nep-cba New Economics Papers
on Central Banking
Issue of 2017‒02‒26
twenty papers chosen by
Maria Semenova
Higher School of Economics

  1. Back-testing European stress tests By B. Camara; P. Pessarossi; T. Philippon
  2. Tight Money-Tight Credit: Coordination Failure in the Conduct of Monetary and Financial Policies By Julio A. Carrillo; Enrique G. Mendoza; Victoria Nuguer; Jessica Roldán-Peña
  3. Capital Regulation: Less Really Can Be More When Incentives Are Socially Aligned By Joseph P. Hughes
  4. The Effect of Supranational Banking Supervision on the Financial Sector: Event Study Evidence from Europe By Loipersberger, Florian
  5. Banking Regulation and Market Making By David A. Cimon; Corey Garriott
  6. Inside asset purchase programs: the effects of unconventional policy on banking competition By Koetter, Michael; Podlich, Natalia; Wedow, Michael
  7. The Macroeconomic Effects of Government Asset Purchases: Evidence from Postwar US Housing Credit Policy By Andrew Fieldhouse; Karel Mertens; Morten O. Ravn
  8. The Anatomy of Financial Vulnerabilities and Crises By Seung Jung Lee; Kelly E. Posenau; Viktors Stebunovs
  9. Low inflation in the euro area: Causes and consequences By Ciccarelli, Matteo; Osbat, Chiara
  10. Asymmetric Exchange Rate Policy in Inflation Targeting Developing Countries By Ahmet Benlialper; Hasan Cömert; Nadir Öcal
  11. Monetary Policy and the Predictability of Nominal Exchange Rates By Martin Eichenbaum; Benjamin K. Johannsen; Sergio Rebelo
  12. How Tolerant Should Inflation-Targeting Central Banks Be? Selecting the Proper Tolerance Band - Lessons from Sweden By Andersson, Fredrik N. G.; Jonung, Lars
  13. Inflation expectations and monetary policy surprises By Elena Andreou; Snezana Eminidou; Marios Zachariadis
  14. Circumventing the Zero Lower Bound with Monetary Policy Rules Based on Money By Michael T. Belongia; Peter N. Ireland
  15. Ambiguity, Monetary Policy and Trend Inflation By Ricardo M. Masolo; Francesca Monti
  16. Model Uncertainty and the Direction of Fit of the Postwar U.S. Phillips Curve(s) By Francesca Rondina
  17. International Inflation Spillovers Through Input Linkages By Raphael A. Auer; Andrei A. Levchenko; Philip Sauré
  18. Domestic banks as lightning rods? Home bias during the Eurozone crisis By Orkun Saka
  19. Pandemic crises in financial systems: a simulation-model to complement stress-testing frameworks. By J. Idier; T. Piquard
  20. Global Risk and Demand for Gold by Central Banks By Gopalakrishnan, Balagopal; Mohapatra, Sanket

  1. By: B. Camara; P. Pessarossi; T. Philippon
    Abstract: We provide a first evaluation of the quality of banking stress tests in the European Union. We use stress tests scenarios and banks’ estimated losses to recover bank level exposures to macroeconomic factors. Once macro outcomes are realized, we predict banks’ losses and compare them to actual losses. We find that stress tests are informative. Model-based losses are good predictors of realized losses and of banks’ equity returns around announcements of macroeconomic news. When we perform our tests for the Union as a whole, we do not detect biases in the construction of the scenarios, or in the estimated losses across banks of different sizes and ownership structures. There is, however, some evidence that exposures are underestimated in countries with ex-ante weaker banking systems. Our results have implications for the modeling of credit losses, quality controls of supervision, and the political economy of financial regulation.
    Keywords: stress test, credit losses, back-testing.
