Transcript Econ 492: Comparative Financial Crises

Econ 492:
Comparative Financial Crises
Lecture 2
18 September 2013
David Longworth
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Outline of Course
(Prediction)
Transmission
Causes
Prevention
Policy
Response
Economics 492 Lecture 2
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Reminder of Last Week
• Three types of crisis: financial, currency,
sovereign debt
• Credit (debt) plays an important role in all
– Credit granted by banks or debt taken on by banks
– International indebtedness, current acc’t deficits
– Government indebtedness (domestic or foreign)
• Overvaluation (asset bubbles, real exch. rate)
• Prediction models typically rely on above
Economics 492 Lecture 2
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Overview of Today’s Lecture
I. Transmission
II. Policy Response During the Crisis
III. Prevention
Note: AG indicates Franklin Allen and Douglas Gale
(2009), Understanding Financial Crises. KA indicates
Charles P. Kindleberger and Robert Aliber (2005),
Manias, Panics, and Crashes. RR indicates Carmen
Reinhart and Kenneth Rogoff (2009), This Time is
Different.
Economics 492 Lecture 2
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I. Transmission
• Illiquidity (“and all its friends”)
– Bank runs
– Margin and liquidity spirals
– Fire Sales (Cash-in-the-market pricing)
• Interconnectedness and contagion
• Decline in wealth of private sector: effects on output and
employment
• Zero bound on nominal interest rates takes away
conventional monetary policy channel
• Effect on sovereign debt crises and vice versa
• Longer-run effects on GDP growth, unemployment,
inflation, credit growth, debt/GDP ratio
Economics 492 Lecture 2
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I. Transmission
• Illiquidity (“and all its friends”)
– Recall that there is both “funding liquidity” and
“market liquidity”
– “all its friends” include (according to Tirole):
•
•
•
•
•
Market freezes
Fire sales
Contagion
Ultimately, insolvencies and bailouts
I would include “bank runs” (as one cause) and market
liquidity spirals
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Banks have liquid liabilities, illiquid assets
– So banks are susceptible to unexpected liquidity
demands (bank runs)
– Model this by having a liquid asset (short asset) that
doesn’t pay interest, and an illiquid asset that does
– Banks (intermediation) solve mismatch between time
preference of customers and asset maturity
– Typically, markets are incomplete and so can’t provide
an efficient solution to this mismatch problem
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– In a two-period model with no aggregate uncertainty
about liquidity withdrawals, there is an equilibrium in
which the bank provides withdrawals (consumption)
c(1) to its depositors at time 1 and c(2) to its
depositors at time 2, invests x in the long asset and y
in the short asset
– In the same model, if the bank can sell the long asset
early (period 1), taking a discount, a bank run will also
be an equilibrium. This is because, if all depositors,
whether they would normally withdraw to consume
at time 1 or time 2, decide to withdraw at time 1, the
bank cannot possibly pay them all off.
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Critics of this type of model have argued that
suspension of convertibility of deposits into cash
could stave off bank runs
– But Diamond and Dybvig have shown that a
sequential payout by bank tellers would mean
that they would not find out until too late that a
run was in progress.
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Equilibrium bank runs:
• Impossible to predict
• Coordination among individuals facilitated by
“sunspots” (extraneous variables, not “fundamental”)
• If “the probability of a bank run is sufficiently small,
there will exist an equilibrium in which the bank is
willing to risk a run because the cost of avoiding the run
outweighs the benefit.” (AG, p.82)
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Are bank runs associated with the business cycle (and
not “sunspots”)? Potential paper. Also, how correlated
with the leverage cycle (C/Y)? How correlated is the
leverage cycle with the business cycle (Y)?
• Some support for a yes answer: Gorton’s 1988 study of U.S.
