nep-cba New Economics Papers
on Central Banking
Issue of 2013‒01‒07
twenty-six papers chosen by
Maria Semenova
Higher School of Economics

  1. Optimal Monetary and Prudential Policies. By Collard, F.; Dellas, H.; Diba, B.; Loisel, O.
  2. Capital Flows and the Risk-Taking Channel of Monetary Policy By Valentina Bruno; Hyun Song Shin
  3. Monetary policy without interest rates. Evidence from France’s Golden Age (1948-1973) using a narrative approach. By Eric Monnet
  4. How effective is central bank forward guidance? By Clemens J.M. Kool; Daniel L. Thornton
  5. The ECB and the interbank market By Domenico Giannone; Michele Lenza; Huw Pill; Lucrezia Reichlin
  6. Robustifying optimal monetary policy using simple rules as cross-checks By Pelin Ilbas; Øistein Røisland; Tommy Sveen
  7. Macro effects of capital requirements and macroprudential policy By Q. Farook Akram
  8. Bank capital and liquidity creation: Granger-causality evidence By Roman Horváth; Jakub Seidler; Laurent Weill
  9. Risk, capital buffer and bank lending: a granular approach to the adjustment of euro area banks By Laurent Maurin; Mervi Toivanen
  10. Bank risk, bailouts and ambiguity. By Nijskens, R.G.M.
  11. Asymmetric information in credit markets, bank leverage cycles and macroeconomic dynamics By Ansgar Rannenberg
  12. Macroeconomic determinants of the credit risk in the banking system: The case of the GIPSI By Vítor Castro
  13. Estimating the Policy Rule from Money Market Rates when Target Rate Changes Are Lumpy By Jean-Sébastien Fontaine
  14. Credit-Risk Valuation in the Sovereign CDS and Bonds Markets: Evidence from the Euro Area Crisis By Óscar Arce; Sergio Mayordomo; Juan Ignacio Peña
  15. Financial system reforms and China’s monetary policy framework: A DSGE-based assessment of initiatives and proposals By Funke , Michael; Paetz , Michael
  16. Financial stress and economic dynamics: the transmission of crises By Kirstin Hubrich; Robert J. Tetlow
  17. Bubbles, banks and financial stability By Kosuke Aoki; Kalin Nikolov
  18. Moral hazard credit cycles with risk-averse agents By Roger Myerson
  19. The effect of commodity price shocks on underlying inflation: the role of central bank credibility By J. Scott Davis
  20. Optimal banking contracts and financial fragility By Todd Keister; Huberto Ennis
  21. Transatlantic systemic risk By Trapp, Monika; Wewel, Claudio
  22. Bank efficiency, market concentration and economic growth in the European Union By Cândida Ferreira
  23. Bank deregulation and racial inequality in America By Ross Levine; Alexey Levkov; Yona Rubinstein
  24. Durable financial regulation: monitoring financial instruments as a counterpart to regulating financial institutions By Leonard Nakamura
  25. The Bank of England as the World gold market-maker during the Classical gold standard era, 1889-1910 By Stefaano Ugolini
  26. Bretton Woods, swap lines, and the Federal Reserve’s return to intervention By Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz

  1. By: Collard, F.; Dellas, H.; Diba, B.; Loisel, O.
    Abstract: The recent financial crisis has highlighted the interconnectedness between macroeconomic and financial stability and has raised the question of whether and how to combine the corresponding main policy instruments (interest rate and bank-capital requirements). This paper offers a characterization of the jointly optimal setting of monetary and prudential policies and discusses its implications for the business cycle. The source of financial fragility is the socially excessive risk-taking by banks due to limited liability and deposit insurance. We characterize the conditions under which locally optimal (Ramsey) policy dedicates the prudential instrument to preventing inefficient risk-taking by banks; and the monetary instrument to dealing with the business cycle, with the two instruments co-varying negatively. Our analysis thus identifies circumstances that can validate the prevailing view among central bankers that standard interest-rate policy cannot serve as the first line of defense against financial instability. In addition, we also provide conditions under which the two instruments might optimally co-move positively and countercyclically.
    Keywords: Prudential policy – Capital requirements – Monetary policy – Ramsey-optimal policies.
