The current crisis will most likely put additional pressure on future macroeconomic research to actively seek ways to incorporate financial frictions and financial market imperfections into mainstream macroeconomic models. To contribute to these research efforts and, at the same time, take stock of the new literature on financial factors and aggregate fluctuations, particularly those contributions that work on issues related to credit crunches, the 10th joint annual BoF-CEPR conference, Credit Crunch and the Macroeconomy, co-organized this time by Cass School (London), focused on these timely questions. The one and a half day conference brought together researchers from many countries and institutions to discuss and debate the topic. Below, we present a summary of the papers presented and also of the panel that ended the conference.
Exploiting the Japanese banking crisis as a laboratory, Mariassunta Giannetti (Stockholm School of Economics) and Andrei Simonov (Michigan State University) argue in their empirical paper, On the Real Effects of Bank Bailouts: Micro-Evidence from Japan, that government recapitalizations of weak banks result in significantly positive abnormal returns for those banks’ clients. Furthermore, after recapitalizations, banks extend larger loans to their existing borrowers and some firms related to recapitalized banks increase investment, but they do not create more jobs than comparable firms. Most importantly, recapitalizations allow banks to extend larger loans to low and high quality firms alike, and low quality firms experience higher abnormal returns than other firms upon the announcement of their lending banks’ recapitalizations.
In their paper, Deposit Insurance and Money Market Freezes, Max Bruche (CEMFI) and Javier Suarez (CEMFI) develop a tractable general equilibrium model in which money markets facilitate the reallocation of funds across banks from different regions. They show that, in the presence of deposit insurance, a rise in counterparty risk may cause a freeze in interbank money markets. Counterparty risk creates an asymmetry between banks in savings-rich regions, which remain marginally financed by the abundant regionally insured deposits, and in savings-poor regions, which have to pay large spreads in money markets. This asymmetry distorts the aggregate allocation of credit and, in the presence of demand externalities, can cause large output losses.
The paper also contributes to the literature on the causes and consequences of financial market freezes. The existing literature has considered causes like maturity mismatches, deposit or market lender runs, adverse selection effects, fire-sales and margin calls, while Bruche and Suarez point to the distortions associated with deposit insurance. Their results suggest, in particular, that these distortions might be both conceptually and quantitatively relevant. They also suggest that policies that imply a subsidized absorption of the risk of bank default by the government or the central bank, as some of the policies seen during the 2007–2009 financial crisis, might improve the allocation of capital by effectively reducing the asymmetries across banks with and without access to abundant deposit funding.
Andrew Rose (University of California) and Mark Spiegel (Federal Reserve Bank of San Francisco) have produced an interesting paper, Cross-Country Causes and Consequences of the 2008 Crisis: Early Warning, on using the Multiple Indicator Multiple Cause (MIMIC) approach to model the causes of the 2008 financial crisis together with its manifestations. Their analysis focuses on national causes and consequences of the crisis, ignoring cross-country ‘contagion’ effects. Their model of the incidence of the crisis combines 2008 changes in real GDP, the stock market, country credit ratings and the exchange rate, and they explore the linkages between these manifestations of the crisis and a number of its possible causes from 2006 and earlier. They include over sixty potential causes of the crisis, such as financial system policies and conditions; asset price appreciation, international imbalances, macroeconomic policies and institutional and geographic features. Their main conclusion is negative, in that they are unable to link most of the commonly cited causes of the crisis to its incidence across countries. On the basis of their results the authors feel sceptical of the accuracy of ‘early warning’ systems of potential crises, which must also predict their timing.
In their paper, Monetary Policy and the Financing of Firms, Fiorella De Fiore (ECB), Pedro Teles (BdP) and Oreste Tristani (ECB) ask how monetary policy should respond to changes in financial conditions. They construct a simple model where firms are subject to idiosyncratic shocks that may force them to default on their debt. The model also assumes that firms’ assets and liabilities are denominated in nominal terms and predetermined when shocks occur. Consequently, monetary policy can affect the real value of funds used to finance production and also loan and deposit rates. The authors find that maintaining price stability at all times is not optimal. More specifically, the optimal response to adverse financial shocks is to engineer a short period of inflation, if policy rates are at the zero bound and cannot be lowered further. Furthermore, interest rate rules like the Taylor rule may implement allocations that have opposite cyclical properties to the fully optimal rules.
