Transcript Models with Financial Imperfections

Imperfections in international
financial markets
Tomáš Holub
([email protected])
International Macroeconomics
FSV UK, 26 April 2016
Motivation
• The recent financial and economic crisis has increased
the interest in studying financial market imperfections;
• Modern macroeconomics had not neglected this topic
(see Obstfeld – Rogoff, chapter 6);
• But these were typically abstracted from in canonical
general equilibrium models;
• Recently an effort to change this in order to be able
to model the „feedback loop“.
• So far in the course: Ramsey model for small open
economies with an assumed borrowing constraint;
Krugman‘s 3rd-generation model with FX mismatches and
an assumed borrowing constraint.
Perfect Financial Markets
• Information fully symmetric;
• Perfect enforcement of contracts;
• Complete financial markets;
• Investment carried out where it is most profitable (MPK=r;
one interest rate for all borrowers / lenders), independently
of the initial financial wealth of agents;
• No substantive role for financial intermediaries,
„anonymous finance“.
Divine
Savers
auctioneer
Debtors
The Reality of Life
• Information is asymmetric, contracts are hard to enforce;
• The creditors must thus scrutinize the debtors carefully,
i.e. finance cannot be anonymous;
• Existence of various interest rates (risk premia etc.), credit
rationing, collateral constraints, debt ceilings, banks etc.
?
Savers
Fin. intermediaries
Regulators
Debtors
The Recent Crisis
vs. Currency Crises Models (i)
• It was not predicted in advance
−
The crisis are hard to predict – see the 2nd and 3rd
generation, poor performance of the EWS, etc.
• It was not a currency crisis, but a financial one;
• Macro-policies (remember the 1st generation) probably
contributed to a build-up of vulnerabilities and bubbles;
• Financial innovation and supervisory failure;
−
Underestimation of the moral hazard problem (not studied
in the course so far)
• Strong global contagion (financial and real channel);
The Recent Crisis
vs. Currency Crises Models (ii)
• Balance sheet weaknesses in some EMEs, e.g. currency
mismatches and reliance on foreign ST financing,
aggravated the problem (like in the 3rd generation);
• Pegged exchange rate faced hard times (but hard pegs
have survived!, even though sometimes at a high cost);
• Policies: provision of liquidity,  deposit insurance,
monetary and fiscal easing, restoring BSs, strengthened
regulation, macro-prudential policies;
• Fiscal easing and bank bail-outs have led to debt
sustainability problems in a number of countries (GR; IR;
PT) – default risk.
Origin of the Crisis
?
• Benign macro environment and low IRs before the crisis;
• Surplus of liquidity, search for yield, low pricing of risk;
• Growing asset prices (real estate prices etc.);
• Originate-to-distribute model, securitization.
• Political support for home ownership.
Some Thoughts
on Securitization
• Securitization is a financial innovation helping to increase
market liquidity and to distribute risks more broadly;
• Diversification of risks is one of key benefits of financial
liberalization and innovations;
• More complete markets→ closer to the Arrow-Debreu world;
• But some risks cannot be diversified in reality;
♦
global shocks
♦
imperfect information, moral hazard, adverse selection,
imperfect enforcement of contracts
• Broader distribution of risks increased moral hazard and
created uncertainty on who had actually suffered losses.
Some Thoughts
on Sovereign Risk
10Y gov't bond yileds (Maastricht criterion)
30
in % p.a.
25
Euro area
20
Belgium
15
?
Germany
Ireland
10
Greece
5
Spain
France
2012M01
2011M09
2011M05
2011M01
2010M09
2010M05
2010M01
2009M09
2009M05
2009M01
2008M09
2008M05
2008M01
2007M09
2007M05
2007M01
2006M09
2006M05
2006M01
0
Italy
Portugal
• Prior to the crisis, there was little differentiation between
bond yields of the individual EA countries – moral hazard;
• From 2010 high risk premia charged on the EA‘s periphery.
Models with Financial
Imperfections
• Micro-foundations of the imperfections (topic of lecture):
−
Imperfect enforcement of contracts
−
Asymmetric information  adverse selection; moral hazard
• Macro models with ad hoc assumptions of
imperfections, studying their implications:
−
−
Static models (e.g. Krugman, 1999 - 3rd generation model)
Dynamic models: e.g. the growth model with human capital;
DSGE models with financial imperfections (seminar topic)
Models with Financial
Imperfections
• Micro-foundations of the imperfections (topic of lecture):
−
Imperfect enforcement of contracts
−
Asymmetric information  adverse selection; moral hazard
• Macro models with ad hoc assumptions of
imperfections, studying their implications:
−
−
Static models (e.g. Krugman, 1999 - 3rd generation model)
Dynamic models: e.g. the growth model with human capital;
DSGE models with financial imperfections (seminar topic)
Imperfect Enforcement +
Sovereign Risk (O-R, ch. 6.2)
• Economy exists for two periods;
• Single tradable consumer good, can be converted into
capital good (and vice versa) at no cost;
• Period 1 income Y1 falls down from heaven; period 2
income is produced using Y2=F(K2);
• Borrowing D2 in internat. bond market at interest rate r.
• Sanctions for default limited to a fraction  of income.
MaxU1  u C1   u C2 
K 2  Y1  D2  C1
C2  F K 2   K 2  ;   min 1  r D2 ; F K 2   K 2 
Decision to Default
C2
C2
GDP
(1+r)D2
GNP
GDP
(1+r)D2
N
GNPN
GNPD
GNPD
Y1+ D2
C1
• With this debt level, it is
better not to default.
Y1 + D 2
C1
• With this higher debt
level, default becomes
the preferred choice.
Debt Ceiling and FOC
U1  ln C1    ln C2 
C2
GNPN
Y2  K 2
Equilibrium
(  r ; 1  r   1   )
 1  

