Timing asset market peaks: the role of the liquidity risk cycle of the banking system

Weber, Patrick (2012): Timing asset market peaks: the role of the liquidity risk cycle of the banking system.

Abstract

Recent financial crisis showed how the unfolding of liquidity risks of financial intermediaries spilled over to asset markets, contributing to asset price deteriorations and the triggering of liquidity spirals. This paper derives and tests a financial fragility condition for predicting asset price peaks on a real-time basis, by combining the term spread and the aggregate funding liquidity risks of the banking system into a simple binary fragility indicator. The main empirical result of this paper is that the fragility condition predicted all major equity market peaks in Germany during the time period 1973 to 2010, including the subprime crisis of 2007, the New Economy Bubble of 2000, and the 1987 stock market crash. The average lead time of the indicator is 2.9 months. About 80% of the declines were later on associated with significant declines in Industrial Production.

• Item Type: MPRA Paper
• Language: English
• Keywords: Predicting Financial Markets; Liquidity Spirals; Macrofinancial Linkages; Asset Price Cycle; Liquidity Management of Financial Intermediaries; Early Warning Indicator
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Prediction Methods ; Simulation Methods

References

Adrian, Tobias, Arturo Estrella, and Hyun Song Shin. "Monetary cycles, financial cycles, and the business cycle." Staff Reports 421, Federal Reserve Bank of New York, 2010.

Adrian, Tobias, and Hyun Song Shin. Financial intermediary leverage and value at risk." Staff Reports 338, Federal Reserve Bank of New York, 2008.

Adrian, Tobias, and Hyun Song Shin. "Liquidity and leverage." Journal of Financial Intermediation 19, 3: (2010) 418-437.

Allen, Franklin, and Douglas Gale. "Asset Price Bubbles and Monetary Policy." Center for Financial Institutions Working Paper 01-26, Wharton School Center for Financial Institutions, University of Pennsylvania, 2000.

Allen, Franklin, and Douglas Gale. "Asset Price Bubbles and Stock Market Interlinkages." Center for Financial Institu- tions Working Paper 02-22, Wharton School Center for Financial Institutions, University of Pennsylvania, 2002.

Allen, Franklin, and Douglas Gale. "Financial Fragility, Liquidity and Asset Prices." Center for Financial Institutions Working Paper 01-37, Wharton School Center for Financial Institutions, University of Pennsylvania, 2003.

Berger, Allen N., and Christa H. S. Bouwman. "Financial Crises and Bank Liquidity Creation." Working papers, 2008.

Berger, Allen N., and Christa H. S. Bouwman. "Bank Liquidity Creation." Review of Financial Studies 22, 9: (2009) 3779-3837.

Borio, Claudio, and Haibin Zhu. "Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?" BISWorking Paper 268, Bank for International Settlements, 2008.

Brunnermeier, Markus K., and Lasse Heje Pedersen. "Market Liquidity and Funding Liquidity." Review of Financial Studies 22, 6: (2009) 2201-2238.

Diamond, Douglas W, and Philip H Dybvig. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91, 3: (1983) 401-419.

Estrella, Arturo, and Frederic S. Mishkin. "Predicting U.S. Recessions: Financial Variables As Leading Indicators." The Review of Economics and Statistics 80, 1: (1998) 45-61.

Fecht, Falko. "On the Stability of Dierent Financial Systems." Journal of the European Economic Association 2, 6: (2004) 969-1014.

Fecht, Falko, and Patrick W. E. Weber. "Liquidity Creation, The Risk Taking Channel and Monetary Policy Transmission - A Cross Country Study for the EMU." Internship project, European Central Bank, 2011.

Helbling, Thomas, and Marco E. Terrones. "When Bubbles Burst." World economic outlook, International Monetary Fund, 2003.

Kaminsky, Graciela L., and Carmen M. Reinhart. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems." American Economic Review 89, 3: (1999) 473-500.

Krishnamurthy, Arvind. "Amplification Mechanisms in Liquidity Crises." American Economic Journal: Macroeconomics 2, 3: (2010) 1-30.

Lowe, Philip, and Claudio Borio. "Asset prices, financial and monetary stability: exploring the nexus." BIS Working Paper 114, Bank for International Settlements, 2002.