    JEL: E2 G2 N2
    Date: 2017
  2. By: Julio A. Carrillo; Enrique G. Mendoza; Victoria Nuguer; Jessica Roldán-Peña
    Abstract: Quantitative analysis of a New Keynesian model with the Bernanke-Gertler accelerator and risk shocks shows that violations of Tinbergen’s Rule and strategic interaction between policymaking authorities undermine significantly the effectiveness of monetary and financial policies. Separate monetary and financial policy rules, with the latter subsidizing lenders to encourage lending when credit spreads rise, produce higher welfare and smoother business cycles than a monetary rule augmented with credit spreads. The latter yields a tight money-tight credit regime in which the interest rate responds too much to inflation and not enough to adverse credit conditions. Reaction curves for the choice of policy-rule elasticity that minimizes each authority’s loss function given the other authority’s elasticity are nonlinear, reflecting shifts from strategic substitutes to complements in setting policy-rule parameters. The Nash equilibrium is significantly inferior to the Cooperative equilibrium, both are inferior to a first-best outcome that maximizes welfare, and both produce tight money-tight credit regimes.
    JEL: E3 E44 E52 G18
    Date: 2017–02
  3. By: Joseph P. Hughes (Rutgers University)
    Abstract: Capital regulation has become increasingly complex as the largest financial institutions arbitrage differences in requirements across financial products to increase expected return for any given amount of regulatory capital, as financial regulators amend regulations to reduce arbitrage opportunities, and as financial institutions innovate to escape revised regulations – a regulatory dialectic. This increasing complexity makes monitoring bank risk-taking by markets and regulators more difficult and does not necessarily improve the risk sensitivity of measures of capital adequacy. Explaining the arbitrage incentive of some banks, several studies have found evidence of dichotomous capital strategies for maximizing value: a relatively low-risk strategy that minimizes the potential for financial distress to protect valuable investment opportunities and a relatively high-risk strategy that, in the absence distress costs due to valuable investment opportunities, “reaches for yield” to exploit the option value of implicit and explicit deposit insurance. In the latter case, market discipline rewards risk-taking and, in doing so, tends to undermine financial stability. The largest financial institutions, belonging to the latter category, maximize value by arbitraging capital regulations to “reach for yield.” This incentive can be curtailed by imposing “pre-financial-distress” costs that make less risky capital strategies optimal for large institutions. Such potential costs can be created by requiring institutions to issue contingent convertible debt (COCOs) that converts to equity to recapitalize the institution well before insolvency. The conversion rate significantly dilutes existing shareholders and makes issuing new equity a better than than conversion. The trigger for conversion is a particular market-value capital ratio. Thus, the threat of conversion tends to reverse risk-taking incentives – in particular, the incentive to increase financial leverage and to arbitrage differences in capital requirement across investments.
    Keywords: banking, capital regulation, contingent convertible debt
    JEL: G21 G28
    Date: 2017–02–22
  4. By: Loipersberger, Florian
    Abstract: This paper investigates how the introduction of the Single Supervisory Mechanism, the European Union’s implementation of harmonized banking supervision, has affected the banking sector in Europe. I perform an event study on banks’ stock returns and find evidence for small but significant positive effects. A potential hypothesis for this result is the fact that a single supervisory authority can take spillover effects between countries into account and is therefore able to stabilize the European banking sector. Splitting the sample by an indicator for supervisory power, an indicator for corruption and by Debt/GDP reveals that the positive impact of the SSM was stronger for banks in countries that perform poorly with respect to these measures.
    Keywords: Banks; event study; supervision; SSM; harmonization
    JEL: G28 H77 F55
    Date: 2017–02
  5. By: David A. Cimon; Corey Garriott
    Abstract: We present a model of market makers subject to recent banking regulations: liquidity and capital constraints in the style of Basel III and a position limit in the style of the Volcker Rule. Regulation causes market makers to reduce their intermediation by refusing principal positions. However, it can improve the bid-ask spread because it induces new market makers to enter. Since market makers intermediate less, asset prices exhibit a liquidity premium. Costs of regulation can be assessed by measuring principal positions and asset prices but not by measuring bid-ask spreads.
