nep-cba New Economics Papers
on Central Banking
Issue of 2012‒10‒13
twenty-two papers chosen by
Maria Semenova
Higher School of Economics

  1. Infrequent Changes of the Policy Target: Robust Optimal Monetary Policy under Ambiguity By Shin-ichi Fukuda
  2. Size and complexity in model financial systems By Arinaminpathy, Nimalan; Kapadia, Sujit; May, Robert
  3. Commodity Prices, Monetary Policy and Inflation By José de Gregorio
  4. International Transmission of Financial Shocks in an Estimated DSGE model By Uluc Aysun; Sami Alpanda
  5. Great expectations? Evidence from Colombia’s exchange rate survey By Juan José Echavarría; Mauricio Villamizar
  6. Building a financial conditions index for the euro area and selected euro area countries: what does it tell us about the crisis? By Eleni Angelopoulou; Hiona Balfoussia; Heather D. Gibson
  7. Reputation, risk-taking and macroprudential policy By Aikman, David; Nelson, Benjamin; Tanaka, Misa
  8. Financial Intermediation, Exchange Rates, and Unconventional Policy in an Open Economy By Luis Felipe Céspedes; Roberto Chang; Andrés Velasco
  9. How Policy Actions Affect Short-term Post-crisis Recovery? By branimir Jovanovic
  10. Economic Reforms and the Indirect Role of Monetary Policy By Andrea Beccarini
  11. Sovereign Risk: A Macro-Financial Perspective By Das, Udaibir S.; Oliva, Maria A.; Tsuda, Takahiro
  12. Sovereign Credit Risk in Latin America and Global Common Factors By Manuel Agosin Trumper; Juan Díaz Maureira
  13. Sovereign default risk and commitment for fiscal adjustment By Carlos Eduardo Gonçalves; Bernardo Guimarães
  14. Banking systems, central banks and international reserve accumulation in East Asian economies By Shrestha, Prakash Kumar
  15. Bank stability and market discipline: The effect of contingent capital on risk taking and default probability By Jens Hilscher; Alon Raviv
  16. Countercyclical Capital Regulation and Bank Ownership Structure By Tommaso Trani
  17. Spillover Effects of the U.S. Financial Crisis on Financial Markets in Emerging Asian Countries By Bong-Han Kim; Hyeongwoo Kim; Bong-Soo Lee
  18. Europe's single supervisory mechanism and the long journey towards banking union By Nicolas Véron
  19. Why solvency regulation of banks fails to reach its objective By Peter Zweifel; Dieter Pfaff; Jochen Kühn
  20. What Prompts Central Bank Intervention in the Barbadian Foreign Exchange Market? By Jackman, Mahalia
  21. Measuring Financial Contagion with Extreme Coexceedances By Apostolos Thomadakis
  22. Familiarity and Surprises in International Financial Markets: Bad news travels like wildfire, good news travels slow By Jordi Mondria; Thomas Wu

  1. By: Shin-ichi Fukuda (Graduate School of Economics, The University of Tokyo, Tokyo)
    Abstract: In many countries, the monetary policy instrument sometimes remains unchanged for a long period and shows infrequent responses to exogenous shocks. The purpose of this paper is to provide a new explanation on why the central bank's policy instrument remains unchanged. In the analysis, we explore how uncertainty on the private agents' expectations affects robust optimal monetary policy. We apply the Choquet expected decision theory to a new Keynesian model. A main result is that the policymaker may frequently keep the interest rate unchanged even when exogenous shocks change output gaps and inflation rates. This happens because a change of the interest rate increases additional uncertainty for the policymaker. To the extent that the policymaker has uncertainty aversion, it can therefore be optimal for the policymaker to maintain an unchanged policy stance for some significant periods and to make discontinuous changes of the target rate. Our analysis departs from previous studies in that we determine an optimal monetary policy rule that allows time-variant feedback parameters in a Taylor rule. We show that if the policymaker has small uncertainty aversion, the calibrated optimal stop-go policy rule can predict actual target rates of FRB and ECB reasonably well.