    JEL: E32 E44 E52
    Date: 2012
  2. By: Valentina Bruno; Hyun Song Shin
    Abstract: This paper examines the relationship between low interests maintained by advanced economy central banks and credit booms in emerging economies. In a model with crossborder banking, low funding rates increase credit supply, but the initial shock is amplified through the "risk-taking channel" of monetary policy where greater risk-taking interacts with dampened measured risks that are driven by currency appreciation to create a feedback loop. In an empirical investigation using VAR analysis, we find that expectations of lower short-term rates dampen measured risks and stimulate cross-border banking sector capital flows.
    Keywords: Capital flows, exchange rate appreciation, credit booms
    Date: 2012–12
  3. By: Eric Monnet (Paris School of Economics)
    Abstract: Central banking in France from 1948 to 1973 was a paradigmatic example of an unconventional policy relying on quantities rather than on interest rates. Usual SVAR find no effect of policy shocks and support the common view that monetary policy was ineffective over this period. I argue that only a narrative approach is able to account for the peculiarity and complexity of quantitative controls on money and credit. Using archival evidence, I measure monetary policy stance with a dummy variable denoting restrictive episodes. Impulse response functions then show standard patterns; monetary policy shocks have a strong and long lasting effect. These results offer a revisionist account of postwar monetary policy under Bretton Woods and before the Great Inflation. They also suggest that quantities of money and credit can play a greater role than their prices in the adjustment process of the economy.
    Keywords: monetary policy, credit controls, VAR, narrative approach, liquidity puzzle, Banque de France, Bretton Woods
    JEL: N14 E31 E32 E51 E52 E58
    Date: 2012–12
  4. By: Clemens J.M. Kool; Daniel L. Thornton
    Abstract: This paper investigates the effectiveness of forward guidance for the central banks of four countries: New Zealand, Norway, Sweden, and the United States. We test whether forward guidance improved market participants’ ability to forecast future short-term and long-term rates. We find that forward guidance improved market participants’ ability to forecast short-term rates over relatively short forecast horizons, but only for Norway and Sweden. Importantly, there is no evidence that forward guidance has increased the efficacy of monetary policy for New Zealand, the country with the longest history of forward guidance.
    Keywords: Monetary policy ; Banks and banking, Central
    Date: 2012
  5. By: Domenico Giannone (ECARES – European Center for Advanced Research in Economics and Statistics; CEPR - Centre for Economic Policy Research); Michele Lenza (European Central Bank); Huw Pill (Goldman Sachs); Lucrezia Reichlin (London Business School; CEPR - Centre for Economic Policy Research)
    Abstract: We analyse the impact on the euro area economy of the ECB’s non-standard monetary policy measures by studying the effect of the expansion of intermediation of interbank transactions across the central bank balance sheet. We exploit data drawn from the aggregated Monetary and Financial Institutions (MFI) balance sheet, which allows us to construct a measure of the ‘policy shock’ represented by the ECB’s increasing role as a financial intermediary. We find small but significant effects both on loans and real economic activity. JEL Classification: E5, E58
    Keywords: Non-standard monetary policy measures, interbank market
    Date: 2012–11
  6. By: Pelin Ilbas (National Bank of Belgium); Øistein Røisland (Norges Bank (Central Bank of Norway)); Tommy Sveen (BI Norwegian Business School)
    Abstract: There are two main approaches to modelling monetary policy; simple instrument rules and optimal policy. We propose an alternative that combines the two by extending the loss function with a term penalizing deviations from a simple rule. We analyze the properties of the modified loss function by considering three different models for the US economy. The choice of the weight on the simple rule determines the trade-off between optimality and robustness. We show that by placing some weight on a simple Taylor-type rule in the loss function, one can prevent disastrous outcomes if the model is not a correct representation of the underlying economy.
    Keywords: Model uncertainty, optimal control, simple rules
    JEL: E52 E58
    Date: 2012–12–18
  7. By: Q. Farook Akram (Norges Bank (Central Bank of Norway))
    Abstract: I investigate macro effects of higher bank capital requirements on the Norwegian economy and their use as a macroprudential policy instrument under Basel III. To this end, I develop a macroeconometric model where the capital adequacy ratio, lending rates, asset prices and credit interact with each other and with the real economy. The empirical results suggest that changes in capital requirements are primarily transmitted via lending rates to the other variables in the model. The proposed increases in capital requirements under Basel III are found to have significant effects especially on house prices and credit. I also derive optimal paths for the countercyclical capital buffer in response to various shocks. The buffer is found to equal its imposed ceiling of 2.5% in response to most of the shocks considered while its duration varies in the range of 1-12 quarters depending on the shock and its persistence.
