Systemic Risk and Asymmetric Responses in the Financial Industry. By López-Espinosa, Germán; Moreno, Antonio; Rubia, Antonio; and Valderrama, Laura
IMF Working Paper No. 12/152
June, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25991.0
Summary: To date, an operational measure of systemic risk capturing non-linear tail comovement between system-wide and individual bank returns has not yet been developed. This paper proposes an extension of the so-called CoVaR measure that captures the asymmetric response of the banking system to positive and negative shocks to the market-valued balance sheets of individual banks. For the median of our sample of U.S. banks, the relative impact on the system of a fall in individual market value is sevenfold that of an increase. Moreover, the downward bias in systemic risk from ignoring this asymmetric pattern increases with bank size. The conditional tail comovement between the banking system and a top decile bank which is losing market value is 5.4 larger than the unconditional tail comovement versus only 2.2 for banks in the bottom decile. The asymmetric model also produces much better estimates and fitting, and thus improves the capacity to monitor systemic risk. Our results suggest that ignoring asymmetries in tail interdependence may lead to a severe underestimation of systemic risk in a downward market.
Excerpts:
In this paper, we discuss the suitability of the general modeling strategy implemented in Adrian and Brunnermeier (2011) and propose a direct extension which accounts for nonlinear tail comovements between individual bank returns and financial system returns. Like most VaR models, the CoVaR approach builds on semi-parametric assumptions that characterize the dynamics of the time series of returns. Among others, the procedure requires the specification of the functional form that relates the conditional quantile of the whole financial system to the returns of the individual firm. The model proposed by Adrian and Brunnermeier (2011) assumes that system returns depend linearly on individual returns, so changes in the latter would feed proportionally into the former. This assumption is simple, convenient, and to a large extent facilitates the estimation of the parameters involved and the generation of downside-risk comovement estimates. On the other hand, this structure imposes certain limitations, as it neglects nonlinear patterns in the propagation of volatility shocks and of perturbations to the risk factors affecting banks' exposures. Both patterns feature distinctively in downside-risk dynamics.
There are strong economic arguments that suggest that the financial system may respond nonlinearly to shocks initiated in a single institution. A sizeable, positive shock in an individual bank is unlikely to generate the same characteristic response (i.e., comovement with the system) in absolute terms than a massive negative shock of the same magnitude, particularly if dealing with large-scale financial institutions.2 The disruption to the banking system caused by the failure of a financial institution may occur through direct exposures to the failing institution, through the contraction of financial services provided by the weakening institution (clearing, settlement, custodial or collateral management services), or from a shock to investor confidence that spreads out to sound institutions under adverse selection imperfections (Nier, 2011). Indeed, an extreme idiosyncratic shock in the banking industry, will not only reduce the market value of the stocks a¤ected, but may also spread uncertainty in the system rushing depositors and lending counterparties to withdraw their holdings from performing institutions and across unrelated asset classes, precipitating widespread insolvency. Historical experience suggests that a confidence loss in the soundness of the banking sector takes time to dissipate and may generate devastating e¤ects on the real economy. Bernanke (1983) comes to the conclusion that bank runs were largely responsible of the systemic collapse of the financial industry and the subsequent contagion to the real sectors during the Great Depression. Another channel of contagion in a downward market is through the fire-sales of assets initiated by the stricken institution to restore its capital adequacy, causing valuation losses in firms holding equivalent securities. This mechanism, induced by the generalized collateral lending practices that are prevalent in the wholesale interbank market, can exacerbate price volatility in a crisis situation, as discussed by Brunnermeier and Pedersen (2009). The increased complexity and connectedness of financial institutions can generate "Black Swan" effects, morphing small perturbations in one part of the financial system into large negative shocks on seemingly unrelated parts of the system. These arguments suggest that the financial system is more sensitive to downside losses than upside gains. In such a case, the linear assumption involved in Adrian and Brunnermeier (2011) would neglect a key aspect of downside risk modeling and lead to underestimate the extent of systemic risk contribution of an individual bank.
We propose a simple extension of this procedure that encompasses the linear functional form as a special case and which, more generally, allows us to capture asymmetric patterns in systemic spillovers. We shall refer to this specification as asymmetric CoVaR in the sequel. This approach retains the tractability of the linear model, which ensures that parameters can readily be identified by appropriate techniques, and produces CoVaR estimates which are expected to be more accurate. Furthermore, given the resultant estimates, the existence of nonlinear patterns that motivate the asymmetric model can be addressed formally through a standard Wald test statistic. In this paper, we analyze the suitability of the asymmetric CoVaR in a comprehensive sample of U.S. banks over the period 1990-2010. We find strong statistical evidence suggesting the existence of asymmetric patterns in the marginal contribution of these banks to the systemic risk. Neglecting these nonlinearities gives rise to estimates that systematically underestimate the marginal contribution to systemic risk. Remarkably, the magnitude of the bias is tied to the size of the firm, so that the bigger the company, the greater the underestimation bias. This result is consistent with the too-big-to-fail hypothesis which stresses the need to maintain continuity of the vital economic functions of a large financial institution whose disorderly failure would cause significant disruption to the wider financial system.3 Ignoring the existence of asymmetries would thus lead to conservative estimates of risk contributions, more so in large firms which are more likely to be systemic. Accounting for asymmetries in a simple extension of the model would remove that bias.
Concluding Remarks
In this paper, we have discussed the suitability of the CoVaR procedure recently proposed by Adrian and Brunnermeier (2011). This valuable approach helps understand the drivers of systemic risk in the banking industry. Implementing this procedure in practice requires specifying the unobservable functional form that relates the dynamics of the conditional tail of system's returns to the returns of an individual bank. Adrian and Brunnermeier (2011) build on a model that assumes a simple linear representation, such that returns are proportional.
We show that this approach may provide a reasonable approximation for small-sized banks. However, in more general terms, and particularly for large-scale banks, the linear assumption leads to a severe underestimation of the conditional comovement in a downward market and, hence, their systemic importance may be perceived to be lower than their actual contribution to systemic risk. Yet, how to measure and buttress e¤ectively the resilience of the financial system to losses crystallizing in a stress scenario is the main concern of policy makers, regulatory authorities, and financial markets alike. Witness the rally on U.S. equities and dollar on March 14, 2012 after the regulator announced favorable bank stress test results for the largest nineteen U.S. bank holding companies.
The reason is that the symmetric model implicitly assumes that positive and negative individual returns are equally strong to capture downside risk comovement. Our empirical results however, provide robust evidence that negative shocks to individual returns generate a much larger impact on the financial system than positive disturbances. For a median-sized bank, the relative impact ratio is sevenfold. We contend that this non-linear pattern should be acknowledged in the econometric modeling of systemic risk to avoid a serious misappraisal of risk. Moreover, our analysis suggests that the symmetric specification introduces systematic biases in risk assessment as a function of bank size. Specifically, the distortion caused by a linear model misspecification is more pronounced for larger banks, which are also more systemic on average. Our results show that tail interdependence between the financial system and a bottom-size decile bank which is contracting its balance sheet is 2.2 times larger than its average comovement. More strikingly, this ratio reaches 5.4 for the top-size decile bank. This result is in line with the too-big-to-fail hypothesis and lends support to recent recommendations put forth by the Financial Stability Board to require higher loss absorbency capacity on large banks. Likewise, it is consistent with the resolution plan required by the Dodd-Frank Act for bank holding companies and non-bank financial institutions with $50 billion or more in total assets. Submitting periodically a plan for rapid and orderly resolution in the event of financial distress or failure will enable the FDIC to evaluate potential loss severity and minimize the disruption that a failure may have in the rest of the system, thus performing its resolution functions more e¢ ciently. This measure will also help alleviate moral hazard concerns associated with systemic institutions and strengthen the stability of the overall financial system.
To capture the asymmetric pattern on tail comovement, we propose a simple yet e¤ective extension of the original CoVaR model. This extension preserves the tractability of the original model and its suitability can formally be tested formally through a simple Wald-type test, given the estimates of the model. We show that this simple extension is robust to more general specifications capturing non-linear patterns in returns, though at the expense of losing tractability.
