nep-cba New Economics Papers
on Central Banking
Issue of 2017‒09‒10
sixteen papers chosen by
Maria Semenova
Higher School of Economics

  1. Dealing with time-inconsistency: Inflation targeting vs. exchange rate targeting By J. Scott Davis; Ippei Fujiwara; Jiao Wang
  2. Financial liberalization and long-run stability of money demand in Nigeria By Folarin, Oludele; Asongu, Simplice
  3. Fines for misconduct in the banking sector: What is the situation in the EU? By Götz, Martin R.; Tröger, Tobias H.
  4. Measuring the Stance of Monetary Policy in a Time-Varying By Fernando J. Pérez Forero
  5. Machine learning at central banks By Chakraborty, Chiranjit; Joseph, Andreas
  6. Leaning Against the Credit Cycle By Gelain, Paolo; Lansing, Kevin J.; Natvik, Gisele J.
  7. Employment, Wages and Optimal Monetary Policy By Martin Bodenstein; Junzhu Zhao
  8. Counterparty Credit Risk in OTC Derivatives under Basel III By Mabelle Sayah
  9. Capital Requirements and Bailouts By Perri, Fabrizio; Stefanidis, Georgios
  10. Too complex to work: A critical assessment of the bail-in tool under the European bank recovery and resolution regime By Tröger, Tobias H.
  11. Bail-ins and Bail-outs: Incentives, Connectivity, and Systemic Stability By Benjamin Bernard; Agostino Capponi; Joseph E. Stiglitz
  12. Why MREL won't help much: Minimum requirements for bail-in capital as insufficient remedy for defunct private sector involvement under the European bank resolution framework By Tröger, Tobias H.
  13. Leaning Against the Wind: The Role of Different Assumptions About the Costs By Lars E.O. Svensson
  14. Asymmetric Unemployment Fluctuations and Monetary Policy Trade-offs By Antoine Lepetit
  15. Informal one-sided target zone model and the Swiss franc By Yu-Fu Chen; Michael Funke; Richhild Moessner
  16. Monetary-Fiscal Interactions and the Euro Area's Malaise By Marek Jarociński; Bartosz Maćkowiak

  1. By: J. Scott Davis; Ippei Fujiwara; Jiao Wang
    Abstract: Abandoning an objective function with multiple targets and adopting single mandate can be an effective way for a central bank to overcome the classic time-inconsistency problem. We show that the choice of a particular single mandate depends on an economy’s level of trade openness and the credibility of the central bank. We begin with reduced form empirical results which show that as central banks become less credible they are more likely to adopt a pegged exchange rate, and crucially, the tendency to peg depends on trade openness. Then in a model where the central bank displays “loose commitment” we show that as central bank credibility falls, they are more likely to adopt either an inflation target or a pegged exchange rate. A relatively closed economy would adopt an inflation target to overcome the time-inconsistency problem, but a highly open economy would prefer an exchange rate peg.
    Keywords: Time-inconsistency, Commitment, Inflation target, Exchange rate peg, Tie-one’s-hands
    JEL: E50 E30 F40
    Date: 2017–08
  2. By: Folarin, Oludele; Asongu, Simplice
    Abstract: A stable money demand function is essential when using monetary aggregate as a monetary policy. Thus, there is need to examine the stability of the money demand function in Nigeria after the deregulation of the financial sector. To achieve this, the study employed CUSUM (cumulative sum) and CUSUMSQ (CUSUM squared) tests after using autoregressive distributive lag bounds test to determine the existence of a long run relationship between monetary aggregate and its determinant. Results of the study show that a long-run relationship holds and that the demand for money is stable in Nigeria. In addition, the inflation rate is found to be a better proxy for an opportunity variable when compared to interest rate. The main implication of the study is that interest rate is ineffective as a monetary policy instrument in Nigeria.
    Keywords: Stable; demand for money; bounds test
    JEL: C22 E41
    Date: 2017–06
  3. By: Götz, Martin R.; Tröger, Tobias H.
    Abstract: Bank regulators have the discretion to discipline banks by executing enforcement actions to ensure that banks correct deficiencies regarding safe and sound banking principles. We highlight the trade-offs regarding the execution of enforcement actions for financial stability. Following this we provide an overview of the differences in the legal framework governing supervisors' execution of enforcement actions in the Banking Union and the United States. After discussing work on the effect of enforcement action on bank behaviour and the real economy, we present data on the evolution of enforcement actions and monetary penalties by U.S. regulators. We conclude by noting the importance of supervisors to levy efficient monetary penalties and stressing that a division of competences among different regulators should not lead to a loss of efficiency regarding the execution of enforcement actions.
