nep-cba New Economics Papers
on Central Banking
Issue of 2013‒04‒13
twenty-two papers chosen by
Maria Semenova
Higher School of Economics

  1. Credit Risks and Monetary Policy Trade-Offs By Kevin x.d. Huang; J. scott Davis
  2. Understanding Financial Crises: Causes, Consequences, and Policy Responses By Claessens, Stijn; Kose, Ayhan; Laeven, Luc; Valencia, Fabian
  3. Capital, Trust and Competitiveness in the Banking Sector By Gehrig, Thomas
  4. Macroprudential Policy and Its Instruments in a Small EU Economy By Jan Frait; Zlatuse Komarkova
  5. The mystique surrounding the central bank’s balance sheet, applied to the European crisis By Reis, Ricardo
  6. Long Term Government Debt, Financial Fragility and Sovereign Default Risk By Christiaan van der Kwaak; Sweder van Wijnbergen
  7. Capital Flows and the Risk-Taking Channel of Monetary Policy By Valentina Bruno; Hyun Song Shin
  8. Monetary Policy and Rational Asset Price Bubbles By Galí, Jordi
  9. Financial Crises: Explanations, Types, and Implications By Claessens, Stijn; Kose, Ayhan
  10. Finance at Center Stage: Some Lessons of the Euro Crisis By Obstfeld, Maurice
  11. How Optimal is US Monetary Policy? By Chen, Xiaoshan; Kirsanova, Tatiana; Leith, Campbell
  12. Three Sisters: The Interlinkage between Sovereign Debt, Currency and Banking Crises By Eijffinger, Sylvester C W; Karatas, Bilge
  13. Sovereign Default Risk in the Euro-Periphery and the Euro-Candidate Countries By Gabrisch, Hurbert; Orlowski, Lucjan; Pusch, Toralf
  14. Financial Development in 205 Economies, 1960 to 2010 By Martin Čihák; Asli Demirgüč-Kunt; Erik Feyen; Ross Levine
  15. Short and Long Interest Rate Targets By Pedro Teles; Isabel Correia; Bernardino Adao
  16. Determinants of sovereign debt yield spreads under EMU: Pairwise approach By Fazlioglu S.
  17. A new data set on competition in national banking markets By Sofronis Clerides; Manthos D. Delis; Sotirios Kokas
  18. The Recent Dynamics of Public Debt in the European Union: A Matter of Fundamentals or the Result of a Failed Monetary Experiment? By Paulo R. Mota; Abel L. Costa Fernandes; Ana-Cristina Nicolescu
  19. International monetary transmission to the Euro area: Evidence from the U.S., Japan and China By Vespignani, Joaquin L.; Ratti, Ronald A
  20. What causes banking crises? An empirical investigation for the world economy By Le, Vo Phuong Mai; Meenagh, David; Minford, Patrick; Ou, Zhirong
  21. Is Debt Overhang a Problem for Monetray Policy? By James Bullard; Jacek Suda; Aarti Singh; Costas Azariadis
  22. Inadequate Regional Financial Safety Nets Reflect Complacency By Iwan J. Azis

  1. By: Kevin x.d. Huang (Vanderbilt University); J. scott Davis (Federal Reserve Bank of Dallas)
    Abstract: Financial frictions and …financial shocks can affect the trade-off between inflation stabilization and output-gap stabilization faced by a central bank. Financial frictions lead to a greater response in output following any deviation of inflation from target and thus lead to an increase in the sacrifice ratio. As a result, optimal monetary policy in the face of credit frictions is to allow greater output gap instability in return for greater inflation stability. Such a shift in optimal monetary policy can be mimicked in a Taylor-type interest rate feedback rule that shifts weight to inflation and the lagged interest rate and away from output. However, the ability of the conventional Taylor rule to mimic optimal policy gets worse as credit market frictions and shocks intensify. By including a …financial variable like the lending spread in the monetary policy rule, the central bank can partially reverse this worsening output-inflation trade-off brought about by financial frictions and partially undo the effects of credit market frictions and shocks. Thus the central bank may want to include lending spreads in the policy rule even when …financial distortions are not explicitly part of the central bank's objective function.