The refinement of the CoVaR statistical measure presented in the paper aims at quantifying asymmetric spillover e¤ects when strains in banks' balance sheets are elevated, and thus contributes a step towards strengthening systemic risk monitoring in stress scenarios. Furthermore, its focus on tail comovement originated from negative perturbations in the growth rate of market-valued banks' balance sheets, may yield insights into the impact on the financial system from large-scale deleveraging by banks seeking to rebuild their capital cushions. This particular concern has been recently rekindled by the continued spikes in volatility in euro area financial markets. It has been estimated that, following pressures on the European banking system as banks cope with sovereign stress, European banks may shrink their combined balance sheet significantly with the potential of unleashing shockwaves to emerging economies hurting their financial stability (IMF, 2012). The estimation of the impact on the real economy from aggregate weakness of the financial sector, and the design of optimal macroprudential policies to arrest systemic risk when tail interdependencies feed non-linearly into the financial system, are left for future research.
Tuesday, June 12, 2012
Friday, June 8, 2012
Policy Analysis and Forecasting in the World Economy: A Panel Unobserved Components Approach
Policy Analysis and Forecasting in the World Economy: A Panel Unobserved Components Approach. By Francis Vitek
IMF Working Paper No. 12/149
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25974.0
Summary: This paper develops a structural macroeconometric model of the world economy, disaggregated into thirty five national economies. This panel unobserved components model features a monetary transmission mechanism, a fiscal transmission mechanism, and extensive macrofinancial linkages, both within and across economies. A variety of monetary policy analysis, fiscal policy analysis, spillover analysis, and forecasting applications of the estimated model are demonstrated, based on a Bayesian framework for conditioning on judgment.
IMF Working Paper No. 12/149
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25974.0
Summary: This paper develops a structural macroeconometric model of the world economy, disaggregated into thirty five national economies. This panel unobserved components model features a monetary transmission mechanism, a fiscal transmission mechanism, and extensive macrofinancial linkages, both within and across economies. A variety of monetary policy analysis, fiscal policy analysis, spillover analysis, and forecasting applications of the estimated model are demonstrated, based on a Bayesian framework for conditioning on judgment.
Thursday, June 7, 2012
Policies for Macrofinancial Stability: How to Deal with the Credit Booms
Policies for Macrofinancial Stability: How to Deal with the Credit Booms. By Dell'Ariccia, Giovanni; Igan, Deniz; Laeven, Luc; Tong, Hui; Bakker, Bas B.; Vandenbussche, Jérôme
IMF Staff Discussion Notes No. 12/06
June 07, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25935.0
Excerpts
Executive summary
Credit booms buttress investment and consumption and can contribute to long-term financial deepening. But they often end up in costly balance sheet dislocations, and, more often than acceptable, in devastating financial crises whose cost can exceed the benefits associated with the boom. These risks have long been recognized. But, until the global financial crisis in 2008, policy paid limited attention to the problem. The crisis—preceded by booms in many of the hardest-hit countries—has led to a more activist stance. Yet, there is little consensus about how and when policy should intervene. This note explores past credit booms with the objective of assessing the effectiveness of macroeconomic and macroprudential policies in reducing the risk of a crisis or, at least, limiting its consequences.
It should be recognized at the onset that a more interventionist policy will inevitably imply some trade-offs. No policy tool is a panacea for the ills stemming from credit booms, and any form of intervention will entail costs and distortions, the relevance of which will depend on the characteristics and institutions of individual countries. With these caveats in mind, the analysis in this note brings the following insights.
First, credit booms are often triggered by financial reform, capital inflow surges associated with capital account liberalizations, and periods of strong economic growth. They tend to be more frequent in fixed exchange rate regimes, when banking supervision is weak, and when macroeconomic policies are loose.
Second, not all booms are bad. About a third of boom cases end up in financial crises. Others do not lead to busts but are followed by extended periods of below-trend economic growth. Yet many result in permanent financial deepening and benefit long-term economic growth. Third, it is difficult to tell “bad” from “good” booms in real time. But there are useful telltales. Bad booms tend to be larger and last longer (roughly half of the booms lasting longer than six years end up in a crisis).
Fourth, monetary policy is in principle the natural lever to contain a credit boom. In practice, however, capital flows (and related concerns about exchange rate volatility) and currency substitution limit its effectiveness in small open economies. In addition, since booms can occur in low-inflation environments, a conflict may emerge with its primary objective.
Fifth, given its time lags, fiscal policy is ill-equipped to timely stop a boom. But consolidation during the boom years can help create fiscal room to support the financial sector or stimulate the economy if and when a bust arrives.
Finally, macroprudential tools have at times proven effective in containing booms, and more often in limiting the consequences of busts, thanks to the buffers they helped to build. Their more targeted nature limits their costs, although their associated distortions, should these tools be abused, can be severe. Moreover, circumvention has often been a major issue, underscoring the importance of careful design, coordination with other policies (including across borders), and close supervision to ensure the efficacy of these tools.
Conclusions
Prolonged credit booms are a harbinger of financial crises and have real costs. Our analysis shows that, while only a minority of booms end up in crises, those that do can have longlasting and devastating real effects if left unaddressed. Yet it appears to be difficult to identify bad booms as they emerge, and the cost of intervening too early and running the risk of stopping a good boom therefore has to be weighed against the desire to prevent financial crises.
While the analysis offers some insights into the origins and dynamics of credit booms, from a policy perspective a number of questions remain unaddressed. In part this reflects the limited experience to date with macroprudential policies and the simultaneous use of multiple policy tools, making it hard to disentangle specific policy measures’ effectiveness.
First, while monetary policy tightening seems the natural response to rapid credit growth, we find only weak empirical evidence that it contains booms and their fallout on the economy. This may be partly the result of a statistical bias. But there are several “legitimate” factors that limit the use and effectiveness of monetary policy in dealing with credit booms, especially in small open economies. In contrast, there is more consistent evidence that macroprudential policy is up to this task, although it is more exposed to circumvention.
All of the above raise important questions about the optimal policy response to credit booms. Our view is that when credit booms coincide with periods of general overheating in the economy, monetary policy should act first and foremost. If the boom lasts and is likely to end up badly or if it occurs in the absence of overheating, then macroprudential policy should come into play. Preferably, this should be in combination and coordination with macroeconomic policy, especially when macroeconomic policy is already being used to address overheating of the economy.
Second, questions remain about the optimal mix and modality of macroprudential policies, also in light of political economy considerations and the type of supervisory arrangements in the country. Political economy considerations call for a more rules-based approach to setting macroprudential policy to avoid pressure from interest groups to relax regulation during a crisis. But such considerations have to be weighed against the practical problems and unintended effects of a rules-based approach, such as the calibration of rules with rather demanding data requirements and the risk of circumvention in the presence of active earnings management. The design of a macroprudential framework should also consider the capacity and ability of supervisors to enforce such rules so that unintended and potentially dangerous side effects can be avoided.
Third, the optimal macroprudential policy response to credit booms, as well as the optimal policy mix, will likely have to depend on the type of credit boom. Because of data limitations, our analysis has focused on aggregate credit. While it seems natural that policy response should adapt to and be targeted to the type of credit, additional analysis is needed to assess the effectiveness of policies to curtail booms that differ in the type of credit.
Fourth, policy coordination, across different authorities and across borders, may increase the effectiveness of monetary tightening and macroprudential policies. Cooperation and a continuous flow of information among national supervisors, especially regarding the activities of institutions that are active across borders, are crucial. Equally important is the coordination of regulations and actions among supervisors of different types of financial institutions. Whether and how national policymakers take into account the effects of their actions on the financial and macroeconomic stability of other countries is a vital issue, calling for further regional and global cooperation in the setup of macroprudential policy frameworks and the conduct of macroeconomic policies.
IMF Staff Discussion Notes No. 12/06
June 07, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25935.0
Excerpts
Executive summary
Credit booms buttress investment and consumption and can contribute to long-term financial deepening. But they often end up in costly balance sheet dislocations, and, more often than acceptable, in devastating financial crises whose cost can exceed the benefits associated with the boom. These risks have long been recognized. But, until the global financial crisis in 2008, policy paid limited attention to the problem. The crisis—preceded by booms in many of the hardest-hit countries—has led to a more activist stance. Yet, there is little consensus about how and when policy should intervene. This note explores past credit booms with the objective of assessing the effectiveness of macroeconomic and macroprudential policies in reducing the risk of a crisis or, at least, limiting its consequences.
It should be recognized at the onset that a more interventionist policy will inevitably imply some trade-offs. No policy tool is a panacea for the ills stemming from credit booms, and any form of intervention will entail costs and distortions, the relevance of which will depend on the characteristics and institutions of individual countries. With these caveats in mind, the analysis in this note brings the following insights.
