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Bubbles, Crashes & the Financial Cycle: The Limits to Credit - - PowerPoint PPT Presentation

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Bubbles, Crashes & the Financial Cycle: The Limits to Credit Growth Sander van der Hoog and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Bubbles, Crashes & the Financial Cycle: The Limits to Credit Growth

Sander van der Hoog and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld University WEHIA Sophia Antipolis, 21-23 May 2015

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

The Big Questions

◮ Which micro- or macro-prudential banking regulations are

beneficial to financial stability?

◮ Prevention and mitigation policies: ◮ How to prevent severe downturns from occurring? ◮ How to mitigate the cumulative economic losses?

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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Activity Role Agent Agent Role Activity

E u r a c e @ U n i b i

B a n k I n v G

  • d

F i r m Household

asset demand savings decision Financial Market

(index bond)

E C B

Monetary policy

G

  • v

Policy maker I n v e s t

  • r

ConsGoodFirm

Consumer C

  • n

s . G

  • d

s M a r k e t

(local malls)

cgood demand consumption choice P r

  • d

u c e r cgood supply posted prices labor supply reservation wage Employee labor demand wage schedule Labor Market

(search & matching)

Creditor D e b t

  • r

credit supply rank credit risk credit demand rank interest C r e d i t M a r k e t

(credit rationing)

Employer I n v e s t

  • r

Producer C a p i t a l G

  • d

s M a r k e t igood supply vintage menu posted prices i g

  • d

d e m a n d v i n t a g e c h

  • i

c e s

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement

Mechanisms in the model

  • 1. Probability of Default (PD): Internal Risk-Based approach (IRB)
  • 2. Interest rate rule for commercial banks
  • 3. Debt-equity transformation: Insolvency / Illiquidity
  • 4. Dividend payout rule
  • 5. Credit rationing rule
  • 6. Capital Adequacy Requirement (CAR)
  • 7. Central Bank Reserve Ratio Requirement (RRR)
  • 8. Future research: Capital Conservation Buffers & Counter-Cyclical Capital Buffers:

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement

Probability of Default, Interest rate rule

  • 1. Firm’s default probability

PDf

t = max{0.0003,1−e−νDf

t /Ef t }, ν = 0.1

  • 2. Interest rate offered by bank b to firm i

r bf

t

= rECB 1+λ B ·PDf

t +εb t

  • , εb

t ∼ U[0,1]

r ECB = 0.01 λ B = 3: penalty rate for high-risk firm, uniform across banks εb

t : bank’s ideosyncratic operating costs

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement

Capital Adequacy Requirement

  • 1. Risk-exposure of credit request (Expected Loss at Default):

rwab

it = PDit ·Lit.

and RWAb

t = F

∑

i=1 K(i)

∑

k=0

PDkt ·Lkt, (1)

  • 2. Constraint 6: Capital Adequacy Requirement (CAR)

RWAb

t ≤ α ·Eb t ,

α ≥ 0 (2)

  • 3. Risk-exposure "budget" of the bank:

V b

t := α ·Eb t −RWAb t

(3)

  • 4. Risk-constrained loan demand:

¯ ℓb

it =

   Lit if PDit ·Lit ≤ V b

t

if 0 ≤ V b

t ≤ PDit ·Lit

if V b

t < 0.

(4)

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement

Reserve Ratio Requirement

◮ Constraint 7: Reserve Ratio Requirement (RRR)

Mb

t ≥ β ·Depb t ,

β ∈ [0,1] (5)

◮ Excess liquidity "budget" of the bank:

W b

t := Mb t −β ·Depb t

(6)

◮ Loan granted: risk- and liquidity constrained credit request

ℓb

i,t =

     ¯ ℓb

i,t

if W b

t ≥ ¯

ℓb

i,t

φ · ¯ ℓb

i,t

if 0 ≤ W b

t ≤ ¯

ℓb

i,t

if W b

t < 0.

(7) Possibility of credit rationing: {φ : W b

t −φ · ¯

ℓb

i,t = 0} → φ = W b t /¯

ℓb

i,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

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth

Parameter sensitivity analysis

200 400 600 800 1000 2000 3000 4000 5000 Months Eurostat_output alfa_20_gamma 1.0 2.0 4.0 8.0 16.0 32.0

α-sensitivity: Cap. Adq. Req.

◮ Default: α = 32 (3%) ◮ Lower: amplitude of recessions

increases

200 400 600 800 1000 2000 3000 4000 5000 Months Eurostat_output beta_20_gamma_10_alfa 0.01 0.02 0.05 0.10 0.20 0.50

β-sensitivity: Reserve Req.

◮ Default: β = 0.05 (5%) ◮ Higher: amplitude of recessions

decreases

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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SLIDE 10

20 40 60 80 100 120 6000 6500 7000 7500 8000 8500 9000

Recessions and expansions

Quarters Output

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth

Parameter sensitivity analysis

α-sensitivity: Cap. Adq. Req.

