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Princeton University

Updates: http://scholar.princeton.edu/markus/files/i_theory_slides.pdf

Brunnermeier & Sannikov 2012

• Systemic risk build-up during (credit) bubble

 “Volatility Paradox” contemp. measures inappropriate  Financial innovation/liberalization more systematic risk

• Spillovers/contagion – externalities

 Direct contractual: domino effect (interconnectedness)  Indirect:

price effect (fire-sale externalities) credit crunch, liquidity spirals

 Adverse GE response

systemic risk is endogenous

The 2 Components of Systemic Risk

2 Loss of net worth Shock to capital Precaution + tighter margins volatility price Fire sales

preventive crisis management

Brunnermeier & Sannikov 2012

Run-ups of Debt – Different Sectors

• Different sectors

 Japan 1980s:

non-fin. business sector + financial

 United States 2000s:

household sector + financial

3

0% 50% 100% 150% 200% 250% 300% 350% 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 0% 100% 200% 300% 400% 500% 600% 700% 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Government Financial Institutions Households Corporates

United States Japan

Brunnermeier & Sannikov 2012

U.S. Financial Sector Debt

4

0% 50% 100% 150% 200% 250% 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Bank Holding Company Net GSE Net Shadow Banking Traditional Banking

Brunnermeier & Sannikov 2012

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Financial Stability Price Stability Debt Sustainability De/inflation Financial Regulators Central Bank Fiscal Authority Liquidity spiral Fiscal Monetary Dominance

Brunnermeier & Sannikov 2012

Liquidity Concepts

• Financial instability arises from the fragility of liquidity

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Technological liquidity

• Reversibility of investment

Market liquidity

• Specificity of capital

Price impact of capital sale

Funding liquidity

• Maturity structure of debt
• Can’t roll over short term

debt

• Sensitivity of margins
• Margin-funding is recalled

A L Maturity mismatch

Brunnermeier & Sannikov 2012

Liquidity Mismatch

• Financial instability arises from the fragility of liquidity
• Liquidity mismatch index = response indicator

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Technological liquidity

• Reversibility of investment

Market liquidity

• Specificity of capital

Price impact of capital sale

Funding liquidity

• Maturity structure of debt
• Can’t roll over short term

debt

• Sensitivity of margins
• Margin-funding is recalled

A L Maturity mismatch

Brunnermeier & Sannikov 2012

Risk Topography: Data collection

• Direct responses to 5%, 10%, 15%,… drop in factor to



ΔValue



ΔLiquidity Mismatch Index

• Predict response



hold out



“fire” sell assets



credit crunch (no new loans) Maturity mismatch ΔValue ΔLMI

joint with Gary Gorton & Arvind Krishnamurthy

Brunnermeier & Sannikov 2012

Risk Topography: General equilibrium

• Direct responses to 5%, 10%, 15%,… drop in factor to



ΔValue



ΔLiquidity Mismatch Index

• Predict response



hold out - “fire” sell assets - credit crunch

• Derive likely indirect equilibrium response to



this stress factor



• ther factors

Find out whether plans were mutually consistent! (if not tail risk)

joint with Gary Gorton & Arvind Krishnamurthy

Brunnermeier & Sannikov 2012

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Financial Stability Price Stability Debt Sustainability De/inflation Financial Regulators Central Bank Fiscal Authority Liquidity spiral Fiscal Monetary Dominance

Brunnermeier & Sannikov 2012

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Financial Stability Price Stability Debt Sustainability De/inflation Π Fiscal Monetary Dominance Fisher Deflation spiral Financial Regulators Central Bank Fiscal Authority Inside money Liquidity spiral

Brunnermeier & Sannikov 2012

Main results

• Passive monetary policy

 Liquidity Spirals

Disinflationary spiral

 Endogenous risk  Redistributional effects

• Active monetary policy

 Interest rate

 Current rate  Forward guidance

 Asset purchase programs – open market operation  “Stealth” recapitalization

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A L

Brunnermeier & Sannikov 2012

Baseline model without intermediaries

• Macro shock

𝜇 = arrival rate

• Idiosyncratic shock

𝜚 = probability of stealing

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Households Productive entrepreneurs Government