    Keywords: Basel III, Capital requirements, Macroprudential policy
    JEL: C52 C53 E52 G38
    Date: 2012–12–20
  8. By: Roman Horváth (Charles University; IOS - Institute for East and Southeast European Studies); Jakub Seidler (Czech National Bank; Charles University); Laurent Weill (EM Strasbourg Business School)
    Abstract: We examine the relation between capital and liquidity creation. This issue is interesting because of the potential impact on liquidity creation from tighter capital requirements such as those in Basel III. We perform Granger-causality tests in a dynamic GMM panel estimator framework on an exhaustive data set of Czech banks, which mainly includes small banks from 2000 to 2010. We observe a strong expansion in liquidity creation until the financial crisis that was mainly driven by large banks. We show that capital negatively Granger-causes liquidity creation in this industry, where majority of banks are small. But we also observe that liquidity creation Granger-causes a reduction in capital. These findings support the view that Basel III can reduce liquidity creation, but also that greater liquidity creation can reduce banks’ solvency. Thus, we show that this reverse causality generates a trade-off between the benefits of financial stability induced by stronger capital requirements and the benefits of increased liquidity creation. JEL Classification: G21, G28
    Keywords: Bank capital, Liquidity creation, Basel III
    Date: 2012–11
  9. By: Laurent Maurin (European Central Bank); Mervi Toivanen (Bank of Finland)
    Abstract: We develop a partial adjustment model in order to estimate the factors contributing to banks’ internal target capital ratio, lending policy and holding of securities. The model is estimated on a panel of listed euro area banks and country specific macrovariables. Firstly, banks’ internal target capital ratios are estimated by using information on banks’ riskiness and earnings capacity. Secondly, the impact of banks’ capital gap on the credit supply and the security portfolio is estimated while controlling for the macroeconomic environment. An increase in bank’ balance sheet risk is shown to increase the target capital ratios. The adjustment towards higher equilibrium capital ratios has a significant impact on banks’ assets. The impact is found to be more sizeable on security holdings than on loans, thereby suggesting a pecking order. JEL Classification: G21
    Keywords: Banks, euro area, capital ratios, credit supply, partial adjustment model
    Date: 2012–11
  10. By: Nijskens, R.G.M. (Tilburg University)
    Abstract: The theoretical analysis in the second part investigates the effect of liquidity assistance and bailouts on bank risk taking and liquidity choice. Furthermore, it explores the possibilities for central banks to create ambiguity about liquidity assistance, thereby influencing bank choices. The results in this thesis have implications for the reform of financial regulation and the safety net. Banks have become more systemically relevant; new regulation has to take this into account. Moreover, a new financial safety net should involve suitable bailout penalties and central banks that can resort to constructive ambiguity to give banks proper incentives.
    Date: 2012
  11. By: Ansgar Rannenberg (Macroeconomic Policy Institute)
    Abstract: I add a moral hazard problem between banks and depositors as in Gertler and Karadi (2009) to a DSGE model with a costly state verification problem between entrepreneurs and banks as in Bernanke et al. (1999) (BGG). This modification amplifies the response of the external finance premium and the overall economy to monetary policy and productivity shocks. It allows my model to match the volatility and correlation with output of the external finance premium, bank leverage, entrepreneurial leverage and other variables in US data better than a BGG-type model. A reasonably calibrated combination of balance sheet shocks produces a downturn of a magnitude similar to the "Great Recession". JEL Classification: E44, E43, E32
    Keywords: Leverage cycle, bank capital, financial accelerator, output effects of financial shock
    Date: 2012–10
  12. By: Vítor Castro (Universidade de Coimbra - NIPE)
    Abstract: In this paper, we analyse the link between the macroeconomic developments and the banking credit risk in a particular group of countries – Greece, Ireland, Portugal, Spain and Italy (GIPSI) – recently affected by unfavourable economic and financial conditions and to which, on this matter, the literature has not given a particular attention yet. Employing dynamic panel data approaches to these five countries over the period 1997q1-2011q3, we conclude that the banking credit risk is significantly affected by the macroeconomic environment: the credit risk increases when GDP growth and the share price indices decrease and rises when the unemployment rate, interest rate, and credit growth increase; it is also positively affected by an appreciation of the real exchange rate; moreover, we observe a substantial increase in the credit risk during the recent financial crisis period. Several robustness tests with different estimators have also confirmed these results.