(1865-1914)
• Indeed, if bank runs are part of transmission of crises, and
crises are typically associated with the credit cycle, which is
highly correlated with the business cycle, no surprise
• Many suspect that liquidity problems are associated with
fears of credit problems and perhaps actual credit problems
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Runs aren’t just from banks (like Northern Rock in
the U.K., and Greek banks recently)
• But from “shadow banking system” as well
– Canadian asset-backed commercial paper, money
market mutual funds, U.S. financial commercial
paper, structured investment vehicles (SIVs), repo
market, etc.
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I. Transmission
• Margin and Liquidity Spirals
– Financial institutions (and large investors) engage in
securities financing transactions
• Repos (sales and repurchase agreements)
– A “haircut” determines the fraction of the market value
that can be borrowed: “haircut” is like a down payment
• Securities borrowing
– A “haircut” again determines what collateral must be
posted
• As well, they engage in derivatives transactions
– Except for large highly-rated banks and securities
dealers, “initial margin” must be posted
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I. Transmission
$100 Million Bond
5 per cent haircut
95 per cent loan
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I. Transmission
• Margin and Liquidity Spirals
– When market liquidity becomes lower, it is typically
associated with higher market volatility
– But higher market volatility means that collateral
coverage for a given “haircut” or “initial margin” is
less: haircuts and margins tend to rise in the market
– One tends to get the type of liquidity and margin
spiral shown in the following diagram
• Spiral can work in the opposite direction in boom periods
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Liquidity Spiral
Liquidity/Margin Spiral
less market making
lower market
liquidity
funding problems
higher margins
losses on existing positions
Adapted from Brunnermeier & Pederson (2009) and
Economics 492 Lecture 2
presentations by Mark Carney and David Longworth
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– First, assume a model with markets only, no banks
– Limited market participation: not everyone
participates in every market (fixed set-up cost)
– Market liquidity depends on amount of cash held by
market participants
– If there is a lack of cash in the market, small shocks
have large effects on prices
• Then prices are not determined by expected present values,
but by ratio of available liquidity to amount of asset supplied
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Amount of cash in market depends on
participants’ liquidity preference, which will
determine the average level of the short-term
asset held
– Changes in liquidity demand relative to liquidity
supply determines price volatility
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Now add banks to the model
• Small events (e.g., small liquidity shocks coming from a
bank’s customers) can have a large impact on the
financial system because of how banks and markets
interact: can lead to systemic crises
• If banks have to provide liquidity to customers, they
may have to sell much-less-liquid assets (if they are
running out of liquid ones)
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– With banks added to the model:
• Prices in those markets may be determined by cash in
the market
• The resulting “fire sale prices” may be quite low
• Banks have to mark assets held in their trading book to
market. At the end of the quarter, these losses will
show up in the calculation of profits/losses and thus
affect the bank’s capital
– The market anticipates this effects even before
quarterly statements are released.
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Interconnectedness: banks hold many liabilities of
other banks (short-term deposits—including those for
settling payments, shares, repos, derivative
instruments)
• Therefore the failure or weakness of one bank could
translate into the failure or weakness of other banks
• As well, the failure of one bank may lead to loss-sharing
arrangements being invoked in payments systems and
central counterparties (for repos or OTC derivatives)
– By their current design, such losses should be limited
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Banking contagion can arise from a number of
factors:
• Interconnectedness as described above
• Concern about common exposures, with fire sales
potentially driving down prices
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I. Transmission
Contagion (across regions or across countries) can
arise from a number of factors:
• Contagion of bubbles: “when money flows from one
country to another and adjustments automatically
occur both in the countries that receive these funds
and in the countries that are the sources of them.” (KA,
p.143)
– Example from KA, pp. 142-3: From real estate and stock
market bubble in Japan (late 1980s) to real estate and stock
market bubbles in Nordic countries (late 1980s) and to
markets in south-east Asia (mid 1990s) and to tech stocks in
the U.S. (late 1990s)
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I. Transmission
• Interconnectedness and contagion Topics:
– What is the analogue in the most recent crisis and
how did it compare with previous crises?