    Keywords: Financial markets, Financial system regulation and policies, Market structure and pricing
    JEL: G14 G20 L10
    Date: 2017
  6. By: Koetter, Michael; Podlich, Natalia; Wedow, Michael
    Abstract: We test if unconventional monetary policy instruments influence the competitive conduct of banks. Between q2:2010 and q1:2012, the ECB absorbed €218 billion worth of government securities from five EMU countries under the Securities Markets Programme (SMP). Using detailed security holdings data at the bank level, we show that banks exposed to this unexpected (loose) policy shock mildly gained local loan and deposit market shares. Shifts in market shares are driven by banks that increased SMP security holdings during the lifetime of the program and that hold the largest relative SMP portfolio shares. Holding other securities from periphery countries that were not part of the SMP amplifies the positive market share responses. Monopolistic rents approximated by Lerner indices are lower for SMP banks, suggesting a role of the SMP to re-distribute market power differentially, but not necessarily banking profits. JEL Classification: C30, C78, G21, G28, L51
    Keywords: competition, security markets program, unconventional monetary policy
    Date: 2017–02
  7. By: Andrew Fieldhouse; Karel Mertens; Morten O. Ravn
    Abstract: We document the portfolio activity of federal housing agencies and provide evidence on its impact on mortgage markets and the economy. Through a narrative analysis, we identify historical policy changes leading to expansions or contractions in agency mortgage holdings. Based on those regulatory events that we classify as unrelated to short-run cyclical or credit market shocks, we find that an increase in mortgage purchases by the agencies boosts mortgage lending and lowers mortgage rates. Agency purchases influence prices in other asset markets and stimulate residential investment. Using information in GSE stock prices to construct an alternative instrument for agency purchasing activity yields very similar results as our benchmark narrative identification approach.
    JEL: E44 E5 G28 R38
    Date: 2017–02
  8. By: Seung Jung Lee; Kelly E. Posenau; Viktors Stebunovs
    Abstract: We extend the framework used in Aikman, Kiley, Lee, Palumbo, and Warusawitharana (2015) that maps vulnerabilities in the U.S. financial system to a broader set of advanced and emerging economies. Our extension tracks a broader set of vulnerabilities and, therefore, captures signs of different types of crises. The typical anatomy of the evolution of vulnerabilities before and after a financial crisis is as follows. Pressures in asset valuations materialize, and a build-up of imbalances in the external, financial, and nonfinancial sectors follows. A financial crisis is typically followed by a build-up of sovereign debt imbalances as the government tries to deal with the consequences of the crisis. Our early warnings indicators which aggregate these vulnerabilities predict banking crises better than the Credit-to-GDP gap at long horizons. Our indicators also predict the severity of banking crises and the duration of recessions, as they take into account possible spill-over and amplification channels of financial stress to from one to another sector in the economy. Our indicators are of relevance for macroprudential and crisis management, in part, because they perform better than the Credit-to-GDP gap and do not suffer from the gaps econometric flaws.
