conflict prof. landskroner 1 yoram landskroner* 16th dubrovnik economic conference 25 june 2010...

ConflictProf. Landskroner 1

Yoram Landskroner*16th Dubrovnik Economic Conference

25 June 2010

*coauthored with E. Barnea & M. Sokolerupdated 21.06.10

Monetary Policy and Financial Stability, Is There a Conflict?

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Presentation Outline1. Introduction2. The model3. Equilibrium Characteristics (FOC)4. Interaction of monetary policy

and financial stability

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1. Introduction


Introduction The recent crisis posed challenges for

monetary policy and has motivated thinking about the interconnection between financial stability and monetary policy

Prior to the recent crisis, some common views on price and financial stability and related policies :

1. They are complimentary “there is no general trade-off between monetary and financial stability” (Issing, 2003).

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Introduction central bank “that was able to maintain price

stability would also incidentally minimize the need for lender-of-last-resort intervention” (Anna Schwartz, 2000)

2. the basic tool of monetary policy, the policy interest rate and the financial stability tools such as reserve and bank capital requirements were viewed as orthogonal.

3. conducting monetary policy and the regulation and supervision of banks and capital markets under one roof creates a potential for a conflict of interest

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Introduction Important lessons of the financial crisis:

monetary and financial stability, and the instruments that are used to achieve them, are much more interrelated than thought previously : ”The Federal Reserve's participation in the

oversight of banks … significantly improves its ability to carry out its central banking functions, including making monetary policy, lending through the discount window, and fostering financial stability," Bernanke (2010)

“Monetary policy and concerns about the structure and condition of banks and the financial system more generally are inextricably intertwined“ Paul Volcker (2010) .

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Introduction

“One roof regulation” is back, the UK government announced (06/10) restructuring of its regulatory system that will consolidate power within the Bank of England , abolishing the FSA.

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Introduction The purpose of this paper is 1. to develop an analytical framework where

systemic risk is endogenous, 2. examine the effectiveness of the transmission

mechanism of monetary policy3. Consider the interaction between inflation and

financial stability and the relationship between Central Bank’s

(CB) monetary policy (monetary rate) and financial stability policy tools (capital and reserve requirements) in obtaining its goals of inflation target and financial stability

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Introduction

Our approach is how a financial crisis (stemming

from systemic risk) can be prevented as

opposed to the "benign neglect" approach that

argues that it is better to pick up the pieces after

a crisis has occurred

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The Model


The Model We consider an overlapping generation

model in which there exists a storable good that can either be consumed or be stored as a capital good, k.

a. Individuals Each generation lives two periods and

each young individual is endowed with w units of the storable good.

Old individuals rely in their consumption on their previous period’s savings and investment returns.

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The Model: Individuals There are two types of young

individuals : “patient” individuals who get more satisfaction from consumption when they are old and “impatient” ones who prefer consumption when young.

The young individuals decide how much physical capital to invest in the production process a period later (when old).

Accordingly, old individuals in period t, have access to production process, f(k),

Prof. Landskroner 12

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The Model The production process is subject to

uncertainty as follows

The special feature of uncertainty is increasing marginal risk : probability of success λ decreases as investment increases,

This feature reflects an externality, individuals and FI don’t take this into their consideration

This is why have possibility of systemic risk


otherwise 0

)( probabilty with ,10 ,)(1

tttt

kAkkfy

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The Model There are three financial assets:

1. money (cash balances), mt, issued by the Central Bank (CB)

2. inherited financial intermediaries’ (FI) equity, that is non-tradable

3. bank deposits d, earning a rate rd

· Also young individuals can borrow from FI, lt, at a nominal interest, il


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The Model: Financial Intermediaries

b. Financial Intermediaries (FI) FI (banks) operate in an imperfect competitive loan

market (assumed identical). the market for deposits is perfectly competitive FI extend one-period loans to investors at an

interest rate, that reflects the risk of the investments.

FI has equity capital, FKt from past shareholder’s endowments and the accumulation of retained earnings.


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The Model: Financial Intermediaries FI can either borrow from the CB a one-period

monetary loan, Lm, which the CB supplies perfectly elastically at a policy rate im.

Collateral constraint: the amount borrowed from CB is limited to the total reserves they hold at the CB.

The FI Balance sheet :rrD+ L=D+ Lm+FKt

If rrD=Lm→ ΔL= ΔD (otherwise ΔL= (1-rr)ΔD) The arrangement is expansionary An increase in rr increases liquidity without

reducing L.Prof. Landskroner 16

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FI’s are subject to two financial stability regulations set by the CB:

(i) reserve requirement at a rate of rr, in the form of deposits at the CB. We assume total reserves equal required reserves,

(ii) a required capital ratio - expected end-of-period equity capital, EtFKt+1 to total assets at time t of percent,

Note that in period t, the financial intermediary has no control over the existing stock of financial capital, FKt, and thus we enter the end-of-period FKt+1 into the capital constraint of time t.