    Keywords: Credit risk; Macroeconomic factors; Banking system; GIPSI; Panel data
    JEL: C23 G21 F41
    Date: 2012
  13. By: Jean-Sébastien Fontaine
    Abstract: Most central banks effect changes to their target or policy rate in discrete increments (e.g., multiples of 0.25%) following public announcements on scheduled dates. Still, for most applications, researchers rely on the assumption that the policy rate changes linearly with economic conditions and they do not distinguish between dates with and without scheduled announcements. This assumption is not innocuous when estimating the policy rule based on daily frequency. For the 1994-2011 period, and using an otherwise standard term structure model, I find that accounting for discrete changes leads to economically different estimates. Only the model based on discrete changes depicts a picture that is consistent with existing evidence on the monetary policy rule and risk premium. I study the information content of key policy announcements in the period from the end of 2008, where the policy rate reached a lower bound in the US, until the end of 2011.
    Keywords: Asset Pricing; Financial markets; Interest rates
    JEL: E43 E44 E47 G12 G13
    Date: 2012
  14. By: Óscar Arce (Directorate General Economics, Statistics and Research, Bank of Spain); Sergio Mayordomo (School of Economics and Business Administration, University of Navarra); Juan Ignacio Peña (Department of Business Administration, Universidad Carlos III de Madrid)
    Abstract: We analyse the extent to which prices in the sovereign credit default swap (CDS) and bond markets reflect the same information on credit risk in the context of the current crisis of the European Monetary Union (EMU). We first document that deviations between CDS and bond spreads are related to counterparty risk, common volatility in EMU equity markets, market illiquidity, funding costs, flight-to-quality, and the volume of debt purchases by the European Central Bank (ECB) in the secondary market. Based on this we conduct a state-dependent price-discovery analysis that reveals that the levels of the counterparty risk and the common volatility in EMU equity markets, and the banks’ agreements to accept losses on their holdings of Greek bonds impair the ability of the CDS market to lead the price discovery process. On the other hand, the funding costs, the flight-to-quality indicator and the volume of debt purchases by the ECB worsen the efficiency of the bond market.
    Keywords: sovereign credit default swaps, sovereign bonds, credit spreads, price discovery
    JEL: G10 G14 G15
    Date: 2012–12–21
  15. By: Funke , Michael (BOFIT); Paetz , Michael (BOFIT)
    Abstract: This paper evaluates various financial system reform initiatives and proposals in China in a DSGE modelling setting. The key reform steps analysed include phasing out benchmark interest rates, deepening the direct finance market, reducing government’s quantity-based intervention on financial institutions. Our counterfactual model simulation results suggest that the reforms will be beneficial only, if Chinese monetary policy continues to rely on quantity-based interventions on financial institutions or tightens the interest rate rule.
    Keywords: DSGE model; financial sector reform; monetary policy; China
    JEL: E42 E52 E58
    Date: 2012–12–11
  16. By: Kirstin Hubrich; Robert J. Tetlow
    Abstract: The recent financial crisis and the associated decline in economic activity have raised some important questions about economic activity and its links to the financial sector. This paper introduces an index of financial stress--an index that was used in real time by the staff of the Federal Reserve Board to monitor the crisis--and shows how stress interacts with real activity, inflation and monetary policy. We define what we call a stress event--a period affected by stress in both shock variances and model coefficients--and describe how financial stress affects macroeconomic dynamics. We also examine what constitutes a useful and credible measure of stress and the role of monetary policy. We address these questions using a richly parameterized Markov-switching VAR model, estimated using Bayesian methods. Our results show that allowing for time variation is important: the constant-parameter, constant-shock-variance model is a poor characterization of the data. We find that periods of high stress coefficients in general, and stress events in particular, line up well with financial events in recent U.S. history. We find that a shift to a stress event is highly detrimental to the outlook for the real economy, and that conventional monetary policy is relatively weak during such periods. Finally, we argue that our findings have implications for DSGE modeling of financial events insofar as researchers wish to capture phenomena more consequential than garden-variety business cycle fluctuations, pointing away from linearized DSGE models toward either MS-DSGE models or fully nonlinear models solved with global methods.