    Keywords: Credit-to-GDP gap ; Crisis management ; Financial vulnerabilities ; Early warning system ; Financial crises ; Banking crises ; Currency crises ; Macroprudential policy
    JEL: C82 D14 G01 G12 G21 G23 G32 H63
    Date: 2017–02
  9. By: Ciccarelli, Matteo; Osbat, Chiara
    Abstract: After 2012, inflation has been unexpectedly low across much of the developed world and economists speak of a “missing inflation” puzzle, namely inflation was expected to be higher on the back of an ongoing recovery. This paper investigates the causes and consequences of low inflation in the euro area after 2012 and analyses whether monetary policy has been successful in dampening the risks associated to low inflation. The paper finds that the missing inflation was primarily due to cyclical factors – domestic in the earlier part of the period and global in the latter part – and that the Phillips curve remains a useful tool in understanding inflation dynamics over the period of interest. The succession of negative shocks constrained headline inflation for a prolonged period, and there is evidence of an increase in the persistence of inflation and a fall in the trend inflation rate, which had begun to have a greater influence on longer-term inflation expectations. This may have signalled uncertainty over the effectiveness of unconventional monetary policy measures, but public belief in the ECB’s commitment to keep the annual rate of HICP inflation below but close to 2% has remained intact. The paper concludes that unconventional monetary policy measures are effective in mitigating the downside risks to price stability, curtailing risks of de-anchoring, and expanding aggregate demand. JEL Classification: E31, E52, E58
    Keywords: inflation expectations, low inflation, Phillips curve, unconventional monetary policy
    Date: 2017–01
  10. By: Ahmet Benlialper (Department of Economics, Middle East Technical University, Ankara, Turkey); Hasan Cömert (Department of Economics, Middle East Technical University, Ankara, Turkey); Nadir Öcal (Department of Economics, Middle East Technical University, Ankara, Turkey)
    Abstract: In the last decades, many developing countries abandoned their existing policy regimes and adopted inflation targeting (IT) by which they aimed to control inflation through the use of policy interest rates. During the period before the crisis, most of these countries experienced large appreciations in their currencies. Given that appreciation helps central banks curb inflationary pressures, we ask whether central banks in developing countries have different policy stances with respect to depreciation and appreciation in order to hit their inflation targets. To that end, we analyze central banks’ interest rate decisions by estimating a nonlinear monetary policy reaction function for a set of IT developing countries using a panel threshold model. Our findings suggest that during the period under investigation (2002-2008), central banks in developing countries implementing IT tolerated appreciation by remaining inactive in case of appreciation, but fought against depreciation pressures beyond some threshold. We are unable to detect a similar asymmetric response for IT advanced countries suggesting that asymmetric policy stance is peculiar to IT developing countries. Although there is a vast literature on asymmetric responses of various central banks to changes in inflation and output, asymmetric stance with regards to exchange rate has not been analyzed yet in a rigorous way especially within the context of IT developing countries. In this sense, our study is the first in the literature and thus is expected to fill an important gap.
    Keywords: Inflation Targeting, Central Banking, Developing Countries, Exchange Rates
    JEL: E52 E58 E31 F31
    Date: 2017–02
  11. By: Martin Eichenbaum; Benjamin K. Johannsen; Sergio Rebelo
    Abstract: This paper documents two facts about the behavior of floating exchange rates in countries where monetary policy follows a Taylor-type rule. First, the current real exchange rate is highly negatively correlated with future changes in the nominal exchange rate at horizons greater than two years. This negative correlation is stronger the longer is the horizon. Second, for most countries, the real exchange rate is virtually uncorrelated with future inflation rates both in the short and in the long run. We develop a class of models that can account for these and other key observations about real and nominal exchange rates.
    JEL: E52 F31 F41
    Date: 2017–02
  12. By: Andersson, Fredrik N. G. (Department of Economics, Lund University); Jonung, Lars (Department of Economics, Lund University)
    Abstract: Should an inflation-targeting central bank have an explicit tolerance band around its inflation target? This paper provides an answer derived from the Swedish experience. The Riksbank is exceptional in the sense that it first adopted and later abolished an explicit band and is currently considering bringing it back. We conclude that the band should be explicit for several reasons. Most important, an inflation-targeting central bank should be open and transparent to the public regarding its actual ability to control inflation. We discuss how a numerical measure of the proper width of the band can be constructed to foster communication and credibility.
    Keywords: inflation targeting; tolerance band; tolerance interval; monetary policy; the Riksbank; Sweden
    JEL: E30 E31 E58
    Date: 2017–02–13
  13. By: Elena Andreou; Snezana Eminidou; Marios Zachariadis
    Abstract: We use monthly data across fifteen euro-area economies for the period 1985:1-2015:3 to obtain monetary policy changes that can be regarded as surprises for different types of consumers. A novel feature of our empirical approach is the estimation of monetary policy surprises based on changes in monetary policy that were unanticipated according to the consumers stated beliefs about the economy. We go on to investigate how these monetary policy surprises affect consumers’ inflation expectations. We find that such monetary policy surprises can have the opposite impact on inflation expectations to those obtained under the assumption that consumers are well informed about a set of macroeconomic variables describing the state of the economy. More specifically, when we relax the assumption of well informed consumers by focusing instead on their stated beliefs about the economy, unanticipated increases in the interest rate raise inflation expectations. This is consistent with imperfect information theoretical settings where unanticipated increases in interest rates are interpreted as positive news about the state of the economy by consumers that know policymakers have relatively more information. This impact changes sign since the Crisis.
