Oct 19, 2010 - Easy to model the cost of macroprudential regulation, very di cult to quantify the bene ts (externalities. . . ) â Intrinsically non-linear (think of tail ...
Monetary Policy and Financial Stability in Emerging Market Economies An Operational Framework Jaromir Benes Michael Kumhof David Vavra 19 October 2010
Why yet another paper/model on FS and macroprudence?
1
Scope of the project • Upgrade the existing FPASs: Operationalise a simple model to provide common language to the two species (MP, FS)
• Two basic types of vulnerabilities to nancial system − Inadequate capital / credit risk / excessive leverage
√
− Inadequate liquidity / rollover risk / maturity mismatch × • Two basic dimensions along which stress scenarios may develop/be magni ed
− Time dimension
√
− Cross-sectional dimension
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• Macroprudential policy in terms of its proximate objective − Resilience of domestic n sector as a whole (Tucker, 2009) − Prevent widespread disruptions to n ows (Milne, 2009) • Examine monetary and macroprudential transmission mechanisms
Not in the scope of the project • Ultimate welfare implications because they are extremely di cult to evaluate
− Easy to model the cost of macroprudential regulation, very di cult to quantify the bene ts (externalities. . . )
− Intrinsically non-linear (think of tail risk scenarios) linearquadratic control and/or local approximation methods will miss the essence
• A large amount of judgment will need to be involved
3
Financial structure of the model
Key characteristics of feedback loop between real and n sectors • Commercial bank lending rather than investment banking • Endogenous defaults exist in equilibrium credit risk • Banks bear non-diversi able (aggregate) risk non-contingent contracts
• Banks have their own net worth (capital) • Capital regulation as an incentive-based mechanism, not hardwired regulatory capital buers
• Imperfections in bank capital market 4
Households and banks • Households borrow to nance both consumption and capital − Simplicity: only one non- n agent with net worth − Closing SOEs: leverage aects consumer rates • Limited enforcement of debt contracts − Households may run away not repaying their obligations − Bank then only seizes assets (physical capital) that collateralise the loan less liquidation cost
• Banks make two decisions − Terms of non-contingent debt (loan) contract (retail lending branch)
− Liability structure: equity (capital) vs debt nance (wholesale branch)
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#1 Heterogeneity • The representative household consists of a continuum of members
• Each member chooses physical capital and loan (collateralised by the capital); her return on capital is idiosyncratic, j RK,t ωt
• The household as a whole chooses the rest (consumption, labour, etc)
• This is a simple way to introduce full risk sharing and keep heterogenous individuals identical ex-ante
6
#2 Contract between household member and bank • Member j will choose to default on the loan whenever j
j
j
j
RL,t−1Lt−1 > RK,tωt PK,t−1Kt−1 |
{z
}
loan repayment
| j
{z
value of collateral
j
}
j
• Optimal contract speci es Lt , Kt , and RL,t to maximise i h j j j j Λt Lt − PK,tKt + β Et Λt+1 −RL,tLt gt+1 | {z } h
j +RK,t+1PK,tKt
i
expected true cost
s.t. the bank's participation (rationality) constraint h i j Et RL,t ht+1 ≡ Et[Rt+1] = given by the wholesale branch | {z }
expected return on loan
• Lending spread arising because of credit risk, RL,t − Et[Rt+1], increasing in the loan-to-value ratio, Lt /(PK,tKt ) 7
#3 Bank capital choice • Bank nances loans by equity capital and debt (deposits, cross-border funds, borrowing from CB, etc), Lt = Et + Ft • Ex-post capital regulation applies (Milne, 2002) Rt+1Lt − RF,tFt < γRt+1Lt ⇒ penalty υLt Return on loans,
Rt+1, uncertain but with known distribution
• Bank maximises pay-os on equity "
Et R 1
E,t+1
Rt+1Lt − RF,tFt − υLt
Z R ˜ 0
#
f (r)dr
• Lending spread arising because of regulation, Et[Rt+1] − RF,t, increases as the ex-ante capital-to-loans ratio decreases (as though there were convex costs)
8
Retail and wholesale branches combined
RL,t = RF,t + risk spread + regulatory spread Each of the spreads entails a considerable non-linearity
9