 1 



1  


D
   r   1  
1 


 1     1   
GNPD
Y1+ D2
• Here, the debt level is
such that the debtor
becomes indifferent
between repayment
and default.
C1


Y
1    1


uC1   1  r uC2   
uC1   1  F K 2 uC2 
 D  D 2   0
Investment Response to Debt
Investment, K2
D
• Beyond the debt ceiling,
there is a discrete drop
in investment.
• Investors know that they
would pay penalty for
default from future
income – they reduce
the future income by
investing less.
• But creditors know this,
and thus would not lend
Debt, D2
more than the debt limit.
Models with Financial
Imperfections
• Micro-foundations of the imperfections (topic of lecture):
−
Imperfect enforcement of contracts
−
Asymmetric information  adverse selection; moral hazard
• Macro models with ad hoc assumptions of
imperfections, studying their implications:
−
−
Static models (e.g. Krugman., 1999; 3rd generation model)
Dynamic models: e.g. the growth model with human capital;
DSGE models with financial imperfections (seminar topic)
Moral Hazard in Int.
Lending (O-R, ch. 6.4)
• Economy exists for two periods (consumption only in 2);
• Single tradable good (real ER always equal to 1);
• Income of a representative household Y1 falls down from
heaven;
• Riskless borrowing / lending in international bond market
at world interest rate r;
• No assets or debt at the beginning of period 1.
MaxU1  C2
Z with probability
 I 
Y2 
 I   0; πI   0
0 with probability 1   I 
Full Information Case
Max  I Z  PZ ; I    I Z  1  r Y1  I 
I
 I PZ ; I   1  r I  Y1  ... zero - profit condition of lenders
 I Z  1  r ... first - order condition of entreprene urs
PZ ; I  ... payment to lender if investment yields Z
conditiona l on I
P0  0
• Marginal product equals the global interest rate, i.e. the
economy achieves an efficient level of investment I .
• We assume I  Y1 , i.e. the entrepreneurs need to
borrow to achieve the efficient level of investment.
Imperfect Information Case
• Assume the creditors cannot observe the actual level of
investment I and entrepreneurs can „hide“ part of their
resources L abroad (e.g. secret foreign accounts).
• Creditors can only observe the outcome of the project.
I  L  Y1  D
L  0; D  0 ... L is lending abroad, D borrowing from abroad
Max EC2   I Z  PZ   1   I P0  1  r L
I
  I Z  PZ   1   I P0  1  r Y1  D  I 
 I Z  PZ   P0  1  r ... first - order condition of entreprene urs
 I PZ   1   I P0  1  r D ... zero - profit condition of lenders
Imperfect Information Case
P0  0; L  0 ... two features of the optimal contract
PZ   Z 
1 r
... incentive - compatibility constraint (IC)
 I 

1  r I  Y1 
... zero - profit condition of lenders (ZP)
PZ  
 I 
 I Z  1  r ... lower eq. investment then I
Imperfect Information Case
Borrower payment, P(Z)
Borrower payment, P(Z)
IC
IC
ZP
Y1
I
Investment, I
ZP
Y1
I
Investment, I
• The efficient level of investment cannot be achieved in
I
equilibrium (marginal return for the entrepreneur has to be
above r to discourage cheating);
• Higher/lower initial wealth of entrepreneurs raises/lowers I;
• Higher Z increases I (IC), higher r lowers it (↓IC, ZP).
Summary
• The recent crisis has increased the focus on studying
financial imperfections;
• Imperfect enforcement of contracts; imperfect info →
moral hazard, adverse selection, etc.;
• The imperfections have important effects on equilibrium
allocation of capital etc. (i.e. they reduce efficiency);
• Balance sheets and cash flow are important for the level
of investment (i.e. higher wealth increases investment);
• Shocks to financial wealth may thus have important real
consequences (i.e. adverse shocks to wealth lead to an
economic recession);
• Credit channel of monetary policy transmission, DSGE
models with financial frictions (see the seminar).