    Keywords: Credit friction; Credit shock; Credit spread; Monetary policy trade-offs; Taylor rule
    JEL: E0 G0
    Date: 2013–03–25
  2. By: Claessens, Stijn; Kose, Ayhan; Laeven, Luc; Valencia, Fabian
    Abstract: The global financial crisis of 2007-09 has led to an intensive research program analyzing a wide range of issues related to financial crises. This paper presents a summary of a forthcoming book, Financial Crises: Causes, Consequences, and Policy Responses, that includes 19 contributions examining these issues and distilling policy lessons. The book covers a wide range of crises, including banking, balance-of-payments, and sovereign debt crises. It reviews the typical patterns prior to crises, considers lessons on their antecedents, and analyzes their evolution and aftermath. It also provides valuable policy lessons on how to prevent, contain and manage financial crises.
    Keywords: asset price busts; banking crises; credit busts; currency crises; debt crises; defaults; global financial crisis; prediction of crises; restructuring; sudden stops; welfare cost
    JEL: E32 E5 E6 F44 G01 H12
    Date: 2013–01
  3. By: Gehrig, Thomas
    Abstract: This note critically assesses the Basel reform process of capital regulation. It highlights the political nature of this process and argues that the absence of clearly spelled-out societal objectives has been detrimental in furthering stability and soundness of the banking systems in the run-up of the 2007/8 financial crisis. The positive externalities of bank capital have not hitherto been explicitly been taken into consideration.
    Keywords: bank capital; Basel process of capital regulation; trust
    JEL: E58 G01 G21 H63
    Date: 2013–02
  4. By: Jan Frait; Zlatuse Komarkova
    Abstract: This paper focuses on the way the macroprudential policy framework in a small EU economy should be designed. With reference to the experience of the Czech Republic's financial system and the Czech National Bank it provides definitions of financial stability and macroprudential policy as well as of their objectives. It then explains how systemic risk evolves over the financial cycle and outlines approaches to preventing systemic risk in the accumulation stage of the cycle and subsequently mitigating the materialisation of such risk if prevention fails. The paper argues that for the establishment of a macroprudential policy framework in a bank-based economy with a relatively simple and small financial sector, the phenomenon of procyclical behaviour has to stand centrally. Correspondingly, a macroprudential authority in such an economy has to look primarily at cyclically induced sources of systemic risks. Nevertheless, structural sources of systemic risks and associated instruments are discussed as well. The arguments for the recommended arrangements are supported by empirical investigations into the extent of procyclicality in European banks' lending behaviour and the contribution of the regulatory and accounting framework to it.
    Keywords: Financial stability, macroprudential policy, monetary policy, procyclicality, systemic risk.
    JEL: E52 E58 E61 G12 G18
    Date: 2012–12
  5. By: Reis, Ricardo
    Abstract: In spite of the mystique behind a central bank’s balance sheet, its resource constraint bounds the dividends it can distribute by the present value of seignorage, which is a modest share of GDP. Moreover, the statutes of the Federal Reserve or the ECB make it difficult for it to redistribute resources across regions. In a simple model of sovereign default, where multiple equilibria arise if debt repudiation lowers fiscal surpluses, the central bank may help to select one equilibrium. The central bank’s main lever over fundamentals is to raise inflation, but otherwise the balance sheet gives it little leeway.
    Keywords: central bank capital; Eurosystem; seignorage; sovereign debt crisis
    JEL: E58 F34
    Date: 2013–02
  6. By: Christiaan van der Kwaak (University of Amsterdam); Sweder van Wijnbergen (University of Amsterdam)
    Abstract: We analyze the interaction between bank rescues, financial fragility and sovereign debt discounts. We construct a model that contains balance sheet constrained financial intermediaries financing both capital expenditure of intermediate goods producers and government deficits. The financial intermediaries face the risk of a (partial) default of the government on its debt obligations. We analyse the impact of a financial crisis, first under full government credibility and then with an endogenous sovereign debt discount. The introduction of the default possibility does not have any impact IF all government debt is short term. Interest rates on debt reflect higher default probabilities, but because all debt is short term, bank balance sheets are unaffected and no further negative effects arise through the endogenous sovereign debt channel. But once long term government debt is introduced, the possibility of capital losses on bank balance sheets arises. Then o utcomes significantly deteriorate compared to the short term debt only case. Higher interest rates on new debt lead to capital losses on banks' holding of existing long term government debt. The associated increase in credit tightness leads to a negative amplification effect, significantly increasing output losses and declines in investment after a financial crisis. This causes potentially conflicting macroeconomic effects of a debt financed recapitalization of banks. We investigate the case where the government announces a bankrecapitalization to occur 4 quarters after announcement. Under the parameter values chosen, the positive effects from an anticipated capital injection dominate the effects of the associated increase in sovereign default risk.