First, credit booms are often triggered by financial reform, capital inflow surges associated with capital account liberalizations, and periods of strong economic growth. They tend to be more frequent in fixed exchange rate regimes, when banking supervision is weak, and when macroeconomic policies are loose.
Second, not all booms are bad. About a third of boom cases end up in financial crises. Others do not lead to busts but are followed by extended periods of below-trend economic growth. Yet many result in permanent financial deepening and benefit long-term economic growth. Third, it is difficult to tell “bad” from “good” booms in real time. But there are useful telltales. Bad booms tend to be larger and last longer (roughly half of the booms lasting longer than six years end up in a crisis).
Fourth, monetary policy is in principle the natural lever to contain a credit boom. In practice, however, capital flows (and related concerns about exchange rate volatility) and currency substitution limit its effectiveness in small open economies. In addition, since booms can occur in low-inflation environments, a conflict may emerge with its primary objective.
Fifth, given its time lags, fiscal policy is ill-equipped to timely stop a boom. But consolidation during the boom years can help create fiscal room to support the financial sector or stimulate the economy if and when a bust arrives.
Finally, macroprudential tools have at times proven effective in containing booms, and more often in limiting the consequences of busts, thanks to the buffers they helped to build. Their more targeted nature limits their costs, although their associated distortions, should these tools be abused, can be severe. Moreover, circumvention has often been a major issue, underscoring the importance of careful design, coordination with other policies (including across borders), and close supervision to ensure the efficacy of these tools.
Conclusions
Prolonged credit booms are a harbinger of financial crises and have real costs. Our analysis shows that, while only a minority of booms end up in crises, those that do can have longlasting and devastating real effects if left unaddressed. Yet it appears to be difficult to identify bad booms as they emerge, and the cost of intervening too early and running the risk of stopping a good boom therefore has to be weighed against the desire to prevent financial crises.
While the analysis offers some insights into the origins and dynamics of credit booms, from a policy perspective a number of questions remain unaddressed. In part this reflects the limited experience to date with macroprudential policies and the simultaneous use of multiple policy tools, making it hard to disentangle specific policy measures’ effectiveness.
First, while monetary policy tightening seems the natural response to rapid credit growth, we find only weak empirical evidence that it contains booms and their fallout on the economy. This may be partly the result of a statistical bias. But there are several “legitimate” factors that limit the use and effectiveness of monetary policy in dealing with credit booms, especially in small open economies. In contrast, there is more consistent evidence that macroprudential policy is up to this task, although it is more exposed to circumvention.
All of the above raise important questions about the optimal policy response to credit booms. Our view is that when credit booms coincide with periods of general overheating in the economy, monetary policy should act first and foremost. If the boom lasts and is likely to end up badly or if it occurs in the absence of overheating, then macroprudential policy should come into play. Preferably, this should be in combination and coordination with macroeconomic policy, especially when macroeconomic policy is already being used to address overheating of the economy.
Second, questions remain about the optimal mix and modality of macroprudential policies, also in light of political economy considerations and the type of supervisory arrangements in the country. Political economy considerations call for a more rules-based approach to setting macroprudential policy to avoid pressure from interest groups to relax regulation during a crisis. But such considerations have to be weighed against the practical problems and unintended effects of a rules-based approach, such as the calibration of rules with rather demanding data requirements and the risk of circumvention in the presence of active earnings management. The design of a macroprudential framework should also consider the capacity and ability of supervisors to enforce such rules so that unintended and potentially dangerous side effects can be avoided.
Third, the optimal macroprudential policy response to credit booms, as well as the optimal policy mix, will likely have to depend on the type of credit boom. Because of data limitations, our analysis has focused on aggregate credit. While it seems natural that policy response should adapt to and be targeted to the type of credit, additional analysis is needed to assess the effectiveness of policies to curtail booms that differ in the type of credit.
Fourth, policy coordination, across different authorities and across borders, may increase the effectiveness of monetary tightening and macroprudential policies. Cooperation and a continuous flow of information among national supervisors, especially regarding the activities of institutions that are active across borders, are crucial. Equally important is the coordination of regulations and actions among supervisors of different types of financial institutions. Whether and how national policymakers take into account the effects of their actions on the financial and macroeconomic stability of other countries is a vital issue, calling for further regional and global cooperation in the setup of macroprudential policy frameworks and the conduct of macroeconomic policies.
IMF Staff Notes: Externalities and Macro-Prudential Policy
Externalities and Macro-Prudential Policy. By De Nicoló, Gianni; Favara, Giovanni; Ratnovski, Lev
IMF Staff Discussion Notes No. 12/05
June 07, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25936.0
Excerpts
Executive Summary
The recent financial crisis has led to a reexamination of policies for macroeconomic and financial stability. Part of the current debate involves the adoption of a macroprudential approach to financial regulation, with an aim toward mitigating boom-bust patterns and systemic risks in financial markets.
The fundamental rationale behind macroprudential policies, however, is not always clearly articulated. The contribution of this paper is to lay out the key sources of market failures that can justify macroprudential regulation. It explains how externalities associated with the activity of financial intermediaries can lead to systemic risk, and thus require specific policies to mitigate such risk.
The paper classifies externalities that can lead to systemic risk as:
1. Externalities related to strategic complementarities, that arise from the strategic interaction of banks (and other financial institutions) and cause the build-up of vulnerabilities during the expansionary phase of a financial cycle;
2. Externalities related to fire sales, that arise from a generalized sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries, especially during the contractionary phase of a financial cycle; and
3. Externalities related to interconnectedness, caused by the propagation of shocks from systemic institutions or through financial networks.
The correction of these externalities can be seen as intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk.
This paper discusses how the main proposed macroprudential policy tools—capital requirements, liquidity requirements, restrictions on activities, and taxes—address the identified externalities. It is argued that each externality can be corrected by different tools that can complement each other. Capital surcharges, however, are likely to play an important role in the design of macroprudential regulation.
This paper’s analysis of macroprudential policy complements the more traditional one that builds on the distinction between time-series and cross-sectional dimensions of systemic risk.
Conclusions
This paper has argued that the first step in the economic analysis of macroprudential policy is the identification of market failures that contribute to systemic risk. Externalities are an important source of such market failures, and macroprudential policy should be thought of as an attempt to correct these externalities.
Building on the discussion in the academic literature, the paper has identified externalities that lead to systemic risk: externalities due to strategic complementarities, which contribute to the accumulation of vulnerabilities during the expansionary phase of a financial cycle; and externalities due to fire sales and interconnectedness, which tend to exacerbate negative shocks especially during a contractionary phase.
The correction of these externalities can be seen as an intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk. This paper has studied how the identified externalities can be corrected by the main macroprudential policy proposals: capital requirements, liquidity requirements, restrictions on bank activities, and taxation. The main finding is that even though some of these policies can complement each other in correcting the same externality, capital requirements are likely to play an important role in the design of any macroprudential framework.
It has also been argued that although externalities can be proxied through a variety of risk measurements, the accumulation of evidence on the effectiveness of alternative policy tools remains the most pressing concern for the design of macroprudential policy.
IMF Staff Discussion Notes No. 12/05
June 07, 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25936.0
Excerpts
Executive Summary
The recent financial crisis has led to a reexamination of policies for macroeconomic and financial stability. Part of the current debate involves the adoption of a macroprudential approach to financial regulation, with an aim toward mitigating boom-bust patterns and systemic risks in financial markets.
The fundamental rationale behind macroprudential policies, however, is not always clearly articulated. The contribution of this paper is to lay out the key sources of market failures that can justify macroprudential regulation. It explains how externalities associated with the activity of financial intermediaries can lead to systemic risk, and thus require specific policies to mitigate such risk.
The paper classifies externalities that can lead to systemic risk as:
1. Externalities related to strategic complementarities, that arise from the strategic interaction of banks (and other financial institutions) and cause the build-up of vulnerabilities during the expansionary phase of a financial cycle;
2. Externalities related to fire sales, that arise from a generalized sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries, especially during the contractionary phase of a financial cycle; and
3. Externalities related to interconnectedness, caused by the propagation of shocks from systemic institutions or through financial networks.
The correction of these externalities can be seen as intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk.
This paper discusses how the main proposed macroprudential policy tools—capital requirements, liquidity requirements, restrictions on activities, and taxes—address the identified externalities. It is argued that each externality can be corrected by different tools that can complement each other. Capital surcharges, however, are likely to play an important role in the design of macroprudential regulation.