    Keywords: Inflation; Expectations; Unanticipated; Monetary policy; Beliefs; Crisis
    JEL: E31 E52 F41
    Date: 2017–01
  14. By: Michael T. Belongia; Peter N. Ireland
    Abstract: Discussions of monetary policy rules after the 2007-2009 recession highlight the potential ineffectiveness of a central bank’s actions when the short-term interest rate under its control is limited by the zero lower bound. This perspective assumes, in a manner consistent with the canonical New Keynesian model, that the quantity of money has no role to play in transmitting a central bank’s actions to economic activity. This paper examines the validity of this claim and investigates the properties of alternative monetary policy rules based on control of the monetary base or a monetary aggregate in lieu of the capacity to manipulate a short-term interest rate. The results indicate that rules of this type have the potential to guide monetary policy decisions toward the achievement of a long-run nominal goal without being constrained by the zero lower bound on a nominal interest rate. They suggest, in particular, that by exerting its influence over the monetary base or a broader aggregate, the Federal Reserve could more effectively stabilize nominal income around a long-run target path, even in a low or zero interest-rate environment.
    JEL: E31 E32 E37 E42 E51 E52 E58
    Date: 2017–02
  15. By: Ricardo M. Masolo (Bank of England; Centre for Macroeconomics (CFM)); Francesca Monti (Bank of England; Centre for Macroeconomics (CFM))
    Abstract: Allowing for ambiguity, or Knightian uncertainty, about the behavior of the policy-maker helps explain the evolution of trend in ation in the US in a simple new-Keynesian model, without resorting to exogenous changes in the in ation target. Using Blue Chip survey data to gauge the degree of private sector confidence, our model helps reconcile the difference between target in ation and the in ation trend measured in the data. We also show how, in the presence of ambiguity, it is optimal for policymakers to lean against the private sectors pessimistic expectations.
    Keywords: Ambiguity Aversion, Monetary Policy, Trend Inflation
    JEL: D84 E31 E43 E52 E58
    Date: 2017–02
  16. By: Francesca Rondina (Department of Economics, University of Ottawa, Ottawa, ON)
    Abstract: This paper proposes a model uncertainty framework that accounts for the uncertainty about both the specification of the Phillips curve and the identification assumption to be used for parameter estimation. More specifically, the paper extends the framework employed by Cogley and Sargent (2005) to incorporate uncertainty over the direction of fit of the Phillips curve. I first study the evolution of the model posterior probabilities, which can be interpreted as a measure of the econometrician's real-time beliefs over the prevailing model of the Phillips curve. I then characterize the optimal policy rule within each model, and I analyze alternative policy recommendations that incorporate model uncertainty. As expected, different directions of fit of the same model of the Phillips curve imply very different optimal policy choices, with the “Classical” specifications typically suggesting low and stable optimal inflation rates. I also find that allowing rational agents to incorporate model uncertainty in their expectations does not change the optimal or robust policies. On the other hand, I show that the models' fit to the data and the robust policy recommendations are affected by the specific price index that is used to measure in inflation.
    Keywords: Phillips curve, Model Uncertainty, Robust Policy, Bayesian Model Averaging, Expectations
    JEL: C52 E37 E52 E58
    Date: 2017
  17. By: Raphael A. Auer; Andrei A. Levchenko; Philip Sauré
    Abstract: We document that observed international input-output linkages contribute substantially to synchronizing producer price inflation (PPI) across countries. Using a multi-country, industry-level dataset that combines information on PPI and exchange rates with international and domestic input-output linkages, we recover the underlying cost shocks that are propagated internationally via the global input-output network, thus generating the observed dynamics of PPI. We then compare the extent to which common global factors account for the variation in actual PPI and in the underlying cost shocks. Our main finding is that across a range of econometric tests, input-output linkages account for half of the global component of PPI inflation. We report three additional findings: (i) the results are similar when allowing for imperfect cost pass-through and demand complementarities; (ii) PPI synchronization across countries is driven primarily by common sectoral shocks and input-output linkages amplify co-movement primarily by propagating sectoral shocks; and (iii) the observed pattern of international input use preserves fat-tailed idiosyncratic shocks and thus leads to a fat-tailed distribution of inflation rates, i.e., periods of disinflation and high inflation.