◮ Basel III: 4.5−10.5%

α = 22.2−9.5

◮ Lower: amplitude of recessions

increases

−8000 −6000 −4000 −2000 Parameter 1 full_amplitude_recession 0.00 0.01 0.02 0.05 0.10 0.20 0.50 0.90 0.99 1.00 −8000 −6000 −4000 −2000

β-sensitivity: Reserve Req.

◮ EU: β = 0.01, US: β = 0.10, CA:

β = 0

◮ Higher: amplitude of recessions

decreases

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth

Parameter sensitivity analysis 2D-grid

alpha beta −1200 −1100 −1000 −900 −800 −700 4.0 6.0 8.0 10.0 12.0 16.0 20.0 24.0 28.0 32.0 0.00 0.02 0.10 0.25 0.35 0.45 0.90 1.00 Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth

Prevention and mitigation policies: The Limits to Credit Growth

Proposed regulations to limit excesses in banking (eg. Admati & Hellwig, 2013):

  • A. Default regulation: Capital ratio 12.5%, Reserve ratio 10%.
  • B. Banning bank dividend payouts → Increases bank equity capital
  • C. Using non-risk-weighted capital ratios → Prevents abuse of risk-weights

("risk-weight management optimization")

  • D. Cutting-off funding to all financially unsound firms → Prevents leverage
  • E. Cutting-off funding to Ponzi firms only → Prevents further leverage
  • F. Combined effect of BCD → Does it help to prevent bubbles?
  • G. Combined effect of BCE → Does it help to prevent bubbles?

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth

Prevention and mitigation policies: The Limits to Credit Growth

Comparison across regulations A - G

−3000 −2500 −2000 −1500 −1000 −500 Parameters full_amplitude_recession A B C D E F G −3000 −2500 −2000 −1500 −1000 −500

amplitude of recessions (output lost)

−10000 −8000 −6000 −4000 −2000 Parameters full_cumm_loss_recession A B C D E F G −10000 −8000 −6000 −4000 −2000

cumulative loss of output (amplitude & duration)

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Main Conclusions

◮ To prevent large cumulative losses that follow from recessions,

it is required to cut-off funding to all financially unsound firms (speculative and Ponzi firms).

◮ Mere capital ratios, and increasing them incrementally, do not

help to prevent credit bubbles.

◮ Imposing strict limits to growth on the excessive supply of

credit seems to work best to mitigate the severity of economic downturns.

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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Thank you for your attention! Model documentation:

www.wiwi.uni-bielefeld.de/lehrbereiche/vwl/etace/Eurace_Unibi/

Papers:

◮ S van der Hoog & H Dawid (2015):

Bubbles, Crashes and the Financial Cycle, Working Paper Bielefeld University.

◮ H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2014):

Agent-Based Macroeconomic Modeling and Policy Analysis: The Eurace@Unibi

  • Model. In: S-H Chen, M Kaboudan (Eds), Handbook on Computational

Economics and Finance. Oxford University Press.

◮ H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2012):

The Eurace@Unibi Model: An Agent-Based Macroeconomic Model for Economic Policy Analysis. Working Paper University Bielefeld.

◮ H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2011):

Eurace@Unibi Model v1.0 User Manual. Working Paper Bielefeld University.

◮ H Dawid & P Harting (2012): Capturing Firm Behavior in Agent-Based Models of

Industry Evolution and Macroeconomic Dynamics, in: G. Bünstorf (Ed), Applied Evolutionary Economics, Behavior and Organizations. Edward Elgar, pp. 103-130.

◮ H Dawid & M Neugart (2011): Agent-based Models for Economic Policy Design,

Eastern Economic Journal 37, 44-50.

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Outlook & Future research

◮ Macroprudential regulation

◮ Systemic risk (SIFIs, SIBs) ◮ Bank-firm networks ◮ size effects ◮ balance sheet contagion

◮ Empirically-grounded bank behavior

◮ Credit quotas ◮ Credit rationing of SMEs ◮ Tighter integration of Basel III regulation Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Scenario: Capital Adequacy Requirement

Output

100 200 300 400 500 1500 2000 2500 3000 Months Eurostat_output alfa 2.0 8.0

Bank activity (α = 2)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Firm activity (α = 2)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Scenario: Minimum Reserve Requirement

Output

100 200 300 400 500 2000 2200 2400 2600 2800 Months Eurostat_output min_cash_reserve_ratio 0.10 0.50

Bank activity (β = 0.50)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Firm activity (β = 0.50)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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Scenario: Capital Adequacy Requirement Output

100 200 300 400 500 1500 2000 2500 3000 Months Eurostat_output alfa 2.0 8.0

Bank activity (α = 2)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Firm activity (α = 2)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L 100 200 300 400 500 5000 10000 15000 20000 Months Bank_equity alfa 2.0 8.0

Bank equity

100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Months F_EARatio alfa 2.0 8.0