This paper’s analysis of macroprudential policy complements the more traditional one that builds on the distinction between time-series and cross-sectional dimensions of systemic risk.
Conclusions
This paper has argued that the first step in the economic analysis of macroprudential policy is the identification of market failures that contribute to systemic risk. Externalities are an important source of such market failures, and macroprudential policy should be thought of as an attempt to correct these externalities.
Building on the discussion in the academic literature, the paper has identified externalities that lead to systemic risk: externalities due to strategic complementarities, which contribute to the accumulation of vulnerabilities during the expansionary phase of a financial cycle; and externalities due to fire sales and interconnectedness, which tend to exacerbate negative shocks especially during a contractionary phase.
The correction of these externalities can be seen as an intermediate targets for macroprudential policy, since policies that control externalities mitigate market failures that create systemic risk. This paper has studied how the identified externalities can be corrected by the main macroprudential policy proposals: capital requirements, liquidity requirements, restrictions on bank activities, and taxation. The main finding is that even though some of these policies can complement each other in correcting the same externality, capital requirements are likely to play an important role in the design of any macroprudential framework.
It has also been argued that although externalities can be proxied through a variety of risk measurements, the accumulation of evidence on the effectiveness of alternative policy tools remains the most pressing concern for the design of macroprudential policy.
Wednesday, May 30, 2012
Financial Intermediation Costs in Low-Income Countries: The Role of Regulatory, Institutional, and Macroeconomic Factors
Financial Intermediation Costs in Low-Income Countries: The Role of Regulatory, Institutional, and Macroeconomic Factors. By Tigran Poghosyan
IMF Working Paper No. 12/140
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25949.0
Summary: We analyze factors driving persistently higher financial intermediation costs in low-income countries (LICs) relative to emerging market (EMs) country comparators. Using the net interest margin as a proxy for financial intermediation costs at the bank level, we find that within LICs a substantial part of the variation in interest margins can be explained by bank-specific factors: margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size. Overall, we find that concentrated market structures and lack of competition in LICs banking systems and institutional weaknesses constitute the key impediments preventing financial intermediation costs from declining. Our results provide strong evidence that policies aimed at fostering banking competition and strengthening institutional frameworks can reduce intermediation costs in LICs.
Excerpts
Introduction
The net interest margin, measured as a difference between lending and deposit rates, is a commonly accepted measure of how costly bank intermediation services are for a society. Research shows that the cost of financial intermediation has important repercussions for economic performance (Jayaratne and Strahan, 1996; Rajan and Zingales, 1998; Beck, et al., 2000). The importance of the bank interest margin as a measure of financial intermediation costs is particularly pertinent for low-income countries (LICs), where in the absence of developed stock markets firms largely depend on bank financing as a source of external funding.
High financial intermediation costs may constitute an important impediment for financial deepening in LICs. The persistence of high margins might be symptomatic of a number of systemic problems, such as: lack of competition, perceived market and credit risks, bank unsoundness, scale diseconomies constrained by small markets, high operating costs due to low efficiency, unfavorable institutional environment, and existence of various regulatory constraints distorting financial market activity.
The main objective of this paper is to examine the influence of market concentration, bank regulations, institutional development, and macroeconomic environment on bank margins across a broad cross-section of LICs and emerging economies (Ems), while controlling for bank-specific factors. We use bank-level data on 359 commercial banks in 48 LICs, and 2535 commercial banks in 67 EMs for the period 1996-2010. For both groups of countries, the sample includes great diversity in terms of financial intermediation costs, bank characteristics, as well as regulation, institutional, and macroeconomic environments. The comparison of results across the two groups of countries helps identify key environmental factors that put upward pressure on financial intermediation costs. Based on the results of the analysis, we provide policy recommendations for reducing financial intermediation costs in LICs and contributing to further financial deepening.
Estimation results suggest that concentrated market structures and lack of competition in LICs’ banking systems remain key impediments preventing financial intermediation costs from declining. In this respect, relaxing restrictions to bank entry could help in reducing the cost of financial intermediation in LICs. Low institutional capacity also plays a prominent role in boosting margins. Within LICs, bank-specific characteristics explain a substantial part of variation in interest margins. Specifically, margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size.
Conclusions
This paper examined the determinants of interest margin in LICs and EMs, given the importance of high financial intermediation costs as an impediment for financial deepening in LICs. The paper adopts two complementary approaches to explore interest margin determinants: (i) an accounting framework for decomposing the interest margin into its cost and profit components; and (ii) econometric specification based on the behavioral (dealership) model of profit maximizing banks.
The analysis provides evidence on the significantly higher interest margins in LICs compared to EMs. Decomposition of the margins into their cost and profit components indicates that higher median margin in LICs is mainly explained by greater profitability of banks (which may be due to less competitive environment) and higher credit risk (which may reflect a weaker environment).
The econometric analysis further highlights differences between LICs and EMs banks. Compared to EMs, margins in LICs banks appear to be more responsive to the market structure, suggesting that promoting banking competition can be an important tool to reduce interest margins in LICs. Furthermore, the positive impact of market structure on LICs margins is robust to different measures of market concentration. On the other hand, margins in LICs banks are less responsive to the macroeconomic and regulatory environment compared to their EMs peers. In both groups of countries, the institutional setting appears to have a dominant impact on margins, overshadowing that of market concentration and many bank-specific controls. Finally, bank characteristics explain a substantial part of withincountry variation in interest margins once country-specific determinants are accounted for. Specifically, margins in both LICs and EMs increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size.
Taken together, these findings provide strong evidence that there is large scope to reduce interest margins in LICs through policies aimed at fostering banking competition. On the regulatory side, relaxing restrictions to bank entry could help in lowering intermediation costs. More important, improvements in the informational, contractual and enforcement frameworks could play a key role in lowering interest margins in LICs.
IMF Working Paper No. 12/140
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25949.0
Summary: We analyze factors driving persistently higher financial intermediation costs in low-income countries (LICs) relative to emerging market (EMs) country comparators. Using the net interest margin as a proxy for financial intermediation costs at the bank level, we find that within LICs a substantial part of the variation in interest margins can be explained by bank-specific factors: margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size. Overall, we find that concentrated market structures and lack of competition in LICs banking systems and institutional weaknesses constitute the key impediments preventing financial intermediation costs from declining. Our results provide strong evidence that policies aimed at fostering banking competition and strengthening institutional frameworks can reduce intermediation costs in LICs.
Excerpts
Introduction
The net interest margin, measured as a difference between lending and deposit rates, is a commonly accepted measure of how costly bank intermediation services are for a society. Research shows that the cost of financial intermediation has important repercussions for economic performance (Jayaratne and Strahan, 1996; Rajan and Zingales, 1998; Beck, et al., 2000). The importance of the bank interest margin as a measure of financial intermediation costs is particularly pertinent for low-income countries (LICs), where in the absence of developed stock markets firms largely depend on bank financing as a source of external funding.
High financial intermediation costs may constitute an important impediment for financial deepening in LICs. The persistence of high margins might be symptomatic of a number of systemic problems, such as: lack of competition, perceived market and credit risks, bank unsoundness, scale diseconomies constrained by small markets, high operating costs due to low efficiency, unfavorable institutional environment, and existence of various regulatory constraints distorting financial market activity.
The main objective of this paper is to examine the influence of market concentration, bank regulations, institutional development, and macroeconomic environment on bank margins across a broad cross-section of LICs and emerging economies (Ems), while controlling for bank-specific factors. We use bank-level data on 359 commercial banks in 48 LICs, and 2535 commercial banks in 67 EMs for the period 1996-2010. For both groups of countries, the sample includes great diversity in terms of financial intermediation costs, bank characteristics, as well as regulation, institutional, and macroeconomic environments. The comparison of results across the two groups of countries helps identify key environmental factors that put upward pressure on financial intermediation costs. Based on the results of the analysis, we provide policy recommendations for reducing financial intermediation costs in LICs and contributing to further financial deepening.
Estimation results suggest that concentrated market structures and lack of competition in LICs’ banking systems remain key impediments preventing financial intermediation costs from declining. In this respect, relaxing restrictions to bank entry could help in reducing the cost of financial intermediation in LICs. Low institutional capacity also plays a prominent role in boosting margins. Within LICs, bank-specific characteristics explain a substantial part of variation in interest margins. Specifically, margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size.