    Keywords: international inflation synchronization, globalisation, inflation, input linkages, monetary policy, global value chain, production structure, input-output linkages, supply chain
    JEL: E31 E52 E58 F02 F14 F33 F41 F42 F62
    Date: 2017
  18. By: Orkun Saka
    Abstract: Governments and domestic banks in Europe have attracted criticism due to the heightening inclination of banks to hold more local sovereign debt in the midst of the crisis. This has traditionally been interpreted as an evidence of financial repression or moral suasion. By using a novel dataset on bank-level exposures to sovereign and private debt covering the entire Eurozone crisis, I confirm that sovereign debt has been reallocated from foreign to domestic banks at the peak of the crisis. Furthermore, this reallocation has been especially visible for banks as opposed to other domestic private agents and cannot be explained by the risk-shifting tendency of the banks located in troubled countries. However, in contrast to the previous literature focusing only on sovereign debt, I show that banks’ private sector exposures have suffered (at least) equally from a rising home bias. Finally, I present a direct information channel and demonstrate that foreign banks – free from moral suasion – located in informationally closer territories have relatively increased their exposures to crisis-countries.
    Keywords: Home bias, Information asymmetries, Eurozone crisis, Sovereign debt
    JEL: F21 F34 F36 G01 G11 G21
    Date: 2017–02
  19. By: J. Idier; T. Piquard
    Abstract: We propose in this paper a simulation framework of pandemic in financial system composed of banks, asset markets and interbank markets. This framework aims at complementing the usual stress-test strategies that evaluate the impact of shocks on individual balance-sheets without taking into account the interactions between several components of the financial system. We build on the network model of Gourieroux, Heam, and Monfort (2012) for the banking system, adding some asset market channels as in Greenwood, Landier, and Thesmar (2015) and interbank markets characterized by collateralized debt and margin calls. We show that rather small shocks can be amplified and destabilize the entire financial system. In our framework, the fact that the system enters in an adverse situation comes from first round losses amplification triggered by asset depreciation, interbank contraction and bank failures in chain. From our simulations, we explain how the different channels of transmission play a role in weakening the financial system, and measure the extent to which each channel could make banks more vulnerable.
    Keywords: Bank network, systemic risk, contagion, stress-testing
    JEL: E52 E44 G12 C58
    Date: 2017
  20. By: Gopalakrishnan, Balagopal; Mohapatra, Sanket
    Abstract: This paper examines the influence of global risk on the holding of gold by central banks based on annual data for 100 countries during 1990-2015. We use a dynamic panel generalized method of moments (GMM) model to estimate this effect, controlling for a variety of domestic factors. Consistent with portfolio diversification and perception of gold as a safe asset, we find that the gold holdings of central banks increase in response to higher global risk. This effect is larger for high-income countries than for developing countries. Moreover, greater capital account openness is associated with a stronger response of central banks’ gold holding to global risk, while a higher ratio of overall reserves to imports is associated with a weaker response. We also find evidence that the sensitivity depends on whether the currency regime followed is fixed or floating, with higher responsiveness in the case of fixed rate regimes. The baseline results are robust to alternate estimation methods, exclusion of crisis years, active and passive management of gold reserves and additional controls. These findings suggest that central banks adjust their gold holdings in response to changes in global risk conditions, with the magnitude of response depending on reserve management capacity and country-specific vulnerabilities.

This nep-cba issue is ©2017 by Maria Semenova. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
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