Roy Zilberman and William Tayler.
Last year the Bank organised a research competition to coincide with the launch of the One Bank Research Agenda. In this guest post, the authors of the winning paper in that competition, Roy Zilberman and William Tayler from Lancaster Business School, summarise their work on optimal macroprudential policy.
Can macroprudential regulation go beyond its remit of financial stability and also contain inflation and output fluctuations? We think it can and argue that macroprudential regulation, in the form of countercyclical bank capital requirements, is a superior instrument to both conventional and financially-augmented Taylor (1993) monetary policy rules. This is especially true in responding to financial shocks that drive output and inflation in opposite directions, as also observed at the start of the recent financial crisis (see Gilchrist, Schoenle, Sim and Zakrajsek (2016)). This helps to effectively shield the real economy without the need for a monetary policy interest rate intervention. Put differently, a well-designed simple and implementable bank capital rule can achieve optimal policy associated with zero welfare losses.
Countercyclical Bank Capital Requirements
In the aftermath of the 2007-2009 financial crisis and Great Recession, it has become clear that restrictions in lending, higher borrowing costs and financial regulation, all of which directly impact the credit markets, have translated into a severe contraction in the wider economy. One of the core suggestions of the new Basel III Accords, set to be fully implemented by 2019, is for bank capital buffers to be countercyclical. By raising capital requirements during economic booms, the expansion of credit is limited, whereas relaxing these constraints in a downturn enables the financial sector to better absorb losses associated with an eruption of a negative credit cycle.
Macroprudential Regulation beyond the Financial Sector
Beyond the direct reforms Basel III imposes on the global banking system, it is crucial to establish the channels through which countercyclical bank capital buffers influence overall macroeconomic and price stability. While these objectives are not officially part of the banking regulation agenda, it is clear that with the undeniable link between the financial sector and real economy, banking regulation may also have sizeable macroeconomic effects. In a recent paper we ask whether Basel III type regulation can contain the adverse spillovers flowing from the financial sector to the real economy. Furthermore, we examine the effectiveness of monetary policy rules in achieving price and output stability when credit market frictions and regulatory requirements prevail.
To address these questions we use a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model with nominal rigidities, endogenous credit risk and a borrowing cost channel. Compared to the majority of the macrofinance literature which uses credit lines to finance house purchases and investment in physical capital, we pursue a different approach and indeed introduce loans to finance labour costs. This modelling viewpoint is motivated by recent evidence suggesting that variations in working-capital loans following adverse financial shocks can have persistent negative effects on economic activity (see Fernandez-Corugedo, McMahon, Millard and Rachel (2011) who estimate the cost channel for the U.K economy and Christiano, Eichenbaum and Trabandt (2015) who estimate this channel for the U.S). This result, therefore, requires the examination of macroprudential policies when firms rely on external finance to support their production activities through a borrowing cost channel (a la Ravenna and Walsh (2006) and De Fiore and Tristani (2013)). To examine the issues surrounding financial frictions and bank capital regulation, the borrowing cost channel in our model is enriched with endogenous financial frictions including collateralized lending, financial regulation, risk of default at the firm level, and ex-ante commercial bank losses. In this way, not only monetary policy, but also credit market imperfections and financial regulation, translate into changes in inflation and output via their direct impact on the cost of borrowing affecting the production sector.
The impact of firm defaults on borrowing costs
Our model captures the increase in credit risk and its endogenous knock on effects on banking sector losses and the real economy during economic downturns, in particular recessions initiated by a fall in the probability of collateral recovery by commercial banks. Significantly, the increase in default risk following such shocks have an adverse impact on both sides of banks’ balance sheets:
- Higher default risk requires an increase in the external finance risk premium to account for the rise in potential losses that banks may encounter.
- Higher default risk necessitates a rise in the bank capital risk premium to ensure that bank capital holders are willing to invest in bank capital despite the increased risk associated with holding this asset. In this way, bank capital holders are indifferent between investing in potential loss-absorbing bank capital and risk-free deposits.