    Date: 2012–09
  2. By: Arinaminpathy, Nimalan (Princeton University); Kapadia, Sujit (Bank of England); May, Robert (Oxford University)
    Abstract: The global financial crisis has precipitated an increasing appreciation of the need for a systemic perspective towards financial stability. For example: What role do large banks play in systemic risk? How should capital adequacy standards recognize this role? How is stability shaped by concentration and diversification in the financial system? We explore these questions using a deliberately simplified, dynamical model of a banking system which combines three different channels for direct spillovers from one bank to another: liquidity hoarding, asset price contagion, and the propagation of defaults via counterparty credit risk. Importantly, we also introduce a mechanism for capturing how swings in ‘confidence’ in the system may contribute to instability. Our results highlight that the importance of relatively large, well-connected banks in system stability scales more than proportionately with their size: the impact of their collapse arises not only from their connectivity, but also from their effect on confidence in the system. Imposing tougher capital requirements on larger banks than smaller ones can thus enhance the resilience of the system. Moreover, these effects are more pronounced in more concentrated systems, and continue to apply even when allowing for potential diversification benefits which may be realised by larger banks. We discuss some tentative implications for policy, as well as conceptual analogies in ecosystem stability, and in the control of infectious diseases.
    Keywords: Systemic risk; financial crises; contagion; network models; liquidity risk; confidence
    JEL: D85 G01 G21 G28
    Date: 2012–10–07
  3. By: José de Gregorio
    Abstract: During the second half of the 2000s, the world experienced a rapid and substantial rise in commodity prices. This shock posed complex challenges for monetary policy, in particular due to the significant increase in food and energy prices, and the repercussions they had on aggregate inflation measures. This paper discusses the role of commodity price shocks in monetary policy in the light of recent episodes of such shocks. It begins by discussing whether monetary policy should target core or headline inflation, and what should be the role of commodity price shocks in setting interest rates. It is argued that there are good reasons to focus on headline inflation, as most central banks actually do. Although core inflation provides a good indicator of underlying inflationary pressures, the evolution of commodity prices should not be overlooked, because of pervasive second-round effects. This paper reviews the evidence on the rise of inflation across countries and reports that food inflation, more than energy inflation, has relevant propagation effects on core inflation. This finding is particularly important in emerging market economies, where the share of food in the consumer basket is significant. The evidence also shows that countries that had lower inflation during the run up of commodity prices before the global crisis had more inflation in the subsequent rise after the global crisis, suggesting that part of the pre-crisis inflationary success may have been due to repressed inflation. This paper also discusses other factors that may explain different inflationary performances across countries.
    Date: 2012–07
  4. By: Uluc Aysun (University of Central Florida, Orlando, FL); Sami Alpanda (Bank of Canada, Ottawa, Ontario, Canada)
    Abstract: This paper investigates the transmission mechanism of financial shocks across large economies. To quantify these effects, we construct and estimate a two-region open economy DSGE model with nominal and real rigidities. We model the financial side of the economies using the financial accelerator mechanism of Bernanke et al. (1999). We find that the baseline model fails to generate the high degree of macroeconomic correlation between the U.S. and Euro Area economies. Allowing for an ad hoc, cross-regional correlation in financial shocks considerably improves the model’s ability to replicate the spill-over effects of U.S. financial shocks. We then extend the baseline model by including global banking and generate an endogenous, crossregional correlation of cost of capital. Simulations demonstrate a larger Euro Area response to U.S. shocks and highlight the importance of including frictions in international financial contracts, and not only in domestic financial contracts, for more accurately capturing the international transmission of domestic shocks.
    Keywords: DSGE, financial accelerator, international business cycles, global banks
    JEL: E32 E44 F33 F44
    Date: 2012–10
  5. By: Juan José Echavarría; Mauricio Villamizar
    Abstract: In this document we use the Expectations Survey conducted monthly by the Central Bank of Colombia during the period of October 2003 – August 2012. We find that exchange rate revaluations were generally followed by expectations of further revaluation in the short run (1 month), but by expectations of devaluations in the long run (1 year), and that expectations are stabilizing both in the short and long run. The forward rate is generally different from the future spot rate, mainly because forecast errors are on average different from cero. This suggests that exchange rate expectations are not rational. The role of the risk premium is also important, albeit statistically significant only for the 1 year ahead forecasts (not for 1 month). One month expectations are much better predictors than the models of extrapolative, adaptive or regressive expectations or even the forward discount, and all of them outperform a random walk. But results are almost the opposite for 1 year. In this case traders and analysts could actually do much better by following some simple models or by looking at some key variables rather than by following the strategy that they pursue today..
