Bubbles, Crashes & the Financial Cycle Sander van der Hoog and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld University SCE@20 in Oslo, June 2014 www.uni-bielefeld.de
Introduction Outline Eurace@Unibi Model The Business & Financial Cycle Simulation Results Financial Instability Hypothesis Summary & Outlook Balance sheets Outline of topics ◮ Agent-based Macroeconomics ◮ Leverage cycle – Geanakoplos ◮ Financial Instability Hypothesis – Minsky ◮ Basel III and the procyclicality of capital adequacy requirements ◮ Macro-prudential banking regulation Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Outline Eurace@Unibi Model The Business & Financial Cycle Simulation Results Financial Instability Hypothesis Summary & Outlook Balance sheets The Business & Financial Cycle 1976-80 1980 1989: 2011: US real-estate boom DIMCA S&L Crisis End of Regulation Q 1980: Depository Institutions Deregulation and Monetary Control Act: Deregulation of Savings and Loans institutions 2011: Regulation Q: prohibition of interest-bearing demand deposit accounts Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Outline Eurace@Unibi Model The Business & Financial Cycle Simulation Results Financial Instability Hypothesis Summary & Outlook Balance sheets Financial Instability Hypothesis ◮ Equity/Asset-ratio: Measure for financial robustness ◮ Fragility synchronized with business cycle? (Fragile booms, deleveraging recovery) Output and E/A ratio Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Outline Eurace@Unibi Model The Business & Financial Cycle Simulation Results Financial Instability Hypothesis Summary & Outlook Balance sheets Empirical Motivations Features of macroeconomics with a financial cycle (Borio, 2012): ◮ the financial boom should not just precede the bust but cause it (` a la Minsky). ◮ the presence of debt and capital stock overhangs (excess stocks, non-full utilization rates). Findings: ◮ Recessions following a crisis after a fragile boom tend to have much larger declines in consumption, investment, output, and employment. (Shularick & Taylor, 2012) ◮ Balance sheet recessions: Recessions driven by deleveraging lead to a prolonged slump. (Koo, 2011) Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Outline Eurace@Unibi Model The Business & Financial Cycle Simulation Results Financial Instability Hypothesis Summary & Outlook Balance sheets Balance sheets Firm Bank Assets Liabilities Assets Liabilities Liquidity CB reserves ( − 0 . 1 % ) Deposits + revenues – interest deposits +/– withdrawals – wage bill + interest on loans + new loans – taxes – taxes – dividends – dividends + interest deposits +/– CB reserves – interest on loans Loans from banks + new loans + new loans Loans to firms CB debt ( + 0 . 15 % ) – bad debt + new loans +/– CB reserves Inventory – bad debt +/– interest + output – sales Capital stock Equity Equity + investment + profits + profits + bad debt – bad debt Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Agent Role Activity Activity Role Agent Household ConsGoodFirm Labor Market labor supply labor demand Employer Employee (search & wage schedule reservation wage matching) o n s . C G o o d s cgood demand cgood supply P r o d u c e r Consumer M a r k e t consumption posted prices ( l o c a l m a l l s ) choice Financial asset demand o r I n v e s t Market savings decision (index bond) o d F i r m I n v G o C a p i t a l igood supply i g o o d d e m a n d o d s G o I n v e s t o r Producer v i n t a g e c h o i c e s vintage menu M a r k e t posted prices a n k B C r e d i t credit supply credit demand M a r k e t Creditor D e b t o r ( c r e d i t rank credit risk rank interest r a t i o n i n g ) G o v C B E Monetary Policy policy maker E u r a c e @ U n i b i
Introduction Monetary Policy & Banking Regulation Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Requirement Summary & Outlook Literature: The Credit Channel of Monetary Policy Transmission 1. The broad borrowers’ balance sheet channel: (Bernanke & Blinder 1988) ◮ Credit demand side ◮ Focusses on external finance premium: probability of default External finance premium: inversely related to borrower’s net worth. ◮ Changes in the value of assets on the balance sheet of a firm affect the firm’s ability to borrow . 2. The narrow bank lending channel: (Bernanke & Gertler 1995) ◮ Supply of bank loans determined by financial health of banks. ◮ Changes in the value of assets on the balance sheet of a bank affects the bank’s ability to lend . Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Monetary Policy & Banking Regulation Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Requirement Summary & Outlook Capital Adequacy Requirement 1. Firm’s default probability t = max { 0 . 03 , 1 − e − ν D f t / E f PD f t } , ν = 0 . 1 2. Interest rate offered by bank b to firm i 1 + λ B · PD f = r ECB � � r bf t + ǫ b , ǫ b t ∼ U [ 0 , 1 ] t t r ECB = 0 . 01 λ B = 3: penalty rate for high-risk firm, uniform across banks ǫ b t : bank’s ideosyncratic operating costs Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Monetary Policy & Banking Regulation Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Requirement Summary & Outlook Capital Adequacy Requirement 1. Risk-exposure of credit request (Expected Loss at Default): x f t = PD f t · L f (1) t 2. Constraint: Capital Adequacy Requirement (CAR) � x f t ≡ X b t ≤ α E b t , α ≥ 0 (2) f 3. Risk-exposure ”budget” of the bank: V b t ≡ α E b t − X b (3) t 4. Loan granted: L f if x f t ≤ V b No rationing t t ℓ f θ · L f t = V b t / PD f if 0 ≤ V b t ≤ x f t = (4) Partial rationing t t if V b 0 t ≤ 0 Full rationing Possibility of credit rationing : { θ : V b t − PD f t · ℓ f t = 0 } → θ L f t = V b t / PD f t Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Monetary Policy & Banking Regulation Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Requirement Summary & Outlook Reserve Requirement ◮ Constraint: Reserve Requirement M b t ≥ β · Dep b (5) t ◮ Excess liquidity ”budget” of the bank: W b t ≡ M b t − β · Dep b (6) t ◮ Loan granted: L f if W b t ≥ L f No rationing t t ℓ bf φ · L f t = W b if 0 ≤ W b t ≤ L f = Partial rationing (7) t t t if W b 0 t < 0 Full rationing Possibility of credit rationing : { φ : W b t − φ · L f t = 0 } → φ = W b t / L f t ◮ Illiquid banks stop lending to all firms (bank lending channel) ◮ Risky firms cannot get loans (borrower’s balance sheet channel) Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Introduction Amplitude of recessions Eurace@Unibi Model Firm activity Simulation Results Bank activity Summary & Outlook Parameter sensitivity analysis alfa_20_gamma beta_20_gamma_10_alfa 1.0 2.0 4.0 8.0 16.0 32.0 0.01 0.02 0.05 0.10 0.20 0.50 5000 5000 4000 4000 Eurostat_output Eurostat_output 3000 3000 2000 2000 0 200 400 600 800 1000 0 200 400 600 800 1000 Months Months α -sensitivity: Cap. Adq. Req. β -sensitivity: Reserve Req. ◮ Default: α = 32 (3 % ) ◮ Default: β = 0 . 05 (5 % ) ◮ Lower: amplitude of recessions ◮ Higher: amplitude of recessions increases decreases Sander van der Hoog Bubbles, Crashes & the Financial Cycle
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