    Keywords: Financial Intermediation; Macrofinancial Fragility; Fiscal Policy; Sovereign Default Risk
    JEL: E44 E62 H30
    Date: 2013–04–02
  7. By: Valentina Bruno; Hyun Song Shin
    Abstract: We study the dynamics linking monetary policy with bank leverage and show that adjustments in leverage act as the linchpin in the monetary transmission mechanism that works through fluctuations in risk-taking. Motivated by the evidence, we formulate a model of the "risk-taking channel" of monetary policy in the international context that rests on the feedback loop between increased leverage of global banks and capital flows amid currency appreciation for capital recipient economies.
    JEL: E5 F32 F33 F34 G21
    Date: 2013–04
  8. By: Galí, Jordi
    Abstract: I examine the impact of alternative monetary policy rules on a rational asset price bubble, through the lens of an overlapping generations model with nominal rigidities. A systematic increase in interest rates in response to a growing bubble is shown to enhance the fluctuations in the latter, through its positive effect on bubble growth. The optimal monetary policy seeks to strike a balance between stabilization of the bubble and stabilization of aggregate demand. The paper's main findings call into question the theoretical foundations of the case for "leaning against the wind" monetary policies.
    Keywords: Asset price volatility; Leaning against the wind policies; Monetary policy rules; Stabilization policies
    JEL: E44 E52
    Date: 2013–02
  9. By: Claessens, Stijn; Kose, Ayhan
    Abstract: This paper reviews the literature on financial crises focusing on three specific aspects. First, what are the main factors explaining financial crises? Since many theories on the sources of financial crises highlight the importance of sharp fluctuations in asset and credit markets, the paper briefly reviews theoretical and empirical studies on developments in these markets around financial crises. Second, what are the major types of financial crises? The paper focuses on the main theoretical and empirical explanations of four types of financial crises—currency crises, sudden stops, debt crises, and banking crises—and presents a survey of the literature that attempts to identify these episodes. Third, what are the real and financial sector implications of crises? The paper briefly reviews the short- and medium-run implications of crises for the real economy and financial sector. It concludes with a summary of the main lessons from the literature and future research directions.
    Keywords: asset booms; banking crises; credit booms; crises prediction; currency crises; debt crises; defaults; financial restructuring; policy implications; Sudden stops
    JEL: E32 E5 E6 F44 G01 H12
    Date: 2013–02
  10. By: Obstfeld, Maurice
    Abstract: Because of recent economic crises, financial fragility has regained prominence in both the theory and practice of macroeconomic policy. Consistent with macroeconomic paradigms prevalent at the time, the original architecture of the euro zone assumed that safeguards against inflation and excessive government deficits would suffice to guarantee macroeconomic stability. Recent events, in both Europe and the industrial world at large, challenge this assumption. After reviewing the roots of the euro crisis in financial-market developments, this essay draws some conclusions for the reform of euro area institutions. The euro area is moving quickly to correct one flaw in the Maastricht treaty, the vesting of all financial supervisory functions with national authorities. However, the sheer size of bank balance sheets suggest that the euro area must also confront a financial/fiscal trilemma: countries in the euro zone can no longer enjoy all three of financial integration with other member states, financial stability, and fiscal independence, because the costs of banking rescues may now go beyond national fiscal capacities. Thus, plans to reform the euro zone architecture must combine centralized supervision with some centralized fiscal backstop to finance bank resolution and deposit insurance.