    Keywords: Exchange rate expectations, risk premium, market efficiency, forecasting accuracy, random walk, forward discount, rational expectations hypothesis. Classification JEL: C23, C53, C83, F31, F37.
    Date: 2012–10
  6. By: Eleni Angelopoulou (Bank of Greece); Hiona Balfoussia (Bank of Greece); Heather D. Gibson (Bank of Greece)
    Abstract: In this paper we construct Financial Conditions Indices (FCIs) for the euro area, for the period 2003 to 2011, using a wide range of prices, quantities, spreads and survey data, grounded in the theoretical literature. One FCI includes monetary policy variables, while two versions of the FCI without monetary policy are also constructed. This enables us to study the impact of monetary policy on financial conditions – indeed, overall, we find evidence of monetary policy ‘leaning against the wind’. The FCIs constructed fit in well with a narrative of financial conditions since the creation of the monetary union. FCIs for individual euro area countries are also provided, with a view to comparing financial conditions in core and periphery countries. There is evidence of significant divergence both before and during the crisis, which becomes less pronounced when monetary policy variables are included in the FCI. However, the impact of monetary policy on financial conditions appears not to be entirely symmetric across the euro area.
    Keywords: fiscal policy; public debt; financial market; crisis; credit
    JEL: E61 E62 H61 H62 H63 E32
    Date: 2012–07
  7. By: Aikman, David (Bank of England); Nelson, Benjamin (Bank of England); Tanaka, Misa (Bank of England)
    Abstract: This paper examines the role of macroprudential capital requirements in preventing inefficient credit booms in a model with reputational externalities. Unprofitable banks have strong incentives to invest in risky assets and generate inefficient credit booms when macroeconomic fundamentals are good in order to signal high ability. We show that across-the-system countercyclical capital requirements that deter credit booms are constrained optimal when fundamentals are within an intermediate range. We also show that when fundamentals are deteriorating, a public announcement of that fact can itself play a powerful role in preventing inefficient credit booms, providing an additional channel through which macroprudential policies can improve outcomes.
    Keywords: Macroprudential policy; credit booms; bank capital regulation
    JEL: E60 G10 G38
    Date: 2012–10–07
  8. By: Luis Felipe Céspedes; Roberto Chang; Andrés Velasco
    Abstract: This paper develops an open economy model in which financial intermediation is subject to occasionally binding collateral constraints, and uses the model to study unconventional policies such as credit facilities and foreign exchange intervention. The model highlights the interaction between the real exchange rate, interest rates, and financial frictions. The exchange rate can affect the financial intermediaries' international credit limit via a net worth effect and a leverage ratio effect; the latter is novel and depends on the equilibrium link between exchange rates and interest spreads. Unconventional policies are nonneutral if and only if financial constraints are binding in equilibrium. Credit programs are more effective if targeted towards financial intermediaries rather than the corporate sector. Sterilized foreign exchange interventions matter because the increased availability of tradables, resulting from the sterilizing credit, can relax financial frictions; this perspective is new in the literature. Finally, self fulfilling expectations can lead to the coexistence of financially constrained and unconstrained equilibria, justifying a policy of defending the exchange rate and the accumulation of international reserves.
    JEL: E58 F34 F41
    Date: 2012–10
  9. By: branimir Jovanovic (Faculty of Economics, University of Rome "Tor Vergata")
    Abstract: This paper investigates which factors determine how countries recover after crises, on a sample of 47 financial, currency and sovereign debt crises in 22 countries from the last thirty years, including the recent Great Recession. Several findings emerge. First, the most important factors which are associated with higher post-crisis growth are expansionary monetary and fiscal policy, exchange rate depreciation and prudent banking regulation. Second, the Great Recession does not seem to differ from the other crises in terms of how the policy actions effect the recovery, and the recovery after it is slower because of the global nature of this crisis. Third, the fiscal multiplier does not seem to be smaller during episodes of high public debt, and public debt does not seem to affect the speed of recovery through channels other than the government spending, which can be considered as an argument in favour of pursuing expansionary fiscal policy during crises even in highly leveraged countries.