Yunus Aksoy (Birkbeck College), Henrique Basso (Uppsala University) and Javier Goto-Martinez (City University of London) present in their paper, Lending Relationships and Monetary Policy, a simple framework that introduces lending relationships into a dynamic stochastic general equilibrium model with staggered prices and cost channels. Their findings are novel and interesting. Firstly, banking spreads move counter-cyclically, generating amplified output responses. Secondly, spread movements are important for monetary policymaking even when a standard Taylor rule is employed by the central bank. Also, modifying the policy rule to include a banking spread adjustment improves stabilization of shocks and increases welfare when compared with rules that only respond to output gap and inflation. Finally, the presence of strong lending relationships in the banking sector can lead to equilibrium indeterminacy, making it necessary for the central bank to react to spread movements.
In their empirical analysis, Unnatural Selection At Work: An Analysis of Bank-Firm Relationships in Italy After Lehman, Ugo Albertazzi (BdI) and Domenico Marchetti (BdI) analyse, using highly detailed data on bank-firm relationships, how the financial crisis has influenced credit supply in Italy since the Lehman bankruptcy. They find evidence of a credit crunch, where the contraction of credit supply is associated with low bank capitalization. More importantly, the authors conclude that under-capitalized banks may have an incentive to allocate credit to adversely affected borrowers in order to avoid the realization of losses on their balance sheets. This result, they argue, provides evidence of unnatural selection in credit allocation, which explains the title of the paper. They also find evidence of ‘evergreening’ behaviour, which proves to be very robust across identification methods and model specifications. This type of evidence is virtually unique in existing data with the exception of the Japanese experience of the nineties.
In their empirical paper using micro-data, Firm Default and Aggregate Fluctuations, Tor Jacobson (Riksbank), Rikard Kindell (Svenska Handelsbanken), Jesper Lindé (Federal Reserve Board) and Kasper Roszbach (Riksbank) study the relation between macroeconomic fluctuations and corporate defaults. The authors find strong evidence for a substantial and stable impact of aggregate fluctuations on corporate defaults. The authors also argue that the estimated macro-effects differ across industries in an economically intuitive way. Furthermore, out-of-sample comparisons clearly suggest that the paper’s approach is superior to both models that exclude macro information and best fitting naive forecasting models. The authors conclude that while firm-specific factors are useful in ranking firms’ relative riskiness, macroeconomic factors capture fluctuations in the absolute risk level.
In their theoretical paper, Liquidity Constraints and Non-market Clearing: A Recipe for Recessions?, John Driffill (Birkbeck College) and Marcus Miller (University of Warwick) extend the model of money and liquidity under flexible prices by Kiyotaki and Moore (2008)[1] to show that, if prices are not flexible enough to ensure continuous market clearing, a credit crunch may cause a recession. In particular, by switching from flex-price to fix-price goods and labour markets, they find that demand failures can emerge after a liquidity shock. In short, a framework that combines elements of intertemporal optimization of the type used in Real Business Cycle literature with Keynesian fix-price assumption implies that financial factors can affect demand as well as supply.
The conference ended in a panel discussion, where the three panellists, Laura Kodres (IMF), Alistair Milne (Cass School) and Javier Suarez (CEMFI) were asked to give their opinion on the main lessons to be drawn from the most recent financial crisis, which has also had severe consequences on global trade and growth in many countries. Laura Kodres argued that the challenge is to mitigate the systemic risks without damaging innovation and risk-transfer: regulatory systems should be incentive-based, where the financial institutions need to internalize externalities. Alistair Milne focused on securitization, which he thought has more to do with funding than risk-transfer. He also pointed out the complexity of some of the new financial products. Javier Suarez, on the other hand, noted that prior to the crisis, the dominant view of the financial markets emphasized the efficient market hypothesis and benefits of risk diversification. Modern banking theory, which puts great emphasis on market imperfections and informational frictions, got far too little attention. Consequently, the originate-and-distribute model was accepted too uncritically. He also wanted to draw participants’ attention to the potentially destabilizing role of deposit insurance systems on international interbank markets during a crisis.
[1] Kiyotaki, N & Moore, J, Liquidity, Business Cycles, and Monetary Policy, working paper, April (2008). |