– How were various emerging market economies
affected in the current crisis when international banks
cut back in foreign lending, particularly in trade
finance (why, and what were the effects?)
– Why was there more banking contagion from the U.S.
to continental Europe and the U.K. than to other
regions? Why was there financial contagion at all to
countries such as Japan and Canada?
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– AG have a model of U.S. regional contagion
• “even though the initial shock occurs only in one
region, which can be an arbitrarily small part of the
economy, it can nevertheless cause banks in all regions
to go bankrupt.”
• Results depend on the nature of the network of
interbank deposits across institutions
– AG cite a number of references to studies of the
actual nature of interbank relationships in
certain countries.
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I. Transmission
• Contagion across countries (stock markets)
– K. Forbes, Jackson Hole, 2012
– Interdependence (high correlations across equity
markets) has increased over time, especially in
euro area
– Contagion, spillovers from extreme negative
events, is more common when country has a
more levered banking system, greater trade
exposure, weaker macro fundamentals, and large
international liabilities
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I. Transmission
• Decline in wealth in private sector: effects on income
and employment
– Lower wealth arises from fire sales, bursting of bubbles,
lower valuation of financial sector firms
– Wealth effects on consumption (standard consumption
function)
– Through financial accelerator, lower collateral means can
borrow less, so lower consumption and housing
expenditure (and investment by businesses)
– Through bank capital channel, less lending by banks, which
means less consumption, housing, and investment
expenditure (but large corps. can go to bond market)
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I. Transmission
• Decline in wealth in private sector: effects on
income and employment
– Spreads increase between interest rates on
loans/market debt and government yields (even
separately from bank capital channel), lowering
housing and investment spending
– In New Keynesian models, lower aggregate demand
leads to lower employment
– Spillovers across borders from lower import demand
in countries suffering declines in wealth and income
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I. Transmission
• Zero bound on nominal interest rates takes away
conventional monetary policy channel
– Normally, the response of monetary policy authorities
to the decline in wealth, income, and employment
would be to lower the policy interest rate because of
the downward pressure on inflation
– When the policy interest rate gets to zero (or near
zero), that option is no longer available
– Central bank must turn to unconventional policy
instruments (discussed in the next section)
– ZLB in history: BoJ; recent crisis: Fed, BoE, BoJ, BoC,
ECB, Swedish Riksbank
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I. Transmission
• Effect on sovereign debt crises and vice versa
– Government bailouts or payouts to insured
depositors increase sovereign debt
– Fall in GDP leads to decline in government
revenue and increase in sovereign debt
– If sovereign debt was high before banking crisis, a
sovereign debt crisis may occur
– Banks hold lots of sovereign debt, so a sovereign
debt crisis can lead to a banking crisis
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I. Transmission
• What happens to GDP growth after the crisis?
– Cecchetti et al. (2010)
• High debt to GDP ratio is bad for growth—beyond 85% for
government debt
– Jorda et al. (2011)
• More credit-intensive booms tend to be followed by deeper
recessions and deeper recoveries
– Reinharts (2010)
• For major shocks, GDP growth lower and unemployment
higher in 10 years after than in 10 years before
– Reinharts and Rogoff (2012)
• The higher the government debt/GDP ratio, the lower the
growth—typically for more than a decade
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I. Transmission
• What happens to GDP growth after the crisis?
• Topics:
– Role of bank capital in mitigating effects?
– Role of cross-country effects?
– What happens to unemployment rate, inflation,
debt/GDP ratio, credit growth after crisis?
• Prediction model as a function of the state of the world
at the time of the crisis (including recent credit/GDP
growth, real asset price increases, government
debt/GDP etc.)