Conclusions
This paper examined the determinants of interest margin in LICs and EMs, given the importance of high financial intermediation costs as an impediment for financial deepening in LICs. The paper adopts two complementary approaches to explore interest margin determinants: (i) an accounting framework for decomposing the interest margin into its cost and profit components; and (ii) econometric specification based on the behavioral (dealership) model of profit maximizing banks.
The analysis provides evidence on the significantly higher interest margins in LICs compared to EMs. Decomposition of the margins into their cost and profit components indicates that higher median margin in LICs is mainly explained by greater profitability of banks (which may be due to less competitive environment) and higher credit risk (which may reflect a weaker environment).
The econometric analysis further highlights differences between LICs and EMs banks. Compared to EMs, margins in LICs banks appear to be more responsive to the market structure, suggesting that promoting banking competition can be an important tool to reduce interest margins in LICs. Furthermore, the positive impact of market structure on LICs margins is robust to different measures of market concentration. On the other hand, margins in LICs banks are less responsive to the macroeconomic and regulatory environment compared to their EMs peers. In both groups of countries, the institutional setting appears to have a dominant impact on margins, overshadowing that of market concentration and many bank-specific controls. Finally, bank characteristics explain a substantial part of withincountry variation in interest margins once country-specific determinants are accounted for. Specifically, margins in both LICs and EMs increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size.
Taken together, these findings provide strong evidence that there is large scope to reduce interest margins in LICs through policies aimed at fostering banking competition. On the regulatory side, relaxing restrictions to bank entry could help in lowering intermediation costs. More important, improvements in the informational, contractual and enforcement frameworks could play a key role in lowering interest margins in LICs.
Tuesday, May 29, 2012
CPSS: Innovations in retail payments
Innovations in retail payments
CPSS Publications No 102
May 29, 2012
May 29, 2012
http://www.bis.org/publ/cpss102.htm
In June 2010, the Committee on Payment and Settlement Systems (CPSS) set up a working group to investigate developments in retail payments, focusing especially on innovations. This report, produced by that group, first provides an overview of innovative retail payment activities in the CPSS and other selected countries from a fact-finding exercise, which attempted to cover influential developments in retail payment instruments and schemes over the past decade. Based on the trends observed and the economics of retail payments, the report identifies a number of exogenous and endogenous factors that could serve as drivers for retail payment innovations or as barriers to them. The analysis was also used to suggest some pointers as to what can be expected over the next five years. Finally, the report identifies a number of issues for central banks concerning their various responsibilities and tasks as catalysts, overseers and/or operators of payment systems.
Friday, May 25, 2012
Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies. By Carlo Cottarelli & Laura Jaramillo
Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies. By Carlo Cottarelli & Laura Jaramillo
May 01, 2012
IMF Working Paper No. 12/137
Summary: Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalize longterm growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt, and financing costs. Revenue and expenditure policies are also critical in affecting productivity and employment growth. This paper discusses the complex relationships between fiscal policy and growth both in the short and in the long run.
Order a print copy: http://www.imfbookstore.org/IMFORG/WPIEA2012137
Appendix. Short-run Determinants of CDS Spreads in Advanced Economies
Introduction
Since the global financial crisis and ensuing sovereign crisis in Europe, financial markets’ assessment of credit risk for advanced economies has changed significantly. Before the crisis, the valuation of advanced economy sovereign debt treated default as a very low probability event, and therefore liquidity risk rather than default risk was seen as the dominant driver of financing costs in advanced economies. However, as the recent crisis in Europe unfolded, assessment of credit risk came to the forefront, taking into account country-specific fundamentals. In response, several countries have made progress in adopting fiscal consolidation plans, although this has not always been met with a reduction in sovereign spreads. The current crisis has shown that while markets are concerned with large debt and fiscal deficits, they also worry about low growth and its effect on debt dynamics, as wells as the feasibility of fiscal adjustment in an environment of very weak economic activity.
While a few studies have looked at sovereign spreads in advanced economies since the onset of the global crisis, we focus here on credit default swap (CDS) spreads in advanced economies during 2011, the height of the euro area crisis. Under the assumption that underlying global factors (such as global risk aversion) are behind general co-movements of CDS spreads, our analysis seeks to identify the set of country specific factors that explain the divergence of spreads across countries during the most recent phase of the global crisis. The results highlight the current short-termism of markets, which makes fiscal policy management more difficult.14 In particular, it shows that lower debt and deficit to GDP ratios lead to lower CDS spreads, but so too does faster short-term growth. There is further evidence of a nonlinear relationship between growth and sovereign bond spreads: spreads are more likely to increase if growth declines from an already low rate and the fiscal tightening is large. If growth deteriorates enough as a result of a fiscal tightening, spreads could actually rise even as the deficit falls.
Background
As fiscal fundamentals have become a growing concern of financial markets, the sovereign CDS market for advanced economies has become increasingly large.15 Several European advanced economies are now among the ten largest single name CDS exposures by net notional position (Figure A1), and since September 2009 investors can trade index products on a basket of Western European sovereign CDS.[For further information on Markit iTraxx SovX Western European Index see http://www.markit.com/assets/en/docs/commentary/credit-wrap/SovX.pdf.] With rising size and liquidity, sovereign CDS spreads now provide more reliable signaling of sovereign credit risk.
The literature on the determinants of CDS spreads in advanced economies since the onset of the financial crisis— typically focusing on a narrow set of countries and using data only through 2010—has highlighted the importance of global factors with an increasingly prominent role of country-specific factors as the crisis progressed. Longstaff et al. (2011) show that sovereign credit risk can be linked to global factors, based on a dataset of 28 advanced and emerging economies over the period October 2000-January 2010. Similarly, Fontana and Scheicher (2010) find that the recent repricing of sovereign credit risk in the CDS market is mostly due to common factors. Dieckmann and Plank (2011) find—for a group of 18 advanced economies between January 2007 and April 2010—that the state of the world financial system as well as a country’s domestic financial system has strong explanatory power for the behavior of CDS spreads, with euro area countries especially sensitive. Forni et al. (2012) find that domestic financial and global factors explain movements in CDS spreads, using a panel dataset of 21 advanced economies over the period January 2008-October 2010.
As the crisis has progressed, differentiation across sovereign CDS spreads has increased significantly (Figure A2), underscoring that markets are reassessing the effect of country specific-factors on default risk. This implies that looking at historical correlations can overshadow some of the important relationships that have emerged as the crisis has evolved. In this context, this appendix attempts to shed light on the particular state of the markets in 2011, at the height of the euro area crisis.
Empirical Model Estimation
Sovereign CDS spreads in several European countries reached historical highs during 2011. High deficits and debt to GDP ratios have typically been a precondition for such a surge, as countries that saw their overall deficit to GDP ratio rise into the double digits or a sizeable increase in their stock of debt faced increasing market pressure (mostly in the euro area). However, there are several indications that other elements beyond fiscal fundamentals were at play. First, countries that announced sizeable fiscal adjustment plans in 2011 were not necessarily greeted with a reduction in spreads (Figure A3). Second, countries with weak fiscal accounts (such as Japan, the United Kingdom, and the United States) did not pay high spreads in 2011, which could in part be attributed to the effects of quantitative easing strategies by central banks in these countries (Figure A4).
With this in mind, this appendix assesses in a more consistent way why 5-year CDS spreads differ across a sample of 31 advanced economies,18 by looking at a set of macroeconomic and fiscal fundamentals, based on a simple OLS cross-section regression. A cross-section analysis is preferred to a panel regression given the desired focus on market behavior in the latest phase of the crisis. In particular, a cross-section allows for a larger number of countries to be included, which adds greater variation to the dataset than does the time dimension (as this analysis covers only one crisis episode).19 CDS spreads (average for 2011) are drawn from Markit20 and transformed into logs in line with Edwards (1984). Fiscal variables used as regressors are drawn from the September 2011 Fiscal Monitor (IMF 2011a), while macroeconomic variables are drawn from the September 2011 World Economic Outlook (IMF 2011b). Regressors include:
Estimation Results
Table A1 provides the results of the model. Column 1 reports a general specification in which all variables are included. The following columns illustrate the specification search, with insignificant variables dropped one by one. Column 5, the preferred specification, provides a relatively good fit with an adjusted R-squared of 0.76. The results illustrate the current short-termism of markets:
Conclusions
The cross-section estimates point to the current short-term vision of markets, with special concern for near-term growth prospects. This could possibly reflect strong risk aversion after four years of market turmoil. These results imply that tighter fiscal policy could actually lead to wider, rather than narrower, spreads in the short term. It is important to note, however, that the euro area crisis is still not fully resolved and financial markets remain unsettled, therefore these results may reflect the particular state of markets in 2011 rather than more permanent features, something that a cross section cannot shed light on. Moreover, it would be important to assess the direct effect on spreads of other variables beyond fiscal fundamentals, such as exposure to contingent liabilities from the banking sector. Potential simultaneity issues (e.g., between spreads and growth) also deserve additional attention.