Firm fragility

100 200 300 400 500 0.040 0.045 0.050 0.055 0.060 0.065 0.070 Months Firm_mean_interest alfa 2.0 8.0

Mean interest

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Scenario: Minimum Reserve Requirement Output

100 200 300 400 500 2000 2200 2400 2600 2800 Months Eurostat_output min_cash_reserve_ratio 0.10 0.50

Bank activity (β = 0.50)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Firm activity (β = 0.50)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L 100 200 300 400 500 5000 10000 15000 20000 Months Bank_equity min_cash_reserve_ratio 0.10 0.50

Bank equity

100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Months F_EARatio min_cash_reserve_ratio 0.10 0.50

Firm fragility

100 200 300 400 500 0.045 0.050 0.055 0.060 0.065 0.070 Months Firm_mean_interest min_cash_reserve_ratio 0.10 0.50

Mean interest

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Firm activity

Number of illiquid firms No constraint

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L

Capital constraint (α = 2)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L

Liquidity constraint (β = 0.50)

100 200 300 400 500 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Bank activity

Number of active banks (unconstrained + constrained by equity/liquidity constraint) No constraint

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Capital constraint (α = 2)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Liquidity constraint (β = 0.5)

100 200 300 400 500 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Scenarios: Firm Fragility

Firm E/A-ratio = 1/leverage Capital constraint

100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Months F_EARatio alfa 2.0 8.0

Liquidity constraint

100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Months F_EARatio min_cash_reserve_ratio 0.10 0.50

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Prevention and mitigation - Bank dividend payout

−3000 −2500 −2000 −1500 −1000 −500 Parameters full_amplitude_recession 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 −3000 −2500 −2000 −1500 −1000 −500

amplitude of recessions

−10000 −8000 −6000 −4000 −2000 Parameters full_cumm_loss_recession 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 −10000 −8000 −6000 −4000 −2000

cumulative loss

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Bank accounting

  • 1. Bank profit

πb

t = r b i Lb i −r b(∑h Mb h +∑i Mb i )+r ECB(Mb t −Db t )

  • 2. Bank cash and reserves

Mb

t+1 = Mb t +∆Mb h +∆Mb i +(1−τ)max[0,πb t ]−db(1−τ)max[0,πb t ]

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Debt-equity transformation

  • 3a. Insolvency bankruptcy

Debt renegotiation is addressed by re-scaling the total debt Df

t with a debt rescaling

parameter ϕ. Target debt is given by: D∗ = ϕAf

t

with 0 ≤ ϕ ≤ 1. (8) After debt restructuring, the equity of the firm is now positive: E∗ = (1−ϕ)Af

t > 0.

(9) The new debt/equity-ratio is given by the constant D∗/E∗ = ϕ/(1−ϕ) < 1.

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Debt-equity transformation

  • 3b. Illiquidity bankruptcy

Debt-renegotiation is not necessary per se, rescaling of the debt is either based on the level of total assets or on the level of the original debt: D∗ =

  • ϕAf

t

if ϕAf

t ≤ Df t

ϕDf

t

if ϕAf

t > Df t .

with 0 ≤ ϕ ≤ 1. (10) The new debt/equity-ratio is given by the following piece-wise function: D∗/E∗ =

  • ϕ/(1−ϕ)

if ϕAf

t ≤ Df t

ϕ/(A/D −ϕ) if ϕAf

t > Df t .

(11)

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Dividend payout rule

◮ Rf nR : average revenues over previous nR months (nR = 3,6,12) ◮ Πf nE : average net earnings (after-tax profits) over the last nE months

Rf nR = 1 nR

nR−1

∑

i=0

Rf

t−i

(12) Πf nE = 1 nE

nE −1

∑

i=0

Πf

t−i

(13)

◮ Prevent liquidity hoarding by firms: Liquidity Buffer Stock

  • 4. Dividend payout rule:

Divf =

  • d ·Πf 4

if Mf

t ≤ µ ·Rf 6

Πf 4 if Mf

t > µ ·Rf 6.

d = 0.7,µ = 0.5 (14)

Sander van der Hoog Bubbles, Crashes & the Financial Cycle

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The Big Questions Eurace@Unibi Model Simulation Results Conclusions

Exogenous Credit Rationing

  • 5a. Full/Partial credit rationing is based on the (exogenously prescribed, ex ante)

constraints of the bank (CAR, CRR).

◮ Full rationing for CAR constraint:

¯ ℓb

it =

   Lit if PDit ·Lit ≤ V b

t

if 0 ≤ V b

t ≤ PDit ·Lit

if V b

t < 0.

(15)

◮ Partial rationing ("filling up to constraint") for CAR constraint:

¯ ℓb

it =

   Lit if PDit ·Lit ≤ V b

t

V b

t /PDit

if 0 ≤ V b

t ≤ PDit ·Lit

if V b

t < 0.

(16)

Sander van der Hoog Bubbles, Crashes & the Financial Cycle