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II. Policy Response During the Crisis
(Prediction)
Causes
Prevention
Transmission
Policy
Response
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II. Policy Response During a Crisis
•
•
•
•
•
Guarantees and closures
Domestic lender of last resort: liquidity policy
Expansionary Monetary Policy
Expansionary Fiscal Policy
International lender of last resort: IMF, EU, etc
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II. Policy Response During a Crisis
Differences in the Mix of Banking Crisis Policies
(% Use to nearest 5%) (Source: Laeven and Valencia, IMF, 2012)
Crisis Policy
Advanced Economies
Emerging Economies
Expansionary fiscal policy
90
50
Expansionary monetary pol.
80
65
Recapitalization
95
80
Nationalizations
65
60
Liquidity support
95
85
Guarantees on bank liabilities
90
35
Deposit freeze
0
15
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II. Policy Response During a Crisis
• Guarantees and closures
–
–
–
–
–
–
Deposit insurance introduced or limits increased
Bank bond debt guaranteed (e.g., Ireland)
Bank holiday (cannot withdraw funds: deposit freeze)
Markets closed (especially stock markets)
Short-selling of bank stocks banned temporarily
Resolution of bank (range of possibilities)
• Government injects capital (recapitalization)
• Government nationalizes (with or without paying)
• Bank taken over by deposit insurance fund to be wound down
(only insured depositors paid off in first instance, then other
creditors)
– Issues: effectiveness, moral hazard, benefit/cost
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Central bank policy existing before recent crisis
• “Discount window” lending against good collateral (bonds, paper)
with haircut (reduction from market value) and small penalty rate
• Repo (purchase and resale agreement) of good bonds and paper
with haircut
• These provided additional liquidity for banks needing it
– Broad (ECB) vs. narrow (BoC, Fed) in normal times
• Potential topic: Does a broad list of collateral in normal times lead
to moral hazard and to major problems in crisis times?
– Expansion in recent crisis was initially in:
frequency of repo operations, size of operations, length of
period, and range of eligible collateral
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Because of “stigma” attached to discount window in U.S., a
Term Auction Facility was introduced that had a wider
range of collateral than repo operations. In Canada, the
non-mortgage loan portfolio of banks was eligible for a
TAF-like facility
• BoE has changed auctions of liquidity so that they always
happen—this is to avoid stigma in a crisis
– Central banks also introduced liquidity facilities to deal
with problems in specific financial markets (as opposed to
financial institutions). The Fed did this in particular for the
commercial paper market (market for under one-year
paper issued by financial or non-financial firms)
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Making foreign currency liquidity available: central
bank FX swap lines
– Potential topic: Why did the range of special
liquidity facilities vary across countries? Why were
special liquidity facilities not needed in previous
crises?
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II. Policy Response During a Crisis
• Monetary Policy
– Conventional monetary policy, reducing policy
interest rate (incentive to get to ZLB quickly in
some instances)
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II. Policy Response During a Crisis
• Monetary Policy
– Unconventional monetary policy (3 types)
• Conditional or unconditional commitment regarding
future policy interest rate; or forward guidance that
takes into account another variable besides inflation
• Potentially, a switch to a price-level target or a nominal
GDP level target
– Interest rates stay low longer, and inflation expectations are
higher
• Expansion of excess bank reserves, purchasing assets
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II. Policy Response During a Crisis
– Unconventional monetary policy
• Expansion of excess bank reserves, purchasing assets
– Untargeted version replicating what is already on the balance
sheet (typically government debt and repos) is pure quantitative
easing (Japan early last decade)
» many modern theories would discount its effectiveness
» “helicopter drop” variant: finances government payments to
individuals (fiscal policy)
– If particular maturities of government debt is purchased, it is also
a form of debt-management policy. (So is selling long-term debt
to buy short-term debt)
– If private sector debt (e.g. private MBS) is purchased, it is also a
form of fiscal policy (credit policy)
– If foreign exchange is purchased, it is essentially FX intervention
– In these latter four cases, there is a question of governance and
coordination
– Effects: expectations of future interest rates; portfolio-balance
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II. Policy Response During a Crisis
– Unconventional monetary policy
• New reference: IMF (2013) “UNCONVENTIONAL
MONETARY POLICIES—RECENT EXPERIENCE AND
PROSPECTS,” April 13.