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FI’s impose a leverage (risk-management) constraint on their borrowers (LTV)

It turns out that this constraint and the Collateral constraint play an important role in our model as they did in reality (binding vs. non-binding before and after crisis)

To prevent renegotiations of the debt terms and To avoid a vicious cycle where growth leads to a crisis


wp

l

t

t

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The Model: The Central bank c. The Central bank pursues two goals:

1. reducing the deviations of the inflation from its target, by adjusting its monetary (policy) interest rate

2. maintaining financial stability:

policy aimed to prevent the systemic risk of run on banks, the collapse of financial intermediation and financial markets


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The Model: The Central bank the CB provides a safety net in the form of

partial deposit insurance, which is financed by seigniorage revenues (SR) that the CB collects from issuing cash and imposing reserve requirements.

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Equilibrium Conditions

In equilibrium all markets must clear and therefore we have

1. Clearing condition for the consumption good market

2. Systemic risk: the probability of FI failure qt+1 has to be consistent with the bank having sufficient capital to absorb the loan losses

where H is the cumulative probability distribution of default of the FI


01111

ttq

ttt LkEFKHq

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Equilibrium Conditions

3. the CB needs to generate sufficient SR to keep its deposit insurance obligations (in case of realization of systemic risk) credible.


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Equilibrium characteristics (FOC)

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Equilibrium characteristics (FOC) a. Individuals

1. we have a separating equilibrium where the “patient” individuals use the bank deposits , while the “impatient individuals” use the investment in the physical capital to smooth consumption.

2. the equilibrium condition for inflation

This is a fisher equation ,Inflation is determined

in a portfolio (pricing of assets) framework. Thus transmission of monetary policy to inflation is

through iL!


k

L

t

t

f

i

p

p 11

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Equilibrium characteristicsb. The Financial Intermediaries

1. the pass-through from the monetary rate to the deposit rate.

Thus the expected deposit interest rate (LHS) is affected not only by the monetary rate (positively) but also by financial stability policy tools ( and rr), and other variables:

φ3 is the shadow price (Lagrange multiplier) of the

collateral constraint on monetary loans from the CB


rrrr

rri

rr

iq t

mtdt

t

111

))1(1( 31

11

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Equilibrium characteristics

φ3 is negatively related to im thus reducing the effectiveness of monetary policy:

As im↓→iL ↓ (demand for loans)Lm↑→ φ3 ↑ offsetting the effect of im

The shadow price is also inversely related to required reserves rr (more collateral reduces φ3 )

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Equilibrium characteristics The issue of Zero Lower Bound (ZLB): Note

when the monetary rate approaches zero it ceases to be a policy instrument. Then the viable monetary policy tools are

reserves and capital requirements which in normal circumstances are financial stability instruments.

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Equilibrium characteristics2. Next we derived the transmission mechanism

from the im to the lending rate iL.

As with the deposit rate a positive relationships between im , φ3 and iL

Where (λ-(1- λ)) is negatively related to the variance of λ for λ>0.5, thus as the variance increases iL increases

As im increases expected iL increases and expected iD declines → the expected spread increases (net effect)

ttmttLtt

tt rrrr

ikikk 3111 )1

1())(1()

11))((1()((

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Interaction of monetary policy and financial stability

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Interaction of monetary policy and financial stability

To analyze the interaction between the two policies we consider the effects of two external shocks:

1. a shock to productivity which is translated in our model to a shock to inflation

2. a shock to risk affecting financial stability. We examine the CB reaction to the shocks

(utilizing policy tools) and how these cross affect inflation and financial stability

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A Shock to productivity1. a positive shock to productivity (higher fk)

increases the demand for k thus lowering λ(k) and yielding a higher iL, under certain conditions reduces inflation

the CB lowers im to maintain the target inflation →The loan rate iL is reduced

In equilibrium the rate iL is greater than before the shock since fk increased and inflation is unchanged due to monetary policy

Now to the other side of the coin

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A Shock to productivity what is effect of monetary policy on financial

stability? : As the CB lowers its rate im→ both (1-λ(k))

(credit risk) and (1-λ(k))l (loan losses) increase → this may affect q and SR.

Outcome depends on the net effect on the bank’s profits of the reduction in im: increase loans increasing profits but also increasing loan losses reducing profits

If profits decline q will increase

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A Shock to productivity

CONCLUSION monetary policy aimed at achieving inflation target will affect adversely financial stability

Ringing a bell? keeping the monetary rate too low too long may lead to a financial crisis

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A Shock to risk2. Next we examine the effects of a negative

shock to λ(k) (increase in credit risk ) the CB increases the capital requirement κ to

increase iL, such that the demand for investment

k falls and λ(k) is restored to its pre-shock level. What about q? increase in κ has opposing

effects on expected profits: reducing L thus reducing profits but also reducing (1- λ)L increasing profits Again a positive net effect will reduce q below its pre-shock level

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A Shock to risk However this action of the CB will affect

expected inflation that will under certain conditions fall (iL L fk )

This shock may also reduce SR, to restore its position the CB will lower the reserve requirements rr (m increases)

This decrease will likely cause an increase in iL

that will under certain conditions further reduce inflation below its target

CONCLUSION: inflation and financial stability are interconnected and thus CB must coordinate its policies in achieving its goals

conflict prof. landskroner 1 yoram landskroner* 16th dubrovnik economic conference 25 june 2010...

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