May 01, 2012
IMF Working Paper No. 12/137
Summary: Implementation of fiscal consolidation by advanced economies in coming years needs to take into account the short and long-run interactions between economic growth and fiscal policy. Many countries must reduce high public debt to GDP ratios that penalize longterm growth. However, fiscal adjustment is likely to hurt growth in the short run, delaying improvements in fiscal indicators, including deficits, debt, and financing costs. Revenue and expenditure policies are also critical in affecting productivity and employment growth. This paper discusses the complex relationships between fiscal policy and growth both in the short and in the long run.
Order a print copy: http://www.imfbookstore.org/IMFORG/WPIEA2012137
Appendix. Short-run Determinants of CDS Spreads in Advanced Economies
Introduction
Since the global financial crisis and ensuing sovereign crisis in Europe, financial markets’ assessment of credit risk for advanced economies has changed significantly. Before the crisis, the valuation of advanced economy sovereign debt treated default as a very low probability event, and therefore liquidity risk rather than default risk was seen as the dominant driver of financing costs in advanced economies. However, as the recent crisis in Europe unfolded, assessment of credit risk came to the forefront, taking into account country-specific fundamentals. In response, several countries have made progress in adopting fiscal consolidation plans, although this has not always been met with a reduction in sovereign spreads. The current crisis has shown that while markets are concerned with large debt and fiscal deficits, they also worry about low growth and its effect on debt dynamics, as wells as the feasibility of fiscal adjustment in an environment of very weak economic activity.
While a few studies have looked at sovereign spreads in advanced economies since the onset of the global crisis, we focus here on credit default swap (CDS) spreads in advanced economies during 2011, the height of the euro area crisis. Under the assumption that underlying global factors (such as global risk aversion) are behind general co-movements of CDS spreads, our analysis seeks to identify the set of country specific factors that explain the divergence of spreads across countries during the most recent phase of the global crisis. The results highlight the current short-termism of markets, which makes fiscal policy management more difficult.14 In particular, it shows that lower debt and deficit to GDP ratios lead to lower CDS spreads, but so too does faster short-term growth. There is further evidence of a nonlinear relationship between growth and sovereign bond spreads: spreads are more likely to increase if growth declines from an already low rate and the fiscal tightening is large. If growth deteriorates enough as a result of a fiscal tightening, spreads could actually rise even as the deficit falls.
Background
As fiscal fundamentals have become a growing concern of financial markets, the sovereign CDS market for advanced economies has become increasingly large.15 Several European advanced economies are now among the ten largest single name CDS exposures by net notional position (Figure A1), and since September 2009 investors can trade index products on a basket of Western European sovereign CDS.[For further information on Markit iTraxx SovX Western European Index see http://www.markit.com/assets/en/docs/commentary/credit-wrap/SovX.pdf.] With rising size and liquidity, sovereign CDS spreads now provide more reliable signaling of sovereign credit risk.
The literature on the determinants of CDS spreads in advanced economies since the onset of the financial crisis— typically focusing on a narrow set of countries and using data only through 2010—has highlighted the importance of global factors with an increasingly prominent role of country-specific factors as the crisis progressed. Longstaff et al. (2011) show that sovereign credit risk can be linked to global factors, based on a dataset of 28 advanced and emerging economies over the period October 2000-January 2010. Similarly, Fontana and Scheicher (2010) find that the recent repricing of sovereign credit risk in the CDS market is mostly due to common factors. Dieckmann and Plank (2011) find—for a group of 18 advanced economies between January 2007 and April 2010—that the state of the world financial system as well as a country’s domestic financial system has strong explanatory power for the behavior of CDS spreads, with euro area countries especially sensitive. Forni et al. (2012) find that domestic financial and global factors explain movements in CDS spreads, using a panel dataset of 21 advanced economies over the period January 2008-October 2010.
As the crisis has progressed, differentiation across sovereign CDS spreads has increased significantly (Figure A2), underscoring that markets are reassessing the effect of country specific-factors on default risk. This implies that looking at historical correlations can overshadow some of the important relationships that have emerged as the crisis has evolved. In this context, this appendix attempts to shed light on the particular state of the markets in 2011, at the height of the euro area crisis.
Empirical Model Estimation
Sovereign CDS spreads in several European countries reached historical highs during 2011. High deficits and debt to GDP ratios have typically been a precondition for such a surge, as countries that saw their overall deficit to GDP ratio rise into the double digits or a sizeable increase in their stock of debt faced increasing market pressure (mostly in the euro area). However, there are several indications that other elements beyond fiscal fundamentals were at play. First, countries that announced sizeable fiscal adjustment plans in 2011 were not necessarily greeted with a reduction in spreads (Figure A3). Second, countries with weak fiscal accounts (such as Japan, the United Kingdom, and the United States) did not pay high spreads in 2011, which could in part be attributed to the effects of quantitative easing strategies by central banks in these countries (Figure A4).
With this in mind, this appendix assesses in a more consistent way why 5-year CDS spreads differ across a sample of 31 advanced economies,18 by looking at a set of macroeconomic and fiscal fundamentals, based on a simple OLS cross-section regression. A cross-section analysis is preferred to a panel regression given the desired focus on market behavior in the latest phase of the crisis. In particular, a cross-section allows for a larger number of countries to be included, which adds greater variation to the dataset than does the time dimension (as this analysis covers only one crisis episode).19 CDS spreads (average for 2011) are drawn from Markit20 and transformed into logs in line with Edwards (1984). Fiscal variables used as regressors are drawn from the September 2011 Fiscal Monitor (IMF 2011a), while macroeconomic variables are drawn from the September 2011 World Economic Outlook (IMF 2011b). Regressors include:
- Macroeconomic variables: real GDP growth rate and growth squared; projected real GDP in 2014; projected potential real GDP growth, averaged over 2011-16; inflation rate for 2011.
- Near-term fiscal variables: General government primary balance and general government debt as a ratio to GDP. For Australia, Canada, and Japan, net debt to GDP is used, in view of the sizeable amount of their assets.
- Long-term fiscal variables: Net present value of the increase in public pension spending during 2010-50 as a ratio to GDP (from IMF, 2010c); net present value of the increase in public health care spending during 2010-50 as a ratio to GDP (from IMF, 2010d); projected primary balance to GDP in 2014; projected debt to GDP in 2014.
- Investor base: General government debt of the country in question held by its national central bank (from the IMF International Financial Statistics) and, in the case of Japan, the U.K. and the U.S., by foreign central banks, based on the latest available data.
Estimation Results
Table A1 provides the results of the model. Column 1 reports a general specification in which all variables are included. The following columns illustrate the specification search, with insignificant variables dropped one by one. Column 5, the preferred specification, provides a relatively good fit with an adjusted R-squared of 0.76. The results illustrate the current short-termism of markets:
- Fiscal variables are important, with markets focusing primarily on short-term developments (the projected primary deficit and debt in 2011). The primary balance is only significant for euro area countries. The coefficients on deficits and debt are broadly in line with what has been found by previous econometric work, though at the lower end of the range.22 For a country with CDS spreads of 200 basis points, a 1 percentage point increase in the debt ratio raises the spread by about 3 basis points and a 1 percentage point increase in the deficit raises the spread by 35 basis points. Given the log-linear specification, the larger the initial level of the CDS spread, the larger the impact on spreads, in basis points, of an increase in deficit and debt ratios; consistently, a weakening of fiscal variables has a more negative impact in countries with higher initial deficit and debt ratios.
- Long-term fiscal variables are not found to be significant. The coefficients on future debt and deficits and on public pension and health spending were not found to be significant. This suggests that reforms to entitlement spending or measures that would only have a long term impact would not necessarily be rewarded by markets in the short run. This result underscores the difficulty of providing credible information to markets in this area and the need for more effective communication of the effect of such reforms on the soundness of public finances.