http://www.imf.org/external/np/pp/eng/2013/041813
a.pdf
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II. Policy Response During a Crisis
• Monetary Policy
– Potential topic: What was the effectiveness of
unconventional monetary policy in the recent
crisis (e.g., QE2 vs. QE1 in the U.S.)? What was the
announcement effect from various Fed, BoE, BoJ
and ECB announcements (whether about asset
purchases or forward guidance)?
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II. Policy Response During a Crisis
• International Lender of Last Resort
– IMF, or EU, or bilateral sovereign loans
– Typically in an exchange crisis (fixed exchange rates)
– But also could be in cases where there is extreme
pressure on exchange rates; or significant associated
fiscal problems
– The history of IMF loans in the last 30 years has been
about the appropriate “conditionality” of loans
– Current European episode: EU and IMF loans: Greece,
Ireland, Portugal, Cyprus and …. (will there be more?)
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III. Prevention
(Prediction)
Causes
Transmission
Prevention
Policy
Response
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III. Prevention
• Macroprudential policy
• Contingent capital and bail-in debt
• Monetary policy
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III. Prevention
• Macroprudential policy
– Focuses on the safety and soundness of the financial
system as a whole
• As opposed to the safety and soundness of individual financial
institutions (microprudential policy)
– Macroprudential tools: deal with market failures
associated with procyclicality of aspects of the financial
system, as well as the interconnections and similar
exposures across financial institutions (cross-sectional
aspect) (recall market failures from last week)
• Possible topic: How do financial cycles compare with “real cycles
and inflation cycles” across countries? How should one measure a
“financial cycle”? Implications?
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Objective: avoiding significant financial
F
instability
r
Goals: dampening procyclicality and
a
reducing potential effects of contagion
m
e
Policy Instruments: Macroprudential
w instruments, advice on policies, warnings
o
r
Activities: Data Collection, Surveillance,
k
Analysis, Risk Assessment, Stress Testing
Powers
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III. Prevention
Proximate Object Excessive
of Concern:
Credit
Creation
Macroprudential
Instrument:
Capital
√ (total or
Requirements
sectoral)
Pigouvian Taxes
√
Constraints on
quantities, or
on credit
conditions
Insufficient
Liquidity
Continuation
of a Bank
√ (maturity
√ (Contingent
mismatch)
capital)
√ (on non-core √
deposits)
√ (Cred; RR √ (BCBS
on assets) Liquidity)
√ (Haircuts, √ (Haircuts,
50
LTV)
LTV)
III. Prevention
• Macroprudential policy
– Capital requirements, leverage requirements, and
liquidity requirements are being dealt with in Basel III
• Higher capital requirements, capital buffer built up,
countercyclical requirements (typically linked to credit) (Note
that effects overall depends on extent to which ModiglianiMiller theorem regarding capital cost and capital structure is
violated.) Is capital high enough?
