Monetary Policy and Balance Sheets

Deniz Igan, Alain Kabundi, Francisco Nadal De Simone, and Natalia Tamirisa

Motivation• The financial crisis has reinforced the urgency of better

understanding the role of monetary and prudential policy in mitigating financial stability risks.

• Could have an earlier tightening of monetary policy prevented the build up of risks in the housing markets and the balance sheets of financial institutions?

• What is the role of financial frictions operating through private sector balance sheets in monetary transmission?

Literature• Traditional channels

– Interest rates: cost of capital– Asset prices: value of equity– Exchange rate: international trade

• Financial frictions and credit channel– Lending channel—the impact of interest rate changes on the supply of

bank loans owing to changes in the cost of external funding (Mishkin, 1996)

– Balance sheet channel—the impact of monetary policy changes on the demand for bank loans through increase in the external finance premium and reduction in the value of collateral (Bernanke and Gertler, 1995; Kiyotaki and Moore, 1997; Iacoviello, 2005)

– Risk-taking channel—changes in the supply of funding sources owing to changes in risk perceptions or risk tolerance of banks and other financial institutions (Borio and Zhu, 2008; Adrian and Shin, 2008 and 2011; and Adrian, Estrella and Shin, 2009; Bruno and Shin, 2012).

Empirical Evidence• Support for the credit channel– Gertler and Gilchrist (1993 and 1994); Kashyap

and Stein (1995); Iacoviello and Minetti (2008)– Bergman and Bouwman (2009) bank funding and

liquidity– Bluedorn and others (2013)

• Question the strength of the credit channel– Ramey (1993)– Carlino and Defina (1998)

This Paper• Evaluates the effect of interest rate changes on private sector

balance sheets in the United States during 1990 Q1 – 2008 Q2

• Augments datasets used in standard macroeconomic models with balance sheet variables and discusses the related technical issues

• Contributes to the analysis of interface between monetary and prudential policies

• Draws some implications for the role of monetary policy before the crisis

Methodology• “Curse of dimensionality” in VARs (Sims, 1980)

• FAVAR (Bernanke, Boivin and Eliasz, 2005)

• Observable variables include the federal funds rate, inflation and unemployment (Koop and Korobilis, 2010)

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Identification Strategy• Cholesky or lower triangular identification scheme for

the three observed variables

• Order the federal funds last and treat its innovations as the policy shocks

• Other variables are divided into two groups: “fast-moving” and “slow-moving”• “Fast-moving” are financial indicators and asset prices• “Slow-moving” are real variables and goods and services prices

Treatment of Balance Sheet Variables

• “Fast-moving”?• Balance sheets of financial intermediaries are marked to

market and reflect valuation changes immediately• Important items on balances sheets of households and

nonfinancial firms are affected by valuation changes because they are reported at market prices

• Consistency with earlier studies which include bank credit

• “Slow-moving”?• Information processing and execution of transactions take

time to alter the composition of assets and liabilities

Data • 1990 Q1 to 2008 Q2, quarterly frequency• The Federal Reserve Bank of St. Louis’ FRED database• The Federal Reserve Board’s Flow of Funds database• S&P/Case-Shiller U.S. National Home Price Index, quality-

adjusted• Seasonally-adjusted (quarterly X11 filter based on an AR(4)

model)• Unit root tests: Elliott, Rothenberg, and Stock (1996) and

Kwiatkowski, Phillips, Schmidt, and Shin (1992)• Number of unobserved factors: Bai and Ng (2002) and

Alessi, Barigozzi, and Capasso (2010)

Figure 1. Balance Sheet Variables, q1 1990 – q2 2008(In billions of U.S. dollars)

Source: Federal Reserve Board, and authors' estimates.

0

1000

2000

3000

4000

5000

6000

7000

1990

q119

91q1

1992

q119

93q1

1994

q119

95q1

1996

q119

97q1

1998

q119

99q1

2000

q120

01q1

2002

q120

03q1

2004

q120

05q1

2006

q120

07q1

2008

q1

ABS Issuers: Total Mortgages

ABS Issuers: Financial Liabilities

MMM Funds: Credit Market Instrument Assets

Security Brokers & Dealers: Credit Market Instrument AssetsCommercial Banks: Commercial and Industrial Loans

Commercial Banks: Real Estate Loans

0

100

200

300

400

500

600

-600000

-500000

-400000

-300000

-200000

-100000

0

100000

200000

300000

400000

1990

q119

91q2

1992

q319

93q4

1995

q119

96q2

1997

q319

98q4

2000

q120

01q2

2002

q320

03q4

2005

q120

06q2

2007

q3

Net due to Related Foreign Offices (LHS Axis)

Foreign Bank Operations in the U.S.: Interbank Transactions due to Foreign Affiliates

