Kurt F. Lewis

Distress in the financial sector and economic activity

This paper explores the relationship between the health of the financial sector and the rest of the economy. We develop an indicator of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. Our measure spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. We then use vector autoregressions to assess whether our indicator of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that our measure has a considerable impact. Moreover, we find that this financial channel amplifies changes in investment resulting from shocks to non-financial firm profitability.

Using Policy Intervention to Identify Financial Stress

This paper describes the construction of a financial stress index. This stress index differs from other indexes in that it incorporates the co-movement and volatility of financial series as well as the levels of the series. Our index also uses past experience more than others to guide the assessment about which characteristics of the data suggest financial stress exists. In addition to describing the construction of our financial stress index, we spend some time discussing issues relevant to the general construction of stress indexes.

Distress in the Financial Sector and Economic Activity

Abstract We construct daily market-based measures of distance to default for large U.S. financial institutions since 1973. These measures have significant predictive power for institution bankruptcy more than one year in advance. We aggregate the distances to default across institutions to provide an index of the overall health of the financial-services industry. We show that deteriorations in this Financial Institution Health Index are associated with tighter lending standards and higher interest rates on bank loans and precede declines in employment and industrial production. We argue that this points to the condition of financial institutions as an independent source of macroeconomic variability, distinct from traditional accelerator mechanisms.

Credit Risk, Liquidity and Lies

We reexamine the relative effects of credit risk and liquidity in the interbank market using bank-level panel data on Libor submissions and CDS spreads. Our model synthesizes previous work by combining the fundamental determinants of interbank spreads with the effects of strategic misreporting by Libor-submitting firms. We find that interbank spreads were very sensitive to credit risk at the peak of the crisis. However, liquidity premia constitute the bulk of those spreads on average, and Federal Reserve interventions coincide with improvements in liquidity at short maturities. Accounting for misreporting, which is large at times, is important for obtaining these results.

Measuring the Natural Rate of Interest: Alternative Specifications

We build on the work of Laubach and Williams (2003) and subsequent studies by analyzing the effect on the estimates of the natural rate of interest (r∗) of accounting for full parameter uncertainty and alternative specifications for the underlying components of the natural rate. Our estimation technique delivers richer time-series dynamics for the median estimate of r∗ within the Laubach and Williams model. Additionally, we find that models with transitory shocks to the non-growth component of the natural rate have a higher marginal likelihood and produce an upward-sloping post-crisis trajectory of the r∗ path and thus a higher recent median point estimate (1.8% in 2016:Q3). JEL: C32, E43, E52, O40

What Drives Bank Funding Spreads

We use matched, bank-level panel data on Libor submissions and credit default swaps to decompose bank-funding spreads at several maturities into components reflecting counterparty credit risk and funding-market liquidity. To account for the possibility that banks may strategically misreport their funding rates in the Libor survey, we nest our decomposition within a model of the costs and benefits of lying. We find that Libor spreads typically consist mostly of a liquidity premium and that this premium declined at short maturities following Federal Reserve interventions in bank funding markets. At longer maturities, credit risk explains much of the time variation in Libor, reflecting in part fluctuations in the degree to which default risk is priced in the interbank market. Our results are consistent with banks both under- and over-reporting their funding costs during the crisis but suggest that the incidence of this behavior may have subsequently declined.