    Keywords: financial stability,banking supervision,banking regulation,bank sanctions,monetary penalties
    Date: 2017
  4. By: Fernando J. Pérez Forero (Central Reserve Bank of Peru)
    Abstract: The stance of monetary policy is a general interest for academics, policy makers and the private sector. The latter is not necessarily observable, since the Fed have used different monetary instruments at different points in time. This paper provides a measure of this stance for the last forty five years, which is a weighted average of a pool of instruments. We extend Bernanke and Mihov (1998)'s Interbank Market model by allowing structural parameters and shock variances to change over time. In particular, we follow the recent work of Canova and Pérez Forero (2015) for estimating non-recursive TVC-VARs with Bayesian Methods. The estimated stance measure describes how tight/loose was monetary policy over time and takes into account the uncertainty related with posterior estimates of time varying parameters. Finally, we present how has monetary transmission mechanism changed over time, focusing our attention in the period after the Great Recession.
    Keywords: SVARs, Interbank Market, Operating Procedures, Monetary Policy Stance, Time-varying parameters, Bayesian Methods, Multi-move Metropolis within Gibbs Sampling
    JEL: C11 E51 E52 E58
    Date: 2017–08
  5. By: Chakraborty, Chiranjit (Bank of England); Joseph, Andreas (Bank of England)
    Abstract: We introduce machine learning in the context of central banking and policy analyses. Our aim is to give an overview broad enough to allow the reader to place machine learning within the wider range of statistical modelling and computational analyses, and provide an idea of its scope and limitations. We review the underlying technical sources and the nascent literature applying machine learning to economic and policy problems. We present popular modelling approaches, such as artificial neural networks, tree-based models, support vector machines, recommender systems and different clustering techniques. Important concepts like the bias-variance trade-off, optimal model complexity, regularisation and cross-validation are discussed to enrich the econometrics toolbox in their own right. We present three case studies relevant to central bank policy, financial regulation and economic modelling more widely. First, we model the detection of alerts on the balance sheets of financial institutions in the context of banking supervision. Second, we perform a projection exercise for UK CPI inflation on a medium-term horizon of two years. Here, we introduce a simple training-testing framework for time series analyses. Third, we investigate the funding patterns of technology start-ups with the aim to detect potentially disruptive innovators in financial technology. Machine learning models generally outperform traditional modelling approaches in prediction tasks, while open research questions remain with regard to their causal inference properties.
    Keywords: Machine learning; artificial intelligence; big data; econometrics; forecasting; inflation; financial markets; banking supervision; financial technology
    JEL: A12 A33 C14 C38 C44 C45 C51 C52 C53 C54 C61 C63 C87 E37 E58 G17 Y20
    Date: 2017–09–04
  6. By: Gelain, Paolo (European Central Bank); Lansing, Kevin J. (Federal Reserve Bank of San Francisco); Natvik, Gisele J. (BI Norwegian Business School)
    Abstract: How should a central bank act to stabilize the debt-to-GDP ratio? We show how the persistent nature of household debt shapes the answer to this question. In environments where households repay mortgages gradually, surprise interest hikes only weakly influence household debt, and tend to increase debt-to-GDP in the short run while reducing it in the medium run. Interest rate rules with a positive weight on debt-to-GDP cause indeterminacy. Compared to inflation targeting, debt-to-GDP stabilization calls for a more expansionary policy when debt-to-GDP is high, so as to deflate the debt burden through inflation and output growth.
    JEL: E32 E44 E52
    Date: 2017–08–30
  7. By: Martin Bodenstein; Junzhu Zhao
    Abstract: We study optimal monetary policy when the empirical evidence leaves the policymaker uncertain whether the true data-generating process is given by a model with sticky wages or a model with search and matching frictions in the labor market. Unless the policymaker is almost certain about the search and matching model being the correct data-generating process, the policymaker chooses to stabilize wage inflation at the expense of price inflation, a policy resembling the policy that is optimal in the sticky wage model, regardless of the true model. This finding reflects the greater sensitivity of welfare losses to deviations from the model-specific optimal policy in the sticky wage model. Thus, uncertainty about important aspects of the structure of the economy does not necessarily translate into uncertainty about the features of good monetary policy.