    Keywords: crises, recovery, monetary policy, ?scal policy, banking regulation
    JEL: E52 E62 E63 G01
    Date: 2012–10–05
  10. By: Andrea Beccarini
    Abstract: Due to pressure from some lobbies, the government is unwilling to perform structural reforms. The probability of its reelection depends, however, on a positive business cycle. The central bank may create surprise deflation even though it maximizes the public’s utility function and even if it faces a rational market. This may explain why the ECB, but not the US FED, is found to be unaffected by the inflation bias.
    Keywords: Political Business Cycles, Time Inconsistency of Monetary Policy
    JEL: E32 E58
    Date: 2012–10
  11. By: Das, Udaibir S. (Asian Development Bank Institute); Oliva, Maria A. (Asian Development Bank Institute); Tsuda, Takahiro (Asian Development Bank Institute)
    Abstract: We examine some of the macro-financial dimensions of sovereign risk and propose a conceptual framework that captures risks other than just the default risk. Morphed under a multi-dimensional notion of sovereign risk, we argue that the existing empirical methodologies to measure sovereign risk cover only partial aspects of sovereign risk and fail to capture its macro-financial dimensions. We highlight a menu of tools that could be used to tackle the broader notion of sovereign risk, and suggest that authorities should actively use them to manage the macro financial dimensions of sovereign risk and before those risks feed into the real economy.
    Keywords: sovereign risk; default risk; macro-financial dimensions
    JEL: E43 F30 F34
    Date: 2012–10–02
  12. By: Manuel Agosin Trumper; Juan Díaz Maureira
    Abstract: This paper studies the importance of global common factors in the evolution of sovereign credit risk in a group of emerging economies (15 countries in Latin America for which daily data are available on sovereign credit spreads and CDS quotations from the beginning of 2007 until February 2012). We arrive at three principal results. First, there is robust evidence for the existence of a common factor in the evolution of the two measurements of sovereign credit risk that we use. Second, the comovement between this common factor and our two measures of individual-country sovereign risk rose significantly after the bankruptcy of Lehman Brothers on September 15, 2008, widely regarded as the beginning of the most acute phase of the crisis. We interpret the results as evidence that changes in the availability of foreign capital to emerging economies is dependent less on developments that are internal to these economies than on international liquidity shocks and risk appetite, which in turn depend on global factors exogenous to the recipient economies. Third the long-run values of the measurements of sovereign risk conform to conventional notions of creditworthiness and are closely related to credit ratings. But even here, important credit events also affect long-run sovereign risk measurements.
    Date: 2012–09
  13. By: Carlos Eduardo Gonçalves; Bernardo Guimarães
    Abstract: This paper studies fiscal policy in a model of sovereign debt and default. A time-inconsistency problem arises: since the price of past debt cannot be affected by current fiscal policy and governments cannot credibly commit to a certain path of tax rates, debtor countries choose suboptimally low fiscal adjustments. An international lender of last resort, capable of designing an implicit contract that coax debtors into a tougher fiscal stance via the provision of cheap (but senior) lending in times of crisis, can work as a commitment device and improve social welfare.