    Date: 2012
  17. By: Kosuke Aoki (University of Tokyo); Kalin Nikolov (European Central Bank)
    Abstract: We build a model of rational bubbles in a limited commitment economy and show that the impact of the bubble on the real economy crucially depends on who holds the bubble. When banks are the bubble-holders, this amplifies the output boom while the bubble survives but also deepens the recession when the bubble bursts. In contrast, the real impact of bubbles held by ordinary savers is more muted.
    Keywords: Financial stability
    Date: 2012–11
  18. By: Roger Myerson (University of Chicago)
    Abstract: We consider a simple overlapping-generations model with risk-averse financial agents subject to moral hazard. Efficient contracts for such financial intermediaries involve back-loaded late-career rewards. Compared to the analogous model with risk-neutral agents, risk aversion tends to reduce the growth of agents' responsibilities over their careers. This moderation of career growth rates can reduce the amplitude of the widest credit cycles, but it also can cause small deviations from steady state to amplify over time in rational-expectations equilibria. We find equilibria in which fluctuations increase until the economy enters a boom/bust cycle where no financial agents are hired in booms.
    Date: 2012
  19. By: J. Scott Davis
    Abstract: This paper seeks to document and explain the effect of a commodity price shock on underlying core inflation, and how that effect changes both across time and across countries. Impulse responses derived from a structural VAR model show that across many countries there was a break in the response of core inflation to a commodity price shock. In an earlier period, a shock to commodity prices would lead to a large and significant increase in core inflation, but in later periods, the effect was insignificant. ; To explain this, we construct a large-scale DSGE model with both headline and core inflation, and most significantly, a mechanism whereby fluctuations in inflation caused by purely transitory shocks can become incorporated into long-term inflation expectations. Inflation has a trend and a cyclical component. Private agents cannot distinguish between the two, so a cyclical fluctuation in inflation may be confused for a shift in the trend component. Bayesian estimation reveals that there was a change between the earlier and the later periods in the parameter that governs the anchoring of expectations. Impulse responses derived from simulations of the model show that this change in the effect of commodity prices on core inflation is driven by the change in the anchoring of inflation expectations.
    Keywords: Price levels
    Date: 2012
  20. By: Todd Keister (Federal Reserve Bank of New York); Huberto Ennis (Richmond Fed)
    Abstract: We study a finite-depositor version of the Diamond-Dybvig model of financial intermediation in which the bank and all depositors observe withdrawals as they occur. We derive the (constrained) efficient allocation of resources in closed-form and show that this allocation provides liquidity insurance to depositors. The contractual arrangement that decentralizes this allocation has debt-like features and resembles the type of demand deposits commonly offered by banking institutions. We provide examples where this arrangement admits another equilibrium in which some depositors run on the bank, withdrawing funds regardless of their liquidity needs. A bank run in our setting is always partial, with only those depositors who can withdraw sufficiently early participating. Depositors who are late to withdraw during a run suffer significant discounts from the face value of their deposits. The run, while partial, may involve a large number of depositors and result in significant inefficiencies.