    Keywords: Model uncertainty ; Optimal monetary policy ; Optimal targeting rules ; Search and matching ; Sticky wages
    JEL: E52
    Date: 2017–08–29
  8. By: Mabelle Sayah (Université Claude Bernard Lyon 1, UCBL, Faculte des Sciences - Universite Saint Joseph - USJ - Université Saint-Joseph de Beyrouth)
    Abstract: Recent financial crises were the root of many changes in regulatory implementations in the banking sector. Basel previously covered the default capital charge for counterparty exposures however, the crisis showed that more than two third of the losses related to this risk emerged from the exposure to the movement of the counterparty's credit quality and not its actual default therefore, Basel III divided the required counterparty risk capital into two categories: The traditional default capital charge and an additional counter-party credit valuation adjustment (CVA) capital charge. In this article, we explain the new methodologies to compute these capital charges on the OTC market: The standardized approach for default capital charge (SA-CCR) and the basic approach for CVA (BA-CVA). Based on historical calibration and future estimations, we built internal models in order to compare them with the amended standardized approach. Up till June 2015, interest rate and FX derivatives constituted more than 90% of the traded total OTC notional amount; we constructed our application on such portfolios containing and computed their total counterparty capital charge. The analysis reflected different impacts of the netting and collateral agreements on the regulatory capital depending on the instruments' typologies. Moreover, results showed an important increase in the capital charge due to the CVA addition doubling it in some cases.
    Keywords: Basel III,Counterparty Credit Risk,SA-CCR,CVA,OTC Derivatives
    Date: 2016–12–30
  9. By: Perri, Fabrizio (Federal Reserve Bank of Minneapolis); Stefanidis, Georgios (Federal Reserve Bank of Minneapolis)
    Abstract: We use balance sheet data and stock market data for the major U.S. banking institutions during and after the 2007-8 financial crisis to estimate the magnitude of the losses experienced by these institutions because of the crisis. We then use these estimates to assess the impact of the crisis under alternative, and higher, capital requirements. We find that substantially higher capital requirements (in the 20% to 30% range) would have substantially reduced the vulnerability of these financial institutions, and consequently they would have significantly reduced the need of a public bailout.
    Keywords: Financial crises; Too big to fail
    JEL: G01 G21
    Date: 2017–08–31
  10. By: Tröger, Tobias H.
    Abstract: This paper analyses the bail-in tool under the BRRD and predicts that it will not reach its policy objective. To make this argument, this paper first describes the policy rationale that calls for mandatory private sector involvement (PSI). From this analysis the key features for an effective bail-in tool can be derived. These insights serve as the background to make the case that the European resolution framework is likely ineffective in establishing adequate market discipline through risk-reflecting prices for bank capital. The main reason for this lies in the avoidable embeddedness of the BRRD's bail-in tool in the much broader resolution process which entails ample discretion of the authorities also in forcing private sector involvement. Finally, this paper synthesized the prior analysis by putting forward an alternative regulatory approach that seeks to disentangle private sector involvement as a precondition for effective bank-resolution as much as possible from the resolution process as such.
    Keywords: bail-in,private sector involvement,precautionary recapitalization,cross-border insolvency,market discipline
    JEL: G01 G18 G21 G28 K22 K23
    Date: 2017
  11. By: Benjamin Bernard; Agostino Capponi; Joseph E. Stiglitz
    Abstract: This paper develops a framework to analyze the consequences of alternative designs for interbank networks, in which a failure of one bank may lead to others. Earlier work had suggested that, provided shocks were not too large (or too correlated), denser networks were preferred to more sparsely connected networks because they were better able to absorb shocks. With large shocks, especially when systems are non-conservative, the likelihood of costly bankruptcy cascades increases with dense networks. Governments, worried about the cost of bailouts, have proposed bail-ins, where banks contribute. We analyze the conditions under which governments can credibly implement a bail-in strategy, showing that this depends on the network structure as well. With bail-ins, government intervention becomes desirable even for relatively small shocks, but the critical shock size above which sparser networks perform better is decreased; with sparser networks, a bail-in strategy is more credible.