    Keywords: fiscal adjustment, sovereign debt, sovereign default; time inconsistency; IMF
    JEL: F33 F34
    Date: 2012–09–18
  14. By: Shrestha, Prakash Kumar
    Abstract: This paper examines changes in the balance sheets of the banking system in five East Asian economies which were affected by the 1997 Asian Crisis. These countries have persistently accumulated foreign currency reserves since the crisis. This paper estimates the impact of reserve accumulation on some important balance sheet variables such as liquid assets, credits and deposits of the banking system by applying panel data techniques. Estimates using data from Thailand, South Korea, Malaysia, Philippines and Indonesia show that reserve accumulation has a positive impact on the liquid assets and deposits of the banking system, but not on credit flows, after controlling for the effect of other potential variables. --
    Keywords: international reserves,central banks,banking systems and East Asian countries
    JEL: F31 E58 G21
    Date: 2012
  15. By: Jens Hilscher (International Business School, Brandeis University); Alon Raviv (International Business School, Brandeis University)
    Abstract: This paper investigates the effects of financial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We analyze a tractable form of contingent convertible bonds ("coco") and provide a closed-form solution for the price. We quantify the reduction in default probability associated with contingent capital as compared to subordinated debt. We then show that appropriate choice of contingent capital parameters (conversion ratio and threshold) can virtually eliminate stockholders' incentives to risk-shift, a motivation that is present when bank liabilities instead include either only equity or subordinated debt. Importantly, risk-taking incentives continue to be weak during times of financial distress. Our findings imply that contingent capital may be an effective tool for stabilizing financial institutions.
    Keywords: Contingent capital, Executive compensation, Risk taking, Banking regulation, Bank default probability, Financial crisis
    JEL: G13 G21 G28 E58
    Date: 2012–09
  16. By: Tommaso Trani (Graduate Institute of International Studies)
    Abstract: This paper develops a macroeconomic framework where the representative bank is owned by inside and outside owners and copes with capital requirements that vary countercyclically. The issuance of outside equity is characterized getting insights from the literature on corporate governance, especially that on corporate governance and investor protection. The insider receives utility benefits from the diversion of dividends, but the costs of diversion increase with the size of bank equity owned by outsiders. The goal is to see to what extent the willingness of insiders to share the bank with outsiders is affected by capital regulation. I find a negative link, which holds only if capital restrictions vary countercyclically. Thinking of a positive shock, the justification for such a negative link is that the shock leads not only to tighter regulation, but also to higher expected dividends and, relatedly, to higher agency costs affecting the distribution of earnings.
    Keywords: macroprudential policy, bank regulation, insider-outsider, bank shareholding
    JEL: E60 G28 G32
    Date: 2012–09–21
  17. By: Bong-Han Kim; Hyeongwoo Kim; Bong-Soo Lee
    Abstract: We examine spillover effects of the recent U.S. financial crisis on five emerging Asian countries by estimating conditional correlations of financial asset returns across countries using multivariate GARCH models. We propose a novel approach that simultaneously estimates the conditional correlation coefficient and the effects of its determining factors over time, which can be used to identify the channels of spillovers. We find some evidence of financial contagion around the collapse of Lehman Brothers in September 2008. We further find a dominant role of foreign investment for the conditional correlations in international equity markets. The dollar Libor-OIS spread, the sovereign CDS premium, and foreign investment are found to be significant factors affecting foreign exchange markets.
    Keywords: Financial Crisis; Spillover Effects; Contagion; Emerging Asian Countries; Dynamic Conditional Correlation; DCCX-MGARCH
    JEL: C32 F31 G15
    Date: 2012–10
  18. By: Nicolas Véron
    Abstract: Problems in the banking system are at the core of the current crisis. The establishment of a banking union is a necessary (though not sufficient) condition for eventual crisis resolution that respects the integrity of the euro. The European Commissionâ??s proposal for the establishment of a Single Supervisory Mechanism and related reform of the European Banking Authority (EBA) do not and cannot create a fully-fledged banking union, but represent a broadly adequate step on the basis of the leadersâ?? declaration of 29 June 2012 and of the decision to use Article 127(6) of the treaty as legal basis. The proposal rightly endows the European Central Bank (ECB) with broad authority over banks within the supervisory mechanismâ??s geographical perimeter; however, the status of non-euro area member states willing to participate in this mechanism, and the governance and decision-making processes of the ECB in this respect, call for further elaboration. Further adjustments are also desirable in the proposed reform of the EBA, even though they must probably retain a stopgap character pending the more substantial review planned in 2014. This Policy Contribution was prepared as a briefing paper for the European Parliament Economic and Monetary Affairs Committeeâ??s Monetary Dialogue.