Tax

Out-money Risky claims

Brunnermeier & Sannikov 2012

Introducing intermediaries

• Monitor
• Diversify
• Maturity/liquidity

transformation

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households Productive entrepreneurs Government

Tax

Out-money Risky claims Intermediaries Risky claims Inside money Net worth

Brunnermeier & Sannikov 2012

Two Polar Regimes without intermediaries

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Regime Frictions Value of fiat money Price of capital “Money” severe high low “Bliss” small low high

Brunnermeier & Sannikov 2012

Two Polar Regimes with Intermediaries

• Role of intermediaries

 Monitoring and thereby reduce friction from 𝜚 to 𝜚

 Have to take on productive agent’s equity risk to have incentive to monitor  Depends on their ability to absorb risk

 Diversify  Maturity/liquidity transformation

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Regime Frictions Value of fiat money Price of capital Intermediaries’ capitalization “Money” severe high low poor “Bliss” small low high well

Brunnermeier & Sannikov 2012

Introducing intermediaries

• Monitor
• Diversify
• Maturity/liquidity

transformation

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households Productive entrepreneurs Government

Tax

Out-money Risky claims Intermediaries Risky claims Inside money Net worth

Brunnermeier & Sannikov 2012

Adverse shock

• Split in 3 steps

1.

Shock impair assets

2.

Balance sheet shrink

3.

Real value of deposit

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households Productive entrepreneurs Government

Tax

Out-money Risky claims Intermediaries

Risky claims

Inside money

Brunnermeier & Sannikov 2012

Shrink balance sheet – sell off of assets

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households Productive entrepreneurs Government

Tax

Out-money

Risky claims

Intermediaries

Risky claims

money

Brunnermeier & Sannikov 2012

Disinflation effect – value of liabilities expand

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households Productive entrepreneurs Government

Tax

Out-money

Risky claims

Intermediaries

Risky claims

money

Brunnermeier & Sannikov 2012

• Intermediary net worth ↓
• Capital:

 fire sales, price q

↓

 Allocation efficiency ↓

• Money:

 Lending + deposits ↓  value of money p ↑  Multiplier

↓

• Banking

 Hit on both sides of balance sheet  Externality among banks  Competition ↓

• Amplification/persistence endogenous risk

wealth redistribution

After adverse shock

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Liquidity spiral Disinflation spiral

Brunnermeier & Sannikov 2012

Monetary Policy

• So far, “Gold Standard”

 outside money supply is fixed  pays no interest  no central bank

• Government issues long-term (perpetual) bonds

 pays fixed interest (in money)

• Monetary policy

 Central bank pays interest 𝑠

𝑢 ≥ 0 on money (by printing)

 Sets total outstanding value 𝑐𝑢𝐿𝑢 of perpetual bond

 By changing interest 𝑠

𝑢

 Additional Quantitative Easing/Open market operations

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Brunnermeier & Sannikov 2012

Money (incl. bonds) + physical capital

• Total wealth in the economy:

𝑞𝑢𝐿𝑢 + 𝑟𝑢𝐿𝑢

• Implies a complete yield curve

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Capital Perpetual bonds:

• pay in money (at unit rate)
• endogenous price 𝐶𝑢 (in money)

money Value 𝑟𝑢𝐿𝑢 Value 𝑞𝑢𝐿𝑢 Value 𝑐𝑢𝐿𝑢

Brunnermeier & Sannikov 2012

Observations

• As interest rate are cut in downturns, bonds held by

intermediaries appreciate, this

 protects intermediaries against shocks  increases the supply of asset that can be used as storage (weakens

deflation)

• Because downturns are softened, for all η

 drop in financial sectors’ capitalization conditional on a shock ↓  price of capital

↑

 money multiplier ↑  price of money

↓

 intermediary allocation to capital

↑

 household allocation to capital

↓

 risk premia (and thus the rate of recovery, conditional on no shocks) ↓

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Brunnermeier & Sannikov 2012

Ex-post Objective of Monetary Policy

• Mitigate redistributional effects from

endogenous risk/amplification

• Targeted redistribution

 US 2000s:

Household sector

 Japan 1980s:

non-financial business sector

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Brunnermeier & Sannikov 2012

Interest rate cut ≠ Forward guidance/LSAP

• Interest rate cut

 Increase long-term fixed assets  Widen term-spread

benefits banks’ net income

• Forward guidance / LSAP

 Lowers 10-1 yrs term spread hurts banks’ net income  Widens 25-10 yrs term spread hurts insurance/pension funds

• LSAP on MBS

 mortgage credit spread

 Reduces debt service burden (if can refinance)  Increases house prices (fall less)

Redistributional effects are very different

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Brunnermeier & Sannikov 2012

(Tail) Risk Redistribution

• Central bank “assumes” tail risk
• Risk redistribution = future contingent wealth redistr.
• Purchase programs – upside and downside

 Interest rate risk  Credit risk

• Lending programs – only downside

 Joint event: insufficient collateral & failed counterparty  Collateral policy changes tail event

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Brunnermeier & Sannikov 2012

Overall Welfare of ex-post Redistribution

• Redistribution is not a zero sum game!
• When is ex-post redistribution most desirable?

 Endogenous risk is large

 Technological and market liquidity (redeployability) is low gap between first and second best use is large

 Exogenous risk is small!

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Brunnermeier & Sannikov 2012

Ex-ante Monetary Policy

• Implementation problem
• “Insurance agreement” across sectors

 completes markets

• Moral Hazard – limits “implementable” rules

 Punish the weak and strengthen the cautious within

sector

 Interest rate rule is not sufficient  Target excessive spreads  Combine with macro-prudential (quantitative) rules

(LTV, haircuts,…)

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Brunnermeier & Sannikov 2012

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Financial Stability Price Stability Debt Sustainability De/inflation Π Fiscal Monetary Dominance Fisher Deflation spiral Financial Regulators Central Bank Fiscal Authority Inside money Liquidity spiral

Brunnermeier & Sannikov 2012

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Financial Stability Price Stability Debt Sustainability De/inflation GDP Π Fiscal Monetary Dominance inflation default Tax revenue Π

Opposing forces

Value of G-bonds

Financial Regulators Central Bank Fiscal Authority

Diabolic loop

Liquidity spiral Fisher Deflation spiral

“I Theory plus” + FTPL

Brunnermeier & Sannikov 2012

Opposing De- and Inflationary Forces

• Difficult to balance
• System is very unforgiving towards small mistakes

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Brunnermeier & Sannikov 2012

Opposing De- and Inflationary Forces

• Difficult to balance
• System is very unforgiving towards small mistakes
• Divergence in inflation expectations

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Brunnermeier & Sannikov 2012

Preventive Monetary Policy

• Early warning signals

 Credit growth and imbalances

• Volatility Paradox + Financial Innovation
• Quantity controls

 Through macro-prudential tools  LTV, …

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Brunnermeier & Sannikov 2012

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New Keynesian I-Theory

Key friction Price stickiness & ZLB Financial friction Role of money Unit of account Store of value Driver Demand driven as firms are obliged to meet demand at sticky price Misallocation of funds Monetary policy

• implementation
• First order effects

Optimal price setting

• ver time

Affect HH’s intertemporal trade-off Nominal interest rate impact real interest rate due to price stickiness Ex-ante insurance “complete markets” Ex-post: redistributional effects Ex-ante: insurance Time consistency Wage stickiness Price stickiness + monopolistic competition Moral hazard in risk taking (bubbles)

• Greenspan put -

Yield curve Expectation hypothesis only Term/inflation risk premia

Brunnermeier & Sannikov 2012

Conclusion

• New perspective – focus on

 Financial frictions, less on price stickiness  Store of value of money, not only unit of account  Wealth/income effects, not only substitution effects

• Redistributive in (i) wealth & (ii) risk
• MP reduces endogenous (self-generated) risk
• Interest rate cut ≠ Forward guidance/LSAP (not only ZLB)
• Stability concepts are highly interlinked
• Opposing de- & inflationary forces

 Difficult to balance  Calls for preventative monetary and macro-prudential tools

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