#4 Distribution of return on loans • Distribution of the recovery rate (return) on loans, Rt+1 = RL,tht+1 (facing the wholesale branch) can be derived from the aggregate return on physical capital, RK,t+1 • Given RL,t, there is a one-to-one mapping between every E possible future RK,t+1 ∈ (0, ∞) and Rt+1 ∈ 0, RL,t Rt+1 = ρ(RK,t+1) • Knowing the p.d.f. for RK,t+1, say f , we can write the p.d.f. for Rt+1 , say φ, as φ = f · (ρ−1)0 = f · (ρ0)−1
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PDF of return on capital
PDF of return on loans
quarterly gross rate
quarterly gross rate
3
100
Steady−state 2.5 return on capital →
Steady−state lending rate →
80
2 60 1.5 40 1 20
0.5 0 0.5
1
1.5
0 0.9
0.92
0.94
0.96
0.98
1
11
1.02
Spread btw expected return on loans and refinance rate pp annualised 60 ς = 0.35 ς = 0.25
50
Spread
40 30 20 10 0
7
8 9 10 11 Ex−ante capital−to−loans ratio
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#5 Bank capital market imperfections • Bank capital obtained from households • Costs of injecting or withdrawing capital relative to last period including return h ξ 2 log Et
i2
− log(ιRE,tEt−1)
• Households want to inject fresh capital only if expected return exceeds normal levels
• With ξ → ∞, the law of motion for Et becomes Et = ιRE,tEt−1 which is assumed in many papers that deal with net worth of various agents
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Rest of the Model
Generic SOEMOLI∗ model • Small open economy, one production function • Monopoly power locally, price taker in world markets (ToT exogenous)
• Real and nominal rigidities (cons habit, invest adj costs, sticky prices, sticky wages, adj costs of changing input factors, export adj costs)
∗ SOEMOLI is a class of models developed in the IMF's Economic Modelling Unit to address issues in countries
Small Open Emerging-Market Or Low Income 13
Speci c assumptions • Assume away local deposits, banks only re nance loans by cross-border borrowing
• Banks owned by foreigners only • Dollarised liabilities of households • In ation targeting, exible exchange rate
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Simulation experiments with xed capital requirements
100bp country spread shock Value added (GDP)
Consumption
Exports
Investment
% level deviations from control 0
% level deviations from control 0
% level deviations from control
% level deviations from control 0
−0.05
0.2
−0.1
−0.5
0.15
−0.1
−1
−0.2 0.1
−0.15 Banks No banks
−0.2 0
10
−1.5
−0.3
0.05 −2
−0.4 20
0
10
20
0
0
10
20
0
10
20
Inflation, Q/Q PA
Nominal exchange rate
Local−currency refinance rate
Total lending spread
pp deviations from control
% level deviations from control
pp deviations from control
pp deviations from control
2
1
0.2
0.1
0.8
1.5 0 1 −0.2 0.5 0
10
20
0.6
−0.1
0.4
0 0
10
20
Credit risk spread
Capital adequacy ratio
pp deviations from control
pp deviations from control
0
0
0.4
0.3
0.05
0.3
0.2
0
0.2
0.1
−0.05
0
−0.1 20
20
−0.2 −0.4 −0.6
0.1 10
10
Price of capital 0.2
0.1
0
0
pp deviations from control
0.4
20
20
0.5
0.15
10
10
Trade balance to GDP
0.5
0
0.2
−0.2
−0.4 0
0
0
−0.8 0
10
20
0
10
20
700bp country spread shock Value added (GDP)
Consumption
Exports
Investment
% level deviations from control 0
% level deviations from control 0
% level deviations from control
% level deviations from control 0
1.5
−0.5
−1
−5
−1
1
−2
−10
−1.5 Banks No banks
−2 0
10
0.5
−3 20
−15 0
10
20
0
0
10
20
0
Inflation, Q/Q PA
Nominal exchange rate
Local−currency refinance rate
pp deviations from control
% level deviations from control
pp deviations from control
2
15
0
20
Total lending spread pp deviations from control 15
1 0
10
10
10
−1
−2 5
−4
−2
5
−3 0
−6
−4 0
10
20
0
Credit risk spread pp deviations from control 8 6
10
20
0 0
10
20
Capital adequacy ratio
Trade balance to GDP
pp deviations from control
pp deviations from control
0
10
20
Price of capital
1
4
0
0
3
−2 −4
4
2
−1 2
−6
1
−8
−2
0 0
10
20
0
10
20
0
−10 0
10
20
0
10
20
700bp country spread shock Value added (GDP)
Consumption
Exports
Investment
% level deviations from control 0
% level deviations from control 0
% level deviations from control
% level deviations from control 0
1.5
−0.5
−1
−5
−1
1
−2
−10
−1.5 Banks No banks
−2 0
10
0.5
−3 20
−15 0
10
20
0
0
10
20
0
Inflation, Q/Q PA
Nominal exchange rate
Local−currency refinance rate
pp deviations from control
% level deviations from control
pp deviations from control
2
15
0
20
Total lending spread pp deviations from control 15
1 0
10
10
10
−1
−2 5
−4
−2
5
−3 0
−6
−4 0
10
20
0
Credit risk spread pp deviations from control 8 6
10
20
0 0
10
20
Capital adequacy ratio
