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    BoE Publishes Various Working Papers in December 2019

    December 20, 2019

    BoE published three working papers on December 20, 2019. Two of these working papers discuss the capital and liquidity interaction in banking and explore the simulation of liquidity stress in the derivatives market. The third paper explores the role of price and income elasticities of demand and the price elasticity of supply in determining the effect of the real risk-free rate on house prices. From a the perspective of a policymaker, the findings of this study add context to how an organization may plan for, and test, financial stability.

    Capital and liquidity interaction in banking. The authors study the interaction between banks’ capital and their liquidity transformation in both a theoretical and an empirical setup. They first construct a simple model to develop hypotheses which they test empirically. Using a confidential BoE dataset that includes bank-specific capital requirement changes since 1989, the authors find that banks engage in less liquidity transformation when their capital increases. This finding suggests that capital and liquidity requirements are at least to some extent substitutes. By establishing a robust causal relationship, these results can help guide the optimal joint calibration of capital and liquidity requirements and inform macro-prudential policy decisions. 

    Simulating liquidity stress in derivatives market. In this paper, the authors investigate whether margin calls on derivative counterparties could exceed their available liquid assets and, by preventing immediate payment of the calls, spread such liquidity shortfalls through the market. Using trade repository data on derivative portfolios, the authors simulate variation margin calls in a stress scenario and compare these with the liquid‑asset buffers of the institutions facing the calls. Where buffers are insufficient, it is assumed that institutions borrow additional liquidity to cover the shortfalls, but only at the last moment when payment is due. Such delays can force recipients to borrow more than otherwise and, thus, liquidity shortfalls can grow in aggregate as they spread through the network. However, the study finds an aggregate liquidity shortfall equivalent to only a small fraction of average daily cash borrowing in international repo markets. It was also found that only a small part of this aggregate shortfall could be avoided if payments were coordinated centrally. 

    UK house prices and decline in risk-free real interest rates.The paper explores the role of price and income elasticities of demand and the price elasticity of supply in determining the effect of the real risk-free rate on house prices. Real house prices in the UK have almost quadrupled over the past 40 years, substantially outpacing real income growth. Meanwhile, rental yields have been trending downward—particularly since the mid‑90s. This paper reconciles these observations by analyzing the contributions of the drivers of house prices. It shows that the rise in house prices relative to incomes between 1985 and 2018 can be more than accounted for by the substantial decline in the real risk‑free interest rate observed over the period. Changes in the risk‑free real rate are a crucial driver of changes in house prices—the model predicts that a 1% sustained increase in index‑linked gilt yields could ultimately (that is, in the long run) result in a fall in real house prices of just under 20%. From a the perspective of a policymaker, the findings of this study add context to how an organization may plan for, and test, financial stability.

     

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    Keywords: Europe, UK, Banking, Research, Financial Stability, Basel III, Regulatory Capital, Liquidity Risk, Derivatives, Risk Free Interest Rate, BoE

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