    JEL: D85 E44 G21 G28 L14
    Date: 2017–08
  12. By: Tröger, Tobias H.
    Abstract: The bail-in tool as implemented in the European bank resolution framework suffers from severe shortcomings. To some extent, the regulatory framework can remedy the impediments to the desirable incentive effect of private sector involvement (PSI) that emanate from a lack of predictability of outcomes, if it compels banks to issue a sufficiently sized minimum of high-quality, easy to bail-in (subordinated) liabilities. Yet, even the limited improvements any prescription of bail-in capital can offer for PSI's operational effectiveness seem compromised in important respects. The main problem, echoing the general concerns voiced against the European bail-in regime, is that the specifications for minimum requirements for own funds and eligible liabilities (MREL) are also highly detailed and discretionary and thus alleviate the predicament of investors in bail-in debt, at best, only insufficiently. Quite importantly, given the character of typical MREL instruments as non-runnable long-term debt, even if investors are able to gauge the relevant risk of PSI in a bank's failure correctly at the time of purchase, subsequent adjustment of MREL-prescriptions by competent or resolution authorities potentially change the risk profile of the pertinent instruments. Therefore, original pricing decisions may prove inadequate and so may market discipline that follows from them. The pending European legislation aims at an implementation of the already complex specifications of the Financial Stability Board (FSB) for Total Loss Absorbing Capacity (TLAC) by very detailed and case specific amendments to both the regulatory capital and the resolution regime with an exorbitant emphasis on proportionality and technical fine-tuning. What gets lost in this approach, however, is the key policy objective of enhanced market discipline through predictable PSI: it is hardly conceivable that the pricing of MREL-instruments reflects an accurate risk-assessment of investors because of the many discretionary choices a multitude of agencies are supposed to make and revisit in the administration of the new regime. To prove this conclusion, this chapter looks in more detail at the regulatory objectives of the BRRD's prescriptions for MREL and their implementation in the prospectively amended European supervisory and resolution framework.
    Keywords: MREL,TLAC,G-SIB,bail-in,bank resolution
    JEL: G01 G18 G21 G28 K22 K23
    Date: 2017
  13. By: Lars E.O. Svensson
    Abstract: “Leaning against the wind” (LAW), that is, tighter monetary policy for financial-stability purposes, has costs in terms of a weaker economy with higher unemployment and lower inflation and possible benefits from a lower probability or magnitude of a (financial) crisis. A first obvious cost is a weaker economy if no crisis occurs. A second cost—less obvious, but higher—is a weaker economy if a crisis occurs. Taking the second cost into account, Svensson (2017) shows that for representative empirical benchmark estimates and reasonable assumptions the costs of LAW exceed the benefits by a substantial margin. Previous literature has disregarded the second cost, by assuming that the crisis loss level is independent of LAW. Some recent literature has effectively disregarded the second cost, making it to be of second order by assuming that the cost of a crisis (the crisis loss level less the non-crisis loss level) is independent of LAW. In these cases where the second cost is disregarded, for representative estimates a small but economically insignificant amount of LAW is optimal.
    JEL: E52 E58 G01
    Date: 2017–08
  14. By: Antoine Lepetit (Banque de France - Banque de France - Banque de France)
    Abstract: I show that a trade-off between inflation volatility and average unemployment arises in a New Keynesian model with search and matching frictions in the labor market. In this environment, unemployment rises more and faster in a recession than it decreases in an expansion. A strong focus on inflation stabilization in response to technology shocks comes at the cost of larger labor market volatility. Because unemployment fluctuations are asymmetric, it also results in higher average unemployment. The optimal policy responds strongly to both inflation and employment and stabilizes labor market fluctuations. Adopting this policy rather than a policy of price stability yields sizeable welfare gains. These gains are mostly accounted for by the increase in average employment relative to the price stability case.
    Keywords: Optimal monetary policy,Unemployment fluctuations,Matching frictions
    Date: 2016–04
  15. By: Yu-Fu Chen; Michael Funke; Richhild Moessner
    Abstract: This paper develops a new theoretical model with an asymmetric informal one-sided exchange rate target zone, with an application to the Swiss franc following the removal of the minimum exchange rate of CHF 1.20 per euro in January 2015. We extend and generalize the standard target zone model of Krugman (1991) by introducing perceived uncertainty about the lower edge of the band. We find that informal soft edge target zone bands lead to weaker honeymoon effects, wider target zone ranges and higher exchange rate volatility than formal target zone bands. These results suggest that it would be beneficial for exchange rate policy intentions to be stated clearly in order to anchor exchange rate expectations and reduce exchange rate volatility. We also study how exchange rate dynamics can be characterized in models in which financial markets are aware of occasional changes in the policy regime. We show that expected changes in the central bank's exchange rate policy may lead to exchange rate oscillations, providing an additional source of exchange rate volatility, and to capture this it is important to take into account the possibility of regime changes in exchange rate policy.
    Keywords: Swiss franc, target zone model, exchange rate interventions
    JEL: F31 E42 C61
    Date: 2017–08
  16. By: Marek Jarociński; Bartosz Maćkowiak
    Abstract: When monetary and fiscal policy are conducted as in the euro area, output, inflation, and government bond default premia are indeterminate according to a standard general equilibrium model with sticky prices extended to include defaultable public debt. With sunspots, the model mimics the recent euro area data. We specify an alternative configuration of monetary and fiscal policy, with a non-defaultable eurobond. If this policy arrangement had been in place since the onset of the Great Recession, output could have been much higher than in the data with inflation in line with the ECB's objective.
    JEL: E31 E32 E63
    Date: 2017–08

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