    Keywords: banking union; euro crisis; financial stability; trilemma
    JEL: E44 F36 G15 G21
    Date: 2013–04
  11. By: Chen, Xiaoshan; Kirsanova, Tatiana; Leith, Campbell
    Abstract: Most of the literature estimating DSGE models for monetary policy analysis assume that policy follows a simple rule. In this paper we allow policy to be described by various forms of optimal policy - commitment, discretion and quasi-commitment. We find that, even after allowing for Markov switching in shock variances, the inflation target and/or rule parameters, the data preferred description of policy is that the US Fed operates under discretion with a marked increase in conservatism after the 1970s. Parameter estimates are similar to those obtained under simple rules, except that the degree of habits is significantly lower and the prevalence of cost-push shocks greater. Moreover, we find that the greatest welfare gain sfrom the 'Great Moderation' arose from the reduction in the variances in shocks hitting the economy, rather than increased inflation aversion. However, much of the high inflation of the 1970s could have been avoided had policy makers been able to commit, even without adopting stronger anti-inflation objectives. More recently the Fed appears to have temporarily relaxed policy following the 1987 stock market crash, and has lost, without regaining, its post-Volcker conservatism following the bursting of the dot-com bubble in 2000.
    Keywords: Discretion; Commitment; Great Moderation; Optimal Monetary Policy; Interest Rate Rules; Bayesian Estimation
    Date: 2013–05
  12. By: Eijffinger, Sylvester C W; Karatas, Bilge
    Abstract: The sovereign debt default and the linkages from banking and currency crisis have been rarely explored in the crisis literature. This study attempts to dive into this unexplored area by applying panel data binary choice model on a sample with 20 emerging countries having monthly observations for the years between 1985 and 2007. The non-linear linkages from currency and banking crises to sovereign defaults are explored by using the interactions of these crises with international illiquidity, appreciated real exchange rates and real international monetary policy rates. It is discovered that currency, banking and debt crises tend to occur simultaneously. Prior occurrence of a currency crisis increases the sovereign default probability through appreciated real exchange rates, and in countries with high short-term indebtedness the occurrence of banking crisis raises the probability of a debt crisis.
    Keywords: banking crisis; currency crisis; debt crisis; emerging markets
    JEL: F31 F41 G01 H63
    Date: 2013–03
  13. By: Gabrisch, Hurbert (Halle Institute for Economic Research); Orlowski, Lucjan (John F. Welch College of Business, Sacred Heart University); Pusch, Toralf (Halle Institute for Economic Research)
    Abstract: This study examines the key drivers of sovereign default risk in five euro area periphery countries and three euro-candidates that are currently pursuing independent monetary policies. We argue that the recent proliferation of sovereign risk premiums stems from both domestic and international sources. We focus on contagion effects of external financial crisis on sovereign risk premiums in these countries, arguing that the countries with weak fundamentals and fragile financial institutions are particularly vulnerable to such effects. The domestic fiscal vulnerabilities include: economic recession, less efficient government spending and a rising public debt. External ÔpushÕ factors entail increasing liquidity- and counter-party risks in international banking, as well as risk-hedging appetites of international investors embedded in local currency depreciation against the US Dollar. We develop a model capturing the internal and external determinants of sovereign risk premiums and test for the examined country groups. The results lead us to caution against premature fiscal consolidation in the aftermath of the global economic crisis, since such policy might actually worsen sovereign default risk. The model works well for the euro-periphery countries; it is less robust for the euro-candidates that upon a future euro adoption will have to pursue real economy growth oriented policies in order to mitigate a potential increase in sovereign default risk.
    Keywords: Sovereign Default Risk, Euro area, Public Debt, Liquidity Risk, Counter-party Risk.
    JEL: E43 E63 G12
    Date: 2012–08
  14. By: Martin Čihák; Asli Demirgüč-Kunt; Erik Feyen; Ross Levine
    Abstract: This paper describes our construction of the Global Financial Development Database and uses the data to compare financial systems around the world. The database provides information on financial systems in 205 economies over the period from 1960 to 2010 and includes measures of (1) size of financial institutions and markets (financial depth), (2) degree to which individuals and firms can and do use financial services (access), (3) efficiency of financial intermediaries and markets in intermediating resources and facilitating financial transactions (efficiency), and (4) stability of financial institutions and markets (stability).