- Short-term growth is important (higher growth leading to lower spreads), while potential growth and future growth are not significant. This relationship is found to be nonlinear—with a positive coefficient on the squared growth term—as spreads are more likely to increase when growth is already low and fiscal tightening is larger.23 Based on these results, if the fiscal multiplier is sufficiently large (higher than 0.7 based on the estimated coefficients), the improvement in spreads from a lower deficit could be offset by the negative impact of adjustment on short-term growth, which also acts through the short-term rise in the debt to GDP ratio (see Figure 5 in the main text).
- Central bank financing (either from national central banks or from foreign central banks) is important in lowering spreads, as long as it is not inflationary. This coefficient is higher than the one on the debt ratio, implying that the effect of purchases by national central banks (and by foreign central banks for reserve currencies) goes beyond the effect of reducing the overall supply of government bonds sold to the public. This probably reflects confidence effects provided by the presence of the central bank in the market. Note, however, that the central bank holdings variable does not include purchases by the ECB through the Securities Market Program.24 The coefficient for inflation is highly significant, and thus implies that central bank purchases are effective in moderating spreads only if they are not inflationary. Given the large accumulation of excess reserves by banks, inflation pressures currently remain at bay in most countries. The respite in sovereign bond markets, following the long-term refinancing operations (LTRO) of the European Central Bank (ECB) are a further example of the confidence effects of central bank intervention. These results suggest that the availability of financing from an entity with sufficiently large resources could help reduce spreads in the current environment.
Conclusions
The cross-section estimates point to the current short-term vision of markets, with special concern for near-term growth prospects. This could possibly reflect strong risk aversion after four years of market turmoil. These results imply that tighter fiscal policy could actually lead to wider, rather than narrower, spreads in the short term. It is important to note, however, that the euro area crisis is still not fully resolved and financial markets remain unsettled, therefore these results may reflect the particular state of markets in 2011 rather than more permanent features, something that a cross section cannot shed light on. Moreover, it would be important to assess the direct effect on spreads of other variables beyond fiscal fundamentals, such as exposure to contingent liabilities from the banking sector. Potential simultaneity issues (e.g., between spreads and growth) also deserve additional attention.
Optimal Liquidity and Economic Stability. By Linghui Han & Il Houng Lee
Optimal Liquidity and Economic Stability. By Linghui Han & Il Houng Lee
IMF Working Paper No. 12/135
May 2012
Summary: Monetary aggregates are now much less used as policy instruments as identifying the right measure has become difficult and interest rate transmission has worked well in an increasingly complex financial system. In this process, little attention was paid to the potential spillover of excess liquidity. This paper suggests a notional level of "optimal" liquidity beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a gap between the face value and the real purchasing value of financial assets and widen the wedge in income between those with capital stock and those living on salaries. Such divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector.
Order a print copy: http://www.imfbookstore.org/IMFORG/WPIEA2012135
Excerpts
Introduction
The definition of money has evolved but is still anchored on the notion that money provides ready access to current and future goods and services, i.e., cash value. Liquidity is often defined as assets that can be easily converted into cash, and now includes most financial assets as financial innovations and financial deepening have enabled them to be readily converted into money. In this regard, the definition of money can be broadened to equal liquidity.
The traditional conceptual framework of money and price dynamics, however, has not kept up with the expanding concept of money. The formalization of the conceptual framework of the role of money M probably started with the infamous Fisher’s “equation of exchange” MV = PT, where M is money, V is velocity, P the price level and T the level of transactions. Since it assumes that V and T are fixed and M is exogenous, an increase in M will lead to an exact proportional increase in the price level. The Cambridge school highlights money’s role as a store-of-wealth (including for precautionary motive) and defines M/P = kY where k is the Cambridge constant capturing the opportunity cost of money (interest). Thus, k is not institutionally fixed but changing. This is equivalent to Fisher's equation if one recognizes that real income (Y) and transactions (T) are identical and k=1/V.
Keynes further enriched the Cambridge equation by providing three motives for money, i.e., transaction, precautionary, and speculative. Money demand is affected by income and interest rates, so that Md = L(r, Y) where r is the average of rate of return on illiquid assets. The basic propositions are L’(r) < 0 due to the opportunity cost, and L’(Y) > 0. These motives provide the basis for holding a larger amount of money within the economy. In Milton Friedman’s general form of money demand Md introduces the generalized portfolio constraint (Md - Ms) + (Bd - Bs) + (Yd - Ys) = 0 which connects the goods market with the money and bond markets. A monetary expansion (Ms) can be offset by an excess demand for goods. Then output Ys will rise and money demand Md will rise so that the goods market and money market are brought back into equilibrium.
Increasingly less attention is paid to the interconnectedness between money and the real sector, and thus on a mechanism for correction if money exceeds a notional optimal level. In large part, this is because the relationship between money in the classical sense and the real economy has weakened with the expansion of financial market instruments. Money M as used in Fisher’s equation is now only a fraction of instruments of transaction and as a store of value. Similarly, Friedman’s generalized portfolio constraint no longer captures the complexity of the current financial system. Indeed, M (narrowly defined money) is only relevant in influencing short term liquidity condition, and hence the short term interest rate.
Accordingly, in several countries monetary aggregates are now playing a relatively minor role in monetary policy formulations. The former Federal Reserve Governor L. Mayer noted that “money plays no role in today’s consensus macro model.” Consistent with this view, the Federal Open Market Committee does not specify a monetary aggregate as a target. Indeed, Bernanke (2006) stated that targeting monetary aggregates have not been effective in “constraining policy or in reducing inflation.” He attributes this to the recurrent instability in the relationship between money demand framework associated with deregulation and financial innovation. While the Federal Reserve continues to monitor and analyze monetary developments, he argued against heavy reliance on monetary aggregate in policy formulation.
These views are supported by Woodford (2007), who reviewed inflation models with no roles for money and suggested that these models are not inconsistent with elementary economic principles. Using a basic new Keynesian model, he showed (implicitly) that central banks’ inflation target credibility and their reaction function (policy rate) are adequate in setting a path for the price level without explicitly modeling a role for money.
In Europe, on the other hand, monetary aggregates are not fully dismissed in policy formulation. As noted by Kahn and Benolkin (2007), the European Central Bank continues to regard money as one of the factors determining inflation outlook over the medium term. Even then, its focus is more on identifying an appropriate money demand framework and less on redefining money that better captures the growing complexity of the financial market.
These said, studies on the role of monetary aggregates have evolved but with focus on their relations with asset prices, especially in light of the disruptive boom and bust cycles of the latter on growth. Borio and Lowe (2002) identified gaps in credit, asset price, and investment, respectively, as periods when the actual deviates from the trend by a sizable amount. They found that the credit gap is the best indicator of an impending financial crisis. The importance of credit to equity and property boom/bust episodes is supported also by Helbling and Terrones (2003) where they found the monetary aggregate to be more relevant for equity, rather than, for housing prices.
Gerdesmeier and others (2009) found asset price booms to follow rapid growth in monetary aggregates (money and credit) and eventually lead to asset price busts. They do so by constructing an asset price indicator composed of stock price and house price markets, similar to the work by Borio and others (1994) where the index was compiled using residential property, commercial property and share prices. Gerdesmeier found that changes in their composite index were consistent with the rapid increase in credit growth that followed the relaxation of constraints in the wake of financial liberalization during the 1980s.
Against these developments, this paper suggests an expanded definition of money, i.e., liquidity, which includes all financial assets held by the nonfinancial private sector. Then a notional level of “optimal” liquidity is proposed beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a “Gap” between the face value and the real purchasing value of financial assets. Such a divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector. This work provides value added by identifying a monetary aggregate the optimal value of which can be targeted at a level consistent with real sector fundamentals. These in turn are defined as the economy’s capacity to produce goods and services. When the Gap widens, it will not only lead to a boom/bust cycle, but also worsen income disparity between those holding capital stock and those who rely on income flows.
Summary and conclusion
Although money in the narrow sense matters less in an increasingly complex financial system, the quantity of a broader measure of monetary aggregate is still very relevant to the real economy. We find that the liquidity defined as the total financial assets held by the nonfinancial sector is an important determent of the value of the physical capital. This is because those who issue a financial asset must have corresponding earnings, including valuation gains, on the liability side that match the value of the issuance. The value of the earnings of a physical asset in turn is the real net present value of return of the capital stock, which depreciates over time, multiplied by the price of the capital stock.