0

10000

20000

30000

40000

50000

60000

0

500

1000

1500

2000

2500

3000

1990

q119

91q2

1992

q319

93q4

1995

q119

96q2

1997

q319

98q4

2000

q120

01q2

2002

q320

03q4

2005

q120

06q2

2007

q3

Total Consumer Credit Outstanding (LHS axis)Households: Real Estate Assets

Households: Financial Assets

-100

400

900

1400

1900

2400

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

50000

1990

q119

91q2

1992

q319

93q4

1995

q119

96q2

1997

q319

98q4

2000

q120

01q2

2002

q320

03q4

2005

q120

06q2

2007

q3

Nonfinancial Noncorporate Business: Liabilities Nonfinancial Noncorporate Business: AssetsNonfinancial Corporate Business: LiabilitiesNonfinancial Corporate Business: Assets

Nonfinancial Firms: Commercial Bank Credit Market Debt Outstanding Corporate Net Cash Flow (RHS Axis)

3 6 9 12 15 18 21-3

-2

-1

0

1

2Interest rate

3 6 9 12 15 18 21-2

-1

0

1

2Inflation

3 6 9 12 15 18 21-1

-0.5

0

0.5

1

1.5

2

2.5Unemployment

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1Gross Domestic Product

3 6 9 12 15 18 21-3

-2

-1

0

1

23-Month Treasury Bill

3 6 9 12 15 18 21-2

-1.5

-1

-0.5

0

0.5

1

1.510-Year Treasury Bond Yield

3 6 9 12 15 18 21-2

-1.5

-1

-0.5

0

0.5

1

1.5Fixed Private Investment

3 6 9 12 15 18 21-1

-0.5

0

0.5

1Stock Prices

3 6 9 12 15 18 21

-0.5

0

0.5

House Prices

3 6 9 12 15 18 21-2

-1.5

-1

-0.5

0

0.5

1

1.5Private Residential Fixed Investment

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5Housing Starts

3 6 9 12 15 18 21-1

-0.5

0

0.5Real Effective Exchange Rate

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5Real Exports

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5Real Imports

3 6 9 12 15 18 21-1

-0.5

0

0.5

1Current Account

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1Gross Capital Inflows

3 6 9 12 15 18 21-1

-0.5

0

0.5

1

1.5Gross Capital Outflows

3 6 9 12 15 18 21-2

-1.5

-1

-0.5

0

0.5

1

1.5VIX

3 6 9 12 15 18 21-3

-2

-1

0

1

2Bank Prime Loan Rate

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5

2External Financial Premium

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5Real Estate Loans at Commercial Banks

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1

1.5Total Loans and Leases at Commercial Banks

3 6 9 12 15 18 21-2

0

2ABS Issuers: Total Mortgage Assets

3 6 9 12 15 18 21-2

-1

0

1ABS Issuers: Total Financial Liabilities

3 6 9 12 15 18 21-2

0

2MMM Funds: Credit Market Instrument Assets

3 6 9 12 15 18 21-1

0

1SB & Dealers: Credit Market Instrument Assets

3 6 9 12 15 18 21-2

0

2M1 Money Stock

3 6 9 12 15 18 21

-1

0

1M2 Money Stock

3 6 9 12 15 18 21-1

-0.5

0

0.5

1Net Due to Related Foreign Offices and Foreign-Related Institutions

3 6 9 12 15 18 21-1

-0.5

0

0.5

1Foreign Bank Offices in the US: Liabilities-Interbank Trans Due to Foreign Affiliates

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1Households: Total Financial Assets

3 6 9 12 15 18 21-2

-1

0

1

Households: Real Estate Assets

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1Households: Credit Market Debt

3 6 9 12 15 18 21-2

-1

0

1

NF NC Business: Assets

3 6 9 12 15 18 21-1.5

-1

-0.5

0

0.5

1NF NC Business: Liabilities

3 6 9 12 15 18 21

-2

-1

0

1

NF Corporate Business: Assets

3 6 9 12 15 18 21-2

-1

0

1NF Corporate Business: Liabilities

3 6 9 12 15 18 21-2

-1

0

1NF Corporates: Credit Market Debt

3 6 9 12 15 18 21-1

0

1

2

Corporate Net Cash Flow

Robustness Checks• Change the number of lags or factors (2-4 lags

and 2-4 factors)– Less stable results

• Treat balance sheet variables as slow-moving – The response lags increase but the shape of

impulse responses does not change

Excluding Balance Sheet Variables

• 1990 Q1 to 2008 Q2– Impulse responses remain broadly unchanged– “Omitted variable problem”: information content of balance

sheet variables is not reflected in data• The share of variance explained by macroeconomic variables and

measures of expectations rises• The share of variance explained by the variables describing bank

funding costs declines

• 1990 Q1 to 2011 Q4– More persistent impact on inflation– The effect on output is smaller and less persistent– Unemployment not affected

Conclusions• The financial frictions channels are no less important than the

traditional channels for monetary transmission.– Monetary policy has statistically significant effects on the balance

sheets of financial institutions, especially banks, ABS issuers and MMFs, and to a lesser extent security brokers and dealers.

– Households’ and nonfinancial firms’ balance sheets are also affected, albeit less so than the balance sheets of financial institutions.

• Yet the economic significance of such “balance sheet multipliers” is small. – Monetary policy alone cannot stop the buildup of financial excesses.

Coordination with macroprudential policy is crucial.

• Monetary transmission should be examined including balance sheet variables, especially when balance sheets are impaired.