Trade balance to GDP
pp deviations from control
pp deviations from control
0
10
20
Price of capital
1
4
0
0
3
−2 −4
4
2
−1 2
−6
1
−8
−2
0 0
10
20
0
10
20
0
−10 0
10
20
0
10
20
700bp country spread shock Value added (GDP)
Consumption
Exports
Investment
% level deviations from control 0
% level deviations from control 0
% level deviations from control
% level deviations from control 0
1.5
−0.5
−1
−5
−1
1
−2
−10
−1.5 Banks No banks
−2 0
10
0.5
−3 20
−15 0
10
20
0
0
10
20
0
Inflation, Q/Q PA
Nominal exchange rate
Local−currency refinance rate
pp deviations from control
% level deviations from control
pp deviations from control
2
15
0
20
Total lending spread pp deviations from control 15
1 0
10
10
10
−1
−2 5
−4
−2
5
−3 0
−6
−4 0
10
20
0
Credit risk spread pp deviations from control 8 6
10
20
0 0
10
20
Capital adequacy ratio
Trade balance to GDP
pp deviations from control
pp deviations from control
0
10
20
Price of capital
1
4
0
0
3
−2 −4
4
2
−1 2
−6
1
−8
−2
0 0
10
20
0
10
20
0
−10 0
10
20
0
10
20
Return on loans: 1−quarter−ahead distribution 90
Regulatory edge →
Expected return on loans →
80 70 60 50 ← Actual return at t=1 40 30 20 10 0 0.95
0.96
0.97
0.98
0.99
1
1.01
1.02
Return on loans: 1−quarter−ahead distribution 90 80
t=0 t=8
70 60 50 40 30 20 10 0 0.95
0.96
0.97
0.98
0.99
1
1.01
1.02
Macroprud policy more like scal rather than monetary • It has real eects (even in the long run) because it creates a wedge between the retail lending rate and the re nance rate
RL,t = RF,t + risk spread + regulatory spread • Capital requirements are observationally similar to taxes (Pigouvian tax to oset overborrowing)
• Variety of instruments considered analogous to scal policies − automatic stabilisers (e.g. dynamic provisioning) − pro-active rules (e.g. counter-cyclical capital requirements) − discretion • Need for monetary-macroprudential co-ordination (monetary policy stance aected by macroprudential policy, not so much vice versa).
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Designing counter-cyclical macroprud rules • Do we want the rule to react to cycles in real economic activity per se?
No!
(although many authors make this
reduced-form short-cut)
• React to nancial cycles (cycles in bank balance sheet risk), not to cycles in real economic activity (cycles in quantities and prices)
• Tighten capital requirements when systemic risk builds up in bank balance sheets. Let the banks draw the capital cushions down when the risk materialises
• The former occurs usually in good times, the latter in bad times, but it is a reduced-form relationship
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Measuring nancial cycles • Well, that's exactly the problem. Much more di cult than measuring real economic cycles.
• Combination of a number of theoretical and empirical models and judgment needed.
• A good idea to conceptually separate the design of the rule and the measurement problems.
• Rule based on a measure of risk speci c to our model: the lending spread
γt = ¯ γ − ρ (RL,t − RF,t − ∆) cf. discussions by Gordo (2009), Borio (2009)
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Simulation experiments with pro-active macroprudential policy
Asset price bubble and burst Value added (GDP)
Consumption
Exports
Investment
% level deviations from control
% level deviations from control
% level deviations from control
% level deviations from control
0.5
2
0
1
0
−0.5
0
0
−0.5
−1
−5
−1
−1.5
−1 0
10
20
0
10
20
−10 0
10
20
0
10
20
Inflation, Q/Q PA
Nominal exchange rate
Local−currency refinance rate
Total lending spread
pp deviations from control
% level deviations from control
pp deviations from control
pp deviations from control
5 0
6
4
4
2
10
5
0 2
−5
−2 0
−10 0
10
20
0
−4 0
10
20
0
10
20
Credit risk spread
Capital adequacy ratio
Trade balance to GDP
pp deviations from control
pp deviations from control
pp deviations from control
3 0
1
−1
0
−2
−1
10
20
Price of capital 30 Fixed capital requirements Pro−active rule 20
1
2
0
0
10
−1
0
−3
−2 0
10
20
−2 0
10
20
0
10
20
0
10
20
Capital requirements 11 10.5 10 9.5 9 8.5 8 7.5 7 6.5 6 0
5
10
15
20
Concluding remarks • Top-down multi-layer systems • Parameterisation (calibration, estimation), dealing with nonlinearities and scarce data on large systemic risk events
• Co-ordination issues − Local monetary and macroprud policies − Macroprud policies internationally
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