    Date: 2012
  21. By: Trapp, Monika; Wewel, Claudio
    Abstract: In this paper we study systemic risk for North America and Europe. We show that banks' exposures to common risk factors are crucial for systemic risk. We come to this conclusion by first showing that relations between North American and European banks are smaller than within each region. We then show that European banks react more strongly to the onset of the financial crisis than North American ones. Regarding the consequences of systemic risk, we show that dependence between the banking sector and a wide range of real sectors is limited. Our results imply that regulators and supervisors should address international bank dependencies arising from common risk factors, while recessions in real sectors due to bank defaults should be a secondary concern. --
    Keywords: systemic risk,banking sector,real sectors,international,copula
    JEL: G01 G15 G18 G21 G28
    Date: 2012
  22. By: Cândida Ferreira
    Abstract: Well-functioning financial markets and banking institutions are usually considered to be a condition favourable to economic growth. The importance of bank efficiency and bank market concentration has also been the object of discussion, with the general belief that while they are of particular relevance in the context of the European Union, there is no consensus on their specific roles. This paper aims to study the effects on economic growth of the efficiency of the banking institutions, measured through Data Envelopment Analysis (DEA), and also of the concentration of the bank markets, measured by the percentage share of the total assets held by the three largest banking institutions (C3) and the Herfindahl-Hirschman Index (HHI). Considering a panel of all 27 EU countries for the time period between 1996 and 2008, the study analyses the influence of these bank and market conditions not only on the Gross Domestic Product (GDP) but also on its components: the final consumption expenditure, the gross fixed capital formation, the export of goods and services and the import of goods and services. The main findings point to the generally positive influence of bank cost efficiency on economic growth. More precisely, this influence is statistically significant for GDP and particularly with respect to the gross fixed capital formation. With regard to the bank market concentration, a generally negative influence is revealed, not only on GDP, but also on its components and is statistically more significant for the gross fixed capital formation, as well as for the export and import of goods and services. JEL Classification: G21; F43; D4; L11
    Keywords: Bank efficiency, market concentration, economic growth, European Union.
    Date: 2012–10
  23. By: Ross Levine; Alexey Levkov; Yona Rubinstein
    Abstract: We use the cross-state, cross-time variation in bank deregulation across the U.S. states to assess how improvements in banking systems affected the labor market opportunities of black workers. Bank deregulation from the 1970s through the 1990s improved bank efficiency, lowered entry barriers facing nonfinancial firms, and intensified competition for labor throughout the economy. Consistent with Becker’s (1957) seminal theory of racial discrimination, we find that deregulation-induced improvements in the banking system boosted blacks’relative wages by facilitating the entry of new firms and reducing the manifestation of racial prejudices in labor markets.
    Keywords: Banks and banking ; Labor market ; Wages ; Bank competition
    Date: 2012
  24. By: Leonard Nakamura
    Abstract: Supersedes Working Paper 10-22> > This paper sets forth a discussion framework for the information requirements of systemic financial regulation. It specifically describes a potential large macro-micro database for the U.S. based on an extended version of the Flow of Funds. I argue that such a database would have been of material value to U.S. regulators in ameliorating the recent financial crisis and could be of aid in understanding the potential vulnerabilities of an innovative financial system in the future. I also suggest that making these data available to the academic research community, under strict confidentiality restrictions, would enhance the detection and measurement of systemic risk.
    Keywords: Finance ; Regulation ; Flow of funds
    Date: 2012
  25. By: Stefaano Ugolini (Sciences Po Toulouse and LEREPS – University of Toulouse 1 Capitole.)
    Abstract: This paper studies the microfoundations of the so-called “gold device” policy by analysing a new dataset on the Bank of England’s operations in the gold market at the heyday of the classical gold standard. It explains that “gold devices” must be understood in connection to the Bank’s role as gold market-maker in London and to the position of London as world gold market. Contrary to the literature, the paper shows that “gold devices” were sophisticated monetary policy tools intended to complement – not to substitute – interest rate policy and aimed at smoothing – not at hampering – international adjustment. These findings demonstrate the potential of adopting a microstructural approach to the study of monetary policy, and call for a reassessment of efficiency measurement for the gold standard.
    Keywords: Monetary policy, Gold standard, Gold market, Market
    JEL: E58 G24 L11 L14 N23
    Date: 2012–12–10
  26. By: Michael D. Bordo; Owen F. Humpage; Anna J. Schwartz
    Abstract: This paper describes the United States’ first line of defense against shortcomings in the Bretton Woods system, which threatened the system’s continuation as early as 1960. The exposition describes the Federal Reserve’s use of swap lines both to provide cover for central banks’ unwanted dollar exposures, thereby forestalling claims on the U.S. gold stock, and to supply dollar liquidity to countries facing temporary balance-of-payments deficits, thereby bolstering confidence in their parities. As suggested by the expansion and growing use of the swap lines, the operations failed to distinguish between temporary and fundamental disequilibrium forces. In substituting temporary for fundamental adjustments, the lines ultimately proved inadequate.
    Keywords: Bretton Woods Agreements Act ; Financial markets ; Monetary policy ; International finance
    Date: 2012

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