, Jan. 22, 2016.
S-CoCo designs: Trigger 30-day average CDS spread > 300 to
400bp
Bank of England, Jan. 22, 2016.
S-CoCo designs: Trigger
Country TriggerSigned
Program Early
response
Greece 24 April 2010 5 Sept. 2010 4 months
Portugal 16 Nov. 2010 20 May 2011 6 months
Ireland 1 Oct. 2010 16 Dec. 2010 2,5 months
Spain 27 March 2012 Dec. 2012 9 months
Cyprus 11 July 2011 15 May 2013 21 months
Bank of England, Jan. 22, 2016.
S-CoCo designs: Incentives
Is there moral hazard?YES –Haldane and Scheibe, Bank of England 2004, othersNO –IMF 2007
Creditor vs Debtor moral hazard“Evidence on moral hazard is not definitive, it is likely that the risk of moral hazard increases as the expected size of official sector support packages rise”
(Brooke et al. Bank of England and Bank of Canada, 2013)
Standstill resolves creditor moral hazard
Bank of England, Jan. 22, 2016.
S-CoCo designs: Incentives
Debtor incentives:
- Why sovereigns pay?- Economic incentives:
Non-linear discounts on S-CoCoSeniority transfers rates to plain debt
- Political incentives:IMF precautionary lineVoted out like ousted Bank Board
Bank of England, Jan. 22, 2016.
S-CoCo designs: Incentives
Bank of England, Jan. 22, 2016.
S-CoCo designs: How long standstill
Bank of England, Jan. 22, 2016.
S-CoCo designs: False alarms and missed crises
Type I error Type II error
Bank of England, Jan. 22, 2016.
S-CoCo designs: Market manipulation and multiple equilibria
B-CoCo subject to multiple equilibria Sundaresan and Wang, J. of Finance, 2015Calomiris and Herring, J. App. Corp. Finance, 2013McDonald, J. Financial Stability, 2013 Prescott, Economic Quarterly, 2012
Market manipulation
Bank of England, Jan. 22, 2016.
S-CoCo designs: Pricing
Triggered by CDS spreadMean-reverting diffusion process with jumps and autocorrelationDonoghue et al., Intl. J. of Theoretical and Applied Finance, 2014.
Regime switching Bai-Perron, Econometrica, 1998
Cross validation K-fold approach for jump parameter (Tibshiriani)
Bank of England, Jan. 22, 2016.
S-CoCo designs: Pricing
Bank of England, Jan. 22, 2016.
S-CoCo designs: Pricing
Bank of England, Jan. 22, 2016.
1 2 3 4 5 6 7 8 9 10 11 12 130
20
40
60
80
100
120
1 2 3 4 5 6 7 8 9 10 11 12 130
20
40
60
80
100
120
Bank of England, Jan. 22, 2016.
S-CoCo designs: Pricing
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring
Bank of England, Jan. 22, 2016.
Sovereign debt risk management
Risk management has not been part of analysis
“Need for development of criteria for “optimal” debt restructuring process”
(Wright 2012, Harvard Business Law Review)
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring
Bank of England, Jan. 22, 2016.
Scenario dependent debt dynamics
Using Debt-to-GDP ratio
Risk management for debt restructuring
Bank of England, Jan. 22, 2016.
D is the term structure of debt r is the term structure of sovereign ratesGDP, NB can be state-dependentSF can be state-contingentTree integrates economic and financial risk factorsObjective and risk neutral probabilities(Consiglio, Carollo, Zenios, Quantitative Finance, in print)
Risk management for debt restructuring
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring
At each terminal node:
Conservation of flow at each node:
xmj – nominal value of debt instrument j, issued at node m.
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring
(Rockafellar and Uryasev 2000)
Conditional Debt-at-Risk
DEaR: Debt-at-Risk
Bank of England, Jan. 22, 2016.
Triggering the CoCo conversion
Difference of trigger variable from threshold
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring with CoCo
Bank of England, Jan. 22, 2016.
Case study of Greece
Bank of England, Jan. 22, 2016.
Case study of Greece
Bank of England, Jan. 22, 2016.
Case study of Greece
Bank of England, Jan. 22, 2016.
Case study of Greece
Bank of England, Jan. 22, 2016.
Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8
Bank of England, Jan. 22, 2016.
Interest rate concessions
Bank of England, Jan. 22, 2016.
Risk management for debt restructuring with CoCo
Bank of England, Jan. 22, 2016.
Conclusions and Challenges Ex ante treatment of uncertainty S-CoCo
Forestall default Reduce probability of default Market discipline debtors Solve creditor moral hazard Automatic stabilizers, countercyclical
fiscal Speedy crisis response Financial stability
Bank of England, Jan. 22, 2016.
Challenges
Safe asset for Banks CDS adjust to the issue of S-CoCo Develop solid investor base IMF involvement
Bank of England, Jan. 22, 2016.
References
Consiglio, A. and Zenios, S.A.Risk management optimization for sovereign debt restructuringJ. of Globalization and Development, special issue Stiglitz et al. (eds.)
Consiglio, A. and Zenios, S.A. Contingent convertible bonds for sovereign debt risk management http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2694973
Consiglio, Carollo and Zenios,A parsimonious model for generating arbitrage free scenario trees Quantitative Finance (in print)http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362014
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