The optimal amount of liquidity is attained at the level where it equals the real earnings times the GDP deflator. This is because the nominal earnings (income flows) of capital by default are measured as a scale to nominal GDP (i.e., relevant because of purchasing power). A Gap is created if the amount of liquidity exceeds this optimal level, which will be reflected through a fall in the GDP deflator/price of capital ratio. In other words, if the Gap arises due to a rapid expansion in liquidity, this will push up the price level of the capital stock at a much faster pace than the GDP deflator. As a result, this gap will (i) lead to a boom and bust cycle if left unchecked, which is disruptive to the economy, and (ii) worsen income inequality by rewarding those with capital stock more than those who depend on flow of income.
While it is true that interest rate transmission mechanism has become an effective monetary policy instrument aimed at controlling inflation, monetary aggregate is also still relevant to providing economic stability. By broadening the definition of money to include all financial assets held by the nonfinancial private sector, and then targeting the total to a level that is consistent with the optimal level liquidity as discussed in this paper, economic and price stability can be achieved. To achieve this desired outcome, monetary policy will have to use a combination of interest rate and monetary aggregate as the intermediate target.
IMF Working Paper No. 12/135
May 2012
Summary: Monetary aggregates are now much less used as policy instruments as identifying the right measure has become difficult and interest rate transmission has worked well in an increasingly complex financial system. In this process, little attention was paid to the potential spillover of excess liquidity. This paper suggests a notional level of "optimal" liquidity beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a gap between the face value and the real purchasing value of financial assets and widen the wedge in income between those with capital stock and those living on salaries. Such divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector.
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Excerpts
Introduction
The definition of money has evolved but is still anchored on the notion that money provides ready access to current and future goods and services, i.e., cash value. Liquidity is often defined as assets that can be easily converted into cash, and now includes most financial assets as financial innovations and financial deepening have enabled them to be readily converted into money. In this regard, the definition of money can be broadened to equal liquidity.
The traditional conceptual framework of money and price dynamics, however, has not kept up with the expanding concept of money. The formalization of the conceptual framework of the role of money M probably started with the infamous Fisher’s “equation of exchange” MV = PT, where M is money, V is velocity, P the price level and T the level of transactions. Since it assumes that V and T are fixed and M is exogenous, an increase in M will lead to an exact proportional increase in the price level. The Cambridge school highlights money’s role as a store-of-wealth (including for precautionary motive) and defines M/P = kY where k is the Cambridge constant capturing the opportunity cost of money (interest). Thus, k is not institutionally fixed but changing. This is equivalent to Fisher's equation if one recognizes that real income (Y) and transactions (T) are identical and k=1/V.
Keynes further enriched the Cambridge equation by providing three motives for money, i.e., transaction, precautionary, and speculative. Money demand is affected by income and interest rates, so that Md = L(r, Y) where r is the average of rate of return on illiquid assets. The basic propositions are L’(r) < 0 due to the opportunity cost, and L’(Y) > 0. These motives provide the basis for holding a larger amount of money within the economy. In Milton Friedman’s general form of money demand Md introduces the generalized portfolio constraint (Md - Ms) + (Bd - Bs) + (Yd - Ys) = 0 which connects the goods market with the money and bond markets. A monetary expansion (Ms) can be offset by an excess demand for goods. Then output Ys will rise and money demand Md will rise so that the goods market and money market are brought back into equilibrium.
Increasingly less attention is paid to the interconnectedness between money and the real sector, and thus on a mechanism for correction if money exceeds a notional optimal level. In large part, this is because the relationship between money in the classical sense and the real economy has weakened with the expansion of financial market instruments. Money M as used in Fisher’s equation is now only a fraction of instruments of transaction and as a store of value. Similarly, Friedman’s generalized portfolio constraint no longer captures the complexity of the current financial system. Indeed, M (narrowly defined money) is only relevant in influencing short term liquidity condition, and hence the short term interest rate.
Accordingly, in several countries monetary aggregates are now playing a relatively minor role in monetary policy formulations. The former Federal Reserve Governor L. Mayer noted that “money plays no role in today’s consensus macro model.” Consistent with this view, the Federal Open Market Committee does not specify a monetary aggregate as a target. Indeed, Bernanke (2006) stated that targeting monetary aggregates have not been effective in “constraining policy or in reducing inflation.” He attributes this to the recurrent instability in the relationship between money demand framework associated with deregulation and financial innovation. While the Federal Reserve continues to monitor and analyze monetary developments, he argued against heavy reliance on monetary aggregate in policy formulation.
These views are supported by Woodford (2007), who reviewed inflation models with no roles for money and suggested that these models are not inconsistent with elementary economic principles. Using a basic new Keynesian model, he showed (implicitly) that central banks’ inflation target credibility and their reaction function (policy rate) are adequate in setting a path for the price level without explicitly modeling a role for money.
In Europe, on the other hand, monetary aggregates are not fully dismissed in policy formulation. As noted by Kahn and Benolkin (2007), the European Central Bank continues to regard money as one of the factors determining inflation outlook over the medium term. Even then, its focus is more on identifying an appropriate money demand framework and less on redefining money that better captures the growing complexity of the financial market.
These said, studies on the role of monetary aggregates have evolved but with focus on their relations with asset prices, especially in light of the disruptive boom and bust cycles of the latter on growth. Borio and Lowe (2002) identified gaps in credit, asset price, and investment, respectively, as periods when the actual deviates from the trend by a sizable amount. They found that the credit gap is the best indicator of an impending financial crisis. The importance of credit to equity and property boom/bust episodes is supported also by Helbling and Terrones (2003) where they found the monetary aggregate to be more relevant for equity, rather than, for housing prices.
Gerdesmeier and others (2009) found asset price booms to follow rapid growth in monetary aggregates (money and credit) and eventually lead to asset price busts. They do so by constructing an asset price indicator composed of stock price and house price markets, similar to the work by Borio and others (1994) where the index was compiled using residential property, commercial property and share prices. Gerdesmeier found that changes in their composite index were consistent with the rapid increase in credit growth that followed the relaxation of constraints in the wake of financial liberalization during the 1980s.
Against these developments, this paper suggests an expanded definition of money, i.e., liquidity, which includes all financial assets held by the nonfinancial private sector. Then a notional level of “optimal” liquidity is proposed beyond which asset prices will start to rise faster than the GDP deflator, thereby creating a “Gap” between the face value and the real purchasing value of financial assets. Such a divergence will eventually lead to an abrupt and disorderly adjustment of the asset value, with repercussions on the real sector. This work provides value added by identifying a monetary aggregate the optimal value of which can be targeted at a level consistent with real sector fundamentals. These in turn are defined as the economy’s capacity to produce goods and services. When the Gap widens, it will not only lead to a boom/bust cycle, but also worsen income disparity between those holding capital stock and those who rely on income flows.
Summary and conclusion
Although money in the narrow sense matters less in an increasingly complex financial system, the quantity of a broader measure of monetary aggregate is still very relevant to the real economy. We find that the liquidity defined as the total financial assets held by the nonfinancial sector is an important determent of the value of the physical capital. This is because those who issue a financial asset must have corresponding earnings, including valuation gains, on the liability side that match the value of the issuance. The value of the earnings of a physical asset in turn is the real net present value of return of the capital stock, which depreciates over time, multiplied by the price of the capital stock.
The optimal amount of liquidity is attained at the level where it equals the real earnings times the GDP deflator. This is because the nominal earnings (income flows) of capital by default are measured as a scale to nominal GDP (i.e., relevant because of purchasing power). A Gap is created if the amount of liquidity exceeds this optimal level, which will be reflected through a fall in the GDP deflator/price of capital ratio. In other words, if the Gap arises due to a rapid expansion in liquidity, this will push up the price level of the capital stock at a much faster pace than the GDP deflator. As a result, this gap will (i) lead to a boom and bust cycle if left unchecked, which is disruptive to the economy, and (ii) worsen income inequality by rewarding those with capital stock more than those who depend on flow of income.
While it is true that interest rate transmission mechanism has become an effective monetary policy instrument aimed at controlling inflation, monetary aggregate is also still relevant to providing economic stability. By broadening the definition of money to include all financial assets held by the nonfinancial private sector, and then targeting the total to a level that is consistent with the optimal level liquidity as discussed in this paper, economic and price stability can be achieved. To achieve this desired outcome, monetary policy will have to use a combination of interest rate and monetary aggregate as the intermediate target.
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