    JEL: G00 G01 G10 G20 O16
    Date: 2013–04
  15. By: Pedro Teles (Banco de Portugal, Universidade Catolica); Isabel Correia (Banco de Portugal); Bernardino Adao (Banco de Portugal)
    Abstract: A target for the short-term nominal interest rate does not pin down realized inflation. Neither does it pin down the term premia. Short and long rates are threrefore independent monetary policy instruments. A target of the term structure is equivalent to a peg of the returns on state-contingent nominal assets. These are the rates that should be targeted in order to pin down realized inflation.
    Date: 2012
  16. By: Fazlioglu S. (GSBE)
    Abstract: This study aims at providing an empirical analysis of long-term determinants of sovereign debt yield spreads under European EMU (Economic and Monetary Union) through pairwise approach within panel framework. Panel gravity models are increasingly used in the cross-market correlation literature while to our knowledge, this is the first empirical study employing the method in the bond market literature. Accordingly, sovereign yield spreads are positively related to differential government debt ratio while negatively related to relative economic growth performance, differential liquidity of the individual debt markets as well as governance quality. Moreover, non-linear dynamic panel estimates indicate that markets seem to ignore fundamentals after the emerge of EMU while the very same risk factors are revalued by the markets after the 2008/2009 financial crisis. Furthermore, markets price fiscal indebtedness more among the EMU members than among the non-EMU members. Finally, the results of the dynamic panel model are robust to different estimation techniques such as GMM as well as sample selection.
    Keywords: National Debt; Debt Management; Sovereign Debt;
    Date: 2013
  17. By: Sofronis Clerides; Manthos D. Delis; Sotirios Kokas
    Abstract: We estimate the degree of competition in the banking sectors of 148 countries worldwide over the period 1997-2010. We employ three methods, namely those of Lerner (1934), Koetter, Kolari and Spierdijk (2012) and Boone (2008a). For the estimation of marginal cost required under all methods, we use the semi-parametric methodology of Delis (2012) that allows increasing the flexibility of the functional form imposed on the cost function. All three indices show that the competitive conditions in banking have deteriorated on average during the period 1997-2006. This trend reverses until 2008, while in 2009 and 2010 market power again increases. Thus, we provide evidence that the competitive conditions are correlated with financial stability. The empirical results also highlight important differences between regional and income groups of countries. On average, the banking systems of Sub-Saharan Africa and subsequently of East Asia and Pacific are the least competitive, while the banking systems of Europe and Central Asia and South Asia seem to be the most competitive ones. Further, the non-OECD countries characterized by either high- or low-income levels have less competitive banking sectors, while middle-income countries have more competitive banking sectors. For the OECD countries the results of the Lerner-type indices and the method by Boone (2008a) give conflicting results.
    Keywords: Bank competition, Semi-parametric estimation, World sample
    Date: 2013–03
  18. By: Paulo R. Mota (University of Porto – School of Economics and Business); Abel L. Costa Fernandes (University of Porto – School of Economics and Business); Ana-Cristina Nicolescu (West University of Timisoara – Faculty of Economics and Business Administration)
    Abstract: The idea that the present euro-zone sovereign debt crisis was caused by structural weaknesses degenerating into fundamental macroeconomic imbalances in the peripheral countries prevails among economists and politicians alike. We use quarterly data from 2000 to 2011 from the 27 European Union countries to uncover the main factors explaining the debt to GDP ratio dynamics. We also examine three possible determinants of that crisis: i) weak fundamentals; ii) inappropriate fiscal policies adopted by the governments at the beginning of the crisis; iii) unfavorable debt dynamics due to a sharp GDP contraction, coupled with substantial increases in the interest rates on government bonds. Except for the current account to GDP ratio, we fail to find any significant relationship between the fundamentals prior to the financial crisis, and the ensuing dynamics on both public debt to GDP, and interest rates on government bonds. We also reject any association between the initial fiscal policy response to the crisis and the following debt crisis. We conclude that the immediate explanation for the adverse debt dynamics unraveling after 2007 was the sharp GDP contraction which, in turn, induced unfavorable expectations by creditors causing higher interest rates charged on peripheral countries’ debt and a liquidity crisis.