    Date: 2012–10
  19. By: Peter Zweifel (Department of Economics, University of Zurich); Dieter Pfaff (Department of Business Administration (IBW), University of Zurich); Jochen Kühn
    Abstract: This paper contains a critique of solvency regulation such as imposed on banks by Basel I and II. Banks’ investment divisions seek to maximize the expected rate of return on risk-adjusted capital. For them, a higher solvency level lowers the cost of refinancing but ties costly capital. Sequential decision making by banks is tracked over three periods. In period 1, exogenous changes in expected returns and volatility occur, causing a pair of optimal adjustments of solvency in period 2. In period 3, the actual adjustment of solvency constitutes an exogenous shock, triggering portfolio adjustments in terms of expected return and volatility which move the bank along an endogenous efficiency frontier. Both Basel I and II are shown to modify the slope of this frontier, inducing senior management to opt for higher volatility in several situations. Therefore, both types of solvency regulation can run counter their stated objective, which may also be true of Basel III.
    Keywords: regulation, banks, solvency, Basel I, Basel II, Basel III
    JEL: G15 G21 G28 L51
    Date: 2012–05
  20. By: Jackman, Mahalia
    Abstract: The Central Bank of Barbados often intervenes – buys or sells from the foreign exchange (FX) reserves – to ensure the daily clearing of the FX market. This paper estimates an FX intervention function for Barbados using a dynamic complementary log-log model. Three general findings emerged: (i) dynamics play an important role in the Central Bank’s intervention function, meaning that the probability that an intervention takes place today is conditional upon an intervention taking place at least one day prior. This most likely reflects the fact that deficits/surpluses on the FX market tend to be persistent, resulting in intervention over a consecutive number of days; (ii) there appears to be some differences in the response of Central Bank interventions to the other key variables. Particularly, seasonal fluctuations in tourism and interest rate spreads are likely to impact the probability of a sale intervention, but don’t seem to affect the likelihood of a purchase intervention. Moreover, an influx of real estate flows is likely to increase the probability that a purchase intervention takes place, but might have limited impact on the marginal propensity of a sale intervention. Finally, (iii) ‘oil price shocks’ is the only exogenous variable which appears to impact both sale and purchase interventions.
    Keywords: Foreign exchange; intervention;fixed exchange rate
    JEL: E58 F31 N26
    Date: 2012–03
  21. By: Apostolos Thomadakis (University of Surrey)
    Abstract: This paper tests for contagion firstly, within the Euro Area (EA thereafter), and secondly from the US to the EA. Using 'coexceedances' - the joint occurrences of extreme negative and positive returns in different countries in a given day - I define contagion within regions as the fraction of the coexceedances that cannot be explained by fundamentals (covariates). On the other hand, contagion across regions can be defined as the fraction of the coexceedance events in the EA that is left unexplained by its own covariates but that is explained by the exceedances from the US. Having applied a multinomial logistic regression model to daily returns on 14 European stock markets for the period 2004-2012, I can provide the following summary of the results. Firstly, I found evidence of contagion within the EA. Especially, the EA 10 year government bond yield and the EUR/USD exchange rate fail to adequately explain the probability of coexceedances in Europe. Therefore, these variables are important determinants of regional crashes. In addition, I have observed that negative movements in stock prices follow continuation patterns - coexceedances cluster across time. Secondly, there is no statistically significant evidence of contagion from the US to the EA, in the sense that US exceedances fail to explain high probabilities of coexceedances in the EA. This result holds under a large battery of robustness checks. I would rather interpret this as a normal interdependence between the two markets.
    JEL: C25 G15 F36 E44
    Date: 2012–09
  22. By: Jordi Mondria (University of North Carolina at Chapel H); Thomas Wu (University of California, Santa Cruz)
    Abstract: In this paper, we decompose attention allocation in two components -- the familiar and the surprising -- with opposite implications for US purchases of foreign stocks. On one hand, familiarity-induced attention leads to an increase in US holdings of foreign equities. On the other hand, surprise-induced attention is associated with net selling of foreign stocks because US investors' tend to pay more attention to negative than to positive economic surprises from other countries. Our findings suggest that information asymmetries between locals and non-locals are more pronounced when it comes to good news, with information regarding bad news being relatively symmetric.
    Date: 2012

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