• Systemically important institutions should have higher
capital requirements (up to 2.5 per cent for global SIFIs and
1.0 per cent in Canada for domestic SI banks)
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III. Prevention
• Macroprudential policy
– Capital requirements, leverage requirements, and
liquidity requirements are being dealt with in
Basel III
• Two types of liquidity requirements
– Liquidity coverage ratio (liquid assets vs. liabilities)
» “Sufficiently high quality liquid assets to survive a
significant stress scenario lasting one month” (BCBS)
– Net stable funding ratio (liability structure)
» “Incentive for banks to fund their activities with more
stable sources of funding” (BCBS)
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III. Prevention
• Macroprudential policy
– A Study Group that I chaired for the Committee on
the Global Financial System proposed regulating
margin requirements on derivatives and haircuts
on repo transactions on a “through the cycle
basis” to reduce the procyclicality of the margin
cycle
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III. Prevention
• Macroprudential policy
– Several Asian countries regulate loan-to-value ratios
for mortgages (particularly on residential properties)
in an active manner to reduce the cycle in property
prices
• There are several aspects of requirements for mortgage
insurance that could be examined for more active regulation
in Canada (LTV ratios, debt-service-to-income ratio, home
equity loan ratio, amortization period); constant level or
varying countercyclically. Potential topic: How should
macroprudential policy connected to mortgages and housing
prices be carried out, i.e., what should be the proximate goal
and the tools? How would this have worked in previous
housing bubbles?
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III. Prevention
• Macroprudential policy
– Some consider “through the cycle provisioning” for
loan losses (as was used in Spain) to be a
macroprudential policy instrument
– There are other possible macroprudential policy
instruments, such as reserve requirements on
assets and levies (taxes) on non-core deposits
• There is some evidence that in modern financial systems
rapid credit growth has as its counterpart the growth in
non-core short-term deposit liabilities (wholesale
deposits, commercial paper, repos, etc.)
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III. Prevention
• Macroprudential policy
– Potential topics: Would macroprudential policy “x”
have prevented the recent and other financial
crises? When household debt is high relative to
personal disposable income (e.g., Canada, New
Zealand, Sweden), should the authorities respond
in order to prevent future crises and, if so, how?
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III. Prevention
• Contingent capital and bail-in debt
– To deal with moral hazard of “too big or complex
to fail” as well as the practical issue of having time
to wind down a large institution or to change its
owners
– “Contingent capital is a subordinated security,
such as a preferred share or subordinated
debenture, that converts to common equity under
certain conditions.” (BoC FSR, Dec 2010, p.52)
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III. Prevention
• Contingent capital (CC) and bail-in debt
– Gone-concern CC converts when supervisor judges
that bank is no longer viable
– Going-concern CC converts well before, for modest
erosions of capital
– Bail-in debt applies to senior debt as well
– Conceptually, “the sum of common equity plus
contingent capital and bail-in senior debt could be
subject to an overall minimum requirement, chosen to
provide for the restoration of prudential capital
requirements” (BoC FSR, Dec 2010, p.54)
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III. Prevention
• Monetary policy
– Giving monetary policy a full-fledged financial
stability objective in addition to, but secondary to,
its price stability objective
• Inflation targeters would implement this by sometimes
returning inflation to target over a longer time period
• Use of reserve requirements (on short-term risky
source of funding or on risky assets) to mimic Pigouvian
taxes. Reference: Anil Kashyap and Jeremy Stein (2012),
“The Optimal Conduct of Monetary Policy with Interest
on Reserves,” AEJMacro, vol.4(1), pp 266-282.
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III. Prevention
• Monetary policy
– Or, having monetary policy play a supporting role
where not in conflict with its price stability
objective:
• Choice of target inflation rate (e.g., inclusion of house
prices)
• Price level target versus inflation target (Carney, 2009)
• Making very prominent the uncertainty about the
future interest rate path (note related criticism of Fed
in past decade)
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III. Prevention
• Monetary policy
– Potential topic: What should the role of monetary
policy (or the relative roles of monetary policy and
macroprudential policy) be in maintaining
financial stability? Could monetary policy have
prevented the recent crisis in some countries? At
what cost?
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This Week
• Prepare two sentence topic description for next
class (typed paper copy necessary)
– What is hypothesis, or question to be answered? (Or,
at this time, merely what is the area to be explored)
• Which crises or countries are being compared?
– Note at top of page: cause, prediction, transmission,
policy response, prevention
• Reference list on course web site should be
helpful; also Lectures 1 and 2
• I have office hours this afternoon and tomorrow
morning; or can e-mail me
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