Both the above channels result in a rise in the lending rate charged by commercial banks, thus acting as financial accelerator mechanisms through the borrowing cost channel. To investigate the role of both Basel II and Basel III, we introduce a bank capital rule that reacts to changes in default risk, perceived as a credible financial stability measure in this model. Procyclical capital requirements in the spirit of Basel II respond positively to credit risk, whereas with countercyclical Basel III type regulation, this co-movement is negative. Consequently, with dynamic bank capital requirements, credit risk operates through an additional bank capital channel:
- Higher bank capital requirements under Basel II act to increase funding costs for banks, which further exacerbate the financial accelerator mechanisms in 1 and 2. The upshot is that macroprudential policy (Basel III) is warranted in order to insulate the effects of the borrowing cost channel and financial sector procyclicality on the real economy.
The simulated model shows that countercyclical financial regulation (Basel III) is very effective at fostering financial and price stability, whereas credit spread-augmented Taylor rules increase price and wage inflation volatilities, and thus provide zero welfare gains. Specifically, from a policy perspective we conclude that:
a) i) If the economy is hit by adverse credit shocks, then in the absence of countercyclical regulation, monetary policy should avoid responding aggressively to inflationary pressures as it mainly acts to further aggravate the rise in borrowing costs.
ii) By Implementing bank capital requirements responding countercyclically to credit risk, regulatory authorities can achieve the anti-inflation target of monetary policy as well as eliminate welfare losses (comprised of variances in price inflation, the output gap and the wage inflation gap). In this state, the output gap – price inflation – wage inflation trade-off is minimized and monetary policy rules become redundant since optimal monetary policy suggests leaving the refinance rate unchanged.
b) Following technology shocks, aggressive macroprudential regulation can restore a more hawkish stance of monetary policy, which in combination yield the highest welfare gain. Under these conditions, central banks can contribute further to price stability through the standard demand channel of monetary policy without intensifying inflationary pressures via the monetary policy cost channel.
Conclusions and Policy Caveats
We demonstrate that when firms require external finance for working-capital loans, then financial distortions, countercyclical regulation and different types of shocks significantly alter the transmission mechanism of monetary policy and its optimal behaviour. Our findings emphasize the importance of the Basel III accords in alleviating the output gap-inflation trade-off faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of financial distress. Our results support the ‘mainstream’ view that financial stability concerns should be primarily attributed to regulatory instruments (Svensson (2012)), whereas a central bank should not ‘lean against the credit cycle’ (Bernanke and Gertler (2001)). With this in mind, macroprudential regulation in the form of countercyclical capital requirements can be very potent in achieving the primary mandates of central banks when the financial markets and the real economy are intertwined. This is one of the first papers which show that macroprudential regulation can, under certain states, “catch two birds with one stone”. In fact, unlike the majority of the literature on macroprudential policy, optimal banking regulation in a model featuring important and empirically-relevant financial imperfections like ours, needs not to be in conflict with monetary policy when the goal is to achieve financial, output and price stability.
The cost push inflationary pressures formed from an increase in borrowing costs and credit risk during periods of financial distress point towards a further explanation of the ‘’missing deflation” observed in the Great Recession. However, we feel it’s necessary to add that to maintain tractability and clarity we limit the scale and features of our model with a focus on the borrowing cost channel as our link between the credit market conditions and the real economy. In this setting, our goal has been to investigate optimal policy tools to tackle this channel. Indeed we recognize that in a model featuring physical capital, for example, the reduction in investment following either adverse financial or demand shocks, may translate into deflationary pressures. Consequently, further research warrants an application of this setup into to an empirically richer, large scale DSGE model with features such as: physical capital, investment, housing, backward look price setters, additional real and financial frictions and a greater array of economic shocks.
Finally, a key practical issue in the context of our paper and more generally in the macroprudential literature is how macroprudential policies can be implemented without adversely affecting the credibility of central banks and regulatory authorities? The common tradition in central banks is to target inflation in an aggressive manner, but if financial regulation can perform better in terms of achieving price stability, how would this impact the anti-inflation credibility of central banks? Hence, these macroprudential tools must be calibrated jointly with a transparent communication of the specific roles of central banks and the regulatory authorities, which in essence may achieve the primary objectives of traditional monetary policy in periods of financial distress.
Roy Zilberman and William Tayler are both lecturers at Lancaster University’s Management School.
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