    Keywords: eurozone; macroeconomic imbalances; sovereign debt crisis
    JEL: H2 H5 H6
    Date: 2012–09
  19. By: Vespignani, Joaquin L.; Ratti, Ronald A
    Abstract: There are marked differences in the effect of increases in monetary aggregates in China, Japan and the U.S. on Euro area economic and financial variables over 1999-2012. Increases in monetary aggregates in China are associated with significant increases in the world price of commodities and with increases in Euro area inflation, industrial production and exports. Results are consistent with shocks to China‟s M2 facilitating domestic growth with expansionary consequences for the Euro area economy. In contrast, increases in monetary aggregates in Japan are associated with significant appreciation of the Euro and decreases in Euro area industrial production and exports. Production of goods highly competitive with European goods in Japan and expenditure switching in Japan are consistent with the results. U.S. monetary expansion has relatively small effects on the Euro area over this period compared to results reported in the literature for earlier sample periods.
    Keywords: International monetary transmission, China‟s monetary aggregates, Euro area Commodity prices
    JEL: E40 E42 E52 E58
    Date: 2013–04–01
  20. By: Le, Vo Phuong Mai; Meenagh, David; Minford, Patrick; Ou, Zhirong
    Abstract: We add the Bernanke-Gertler-Gilchrist model to a world model consisting of the US, the Euro-zone and the Rest of the World in order to explore the causes of the banking crisis. We test the model against linear-detrended data and reestimate it by indirect inference; the resulting model passes the Wald test only on outputs in the two countries. We then extract the model’s implied residuals on unfi…ltered data to replicate how the model predicts the crisis. Banking shocks worsen the crisis but ‘traditional’ shocks explain the bulk of the crisis; the non-stationarity of the productivity shocks plays a key role. Crises occur when there is a ‘run’ of bad shocks; based on this sample Great Recessions occur on average once every quarter century. Financial shocks on their own, even when extreme, do not cause crises — provided the government acts swiftly to counteract such a shock as happened in this sample.
    Keywords: Banking; DSGE; Indirect Inference
    JEL: E0
    Date: 2013–03
  21. By: James Bullard (Federal Reserve Bank of St. Louis); Jacek Suda (Banque de France - Paris School of Economics); Aarti Singh (University of Sydney); Costas Azariadis (Dept of Economics)
    Abstract: The U.S economy has accumulated in recent years seemingly excessive levels of household debt. U.S monetary policy has responded to the situation by keeping real interest rates low. Critics of the low real interest rate policy contend that such a policy helps borrowers and punishes savers, thus delaying the necessary adjustment needed to return to balanced growth. We consider a macroeconomic setting which gives voice to these concerns. In the model, lifecycle considerations lead to a natural interaction between young borrowers and middle-aged lenders. Optimism concerning future income prospects will raise borrowing, but if the optimism later turns out to be unwarranted, households will have borrowed too much. We show that, in this setting, overhang drives real interest rates up, not down, and that policy attempts to keep rates lower may drag out the necessary adjustment to the balanced growth path, and lower lifecycle welfare. We compare these findings to recent contributions on debt overhang emphasizing exogenous debt constraints due to Eggertsson and Krugman(2010) and Guerrierri and Lorenzoni(2010).
    Date: 2012
  22. By: Iwan J. Azis (Asian Development Bank Institute (ADBI))
    Abstract: To the extent that financial contagion from the United States and the euro area crisis has occurred in Asia, this paper focuses on the importance of strengthening the regional financial safety nets. By conjecturing that efforts to prevent and manage a crisis are the essence of providing such safety nets, I argue that efforts made by ASEAN+3 officials, especially in the provision of liquidity support during a crisis, are far from adequate. The collapse of Lehman Brothers in the autumn of 2008 could be a game-changer in the global financial market, making the probability of financial contagion higher than ever before. Even with improved financial conditions and stronger regulations in ASEAN+3 member countries, contagion can and will strike. Making the Chiang Mai Initiative Multilateralization more effective is therefore urgent and critical.
    Keywords: Financial Safety Nets, regional, ASEAN+3, financial contagion, Chiang Mai Innitiative
    JEL: F15 F32 F33
    Date: 2013–03

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