Julia Giese, Michael McLeay, David Aikman and Sujit Kapadia
Central banks have been using a range of monetary policy and macroprudential tools to maintain monetary and financial stability. But when should monetary versus macroprudential tools be used and how should they be combined? Our recent paper develops a macroeconomic model to answer these questions. We find that two instruments are better than one. Used alone, interest rates can control inflation, but are ineffective for financial stability. Policymakers can do better by also deploying the countercyclical capital buffer, a tool that varies the amount of additional capital banks must set aside. The appropriate combination of tools can vary: both should tighten to counter a joint expansion of credit and activity, but move in opposite directions during an exuberance-driven credit boom.
Álvaro Fernández-Gallardo, Simon Lloyd and Ed Manuel
Since the 2007–09 Global Financial Crisis, central banks have developed a range of macroprudential policies (‘macropru’) to address fault lines in the financial system. A key aim of macropru is to reduce ‘left-tail risks‘ – ie, minimise the probability and severity of future economic crises. However, building this resilience could influence other parts of the GDP-growth distribution and so may not always be costless. In our Working Paper, we gauge these potential costs and benefits by estimating the effects of macropru on the entire GDP-growth distribution, and explore its transmission channels. We find that macropru is effective at reducing the variance of GDP growth, and that it does so by reducing the probability and severity of excessive credit booms.
Any distributional effects on credit of macroprudential policies are only one part of the distributional story. Relatively little is known about how such policies affect the income distribution in the longer term via their role in preventing crises or mitigating their severity. Our paper helps to fill that gap in the literature by looking at the impact of past recessions and crises on inequality, and the amplifying roles of credit and capital within that. This helps to shed light on the distributional implications of not intervening – in the form of an amplified recession. We find that inequality rises following recessions and that rapid credit growth prior to recessions exacerbates that effect by around 40%.
The academic literature finds that the build-up of household debt before the 2008 financial crisis is linked to weaker consumption afterwards. But there is wider debate over the mechanisms at play. One strand of literature emphasises debt overhang acting through the level of leverage. Others find it was over-optimism acting through leverage growth. In this post, we revisit our previous analysis on leverage and consumption in the UK using synthetic cohort analysis. The correlation between leverage measures and their link to other macroeconomic variables mean it’s challenging to tease out their effects. Yet we find that whilst both mechanisms played a role, there is evidence that debt overhang linked to a tighter credit constraints was the bigger driver.
Kristina Bluwstein, Marcus Buckmann, Andreas Joseph, Miao Kang, Sujit Kapadia and Özgür Şimşek
Financial crises are recurrent events in economic history. But they are as rare as a Kraftwerk album, making their prediction challenging. In a recent study, we apply robots — in the form of machine learning — to a long-run dataset spanning 140 years, 17 countries and almost 50 crises, successfully predicting almost all crises up to two years ahead. We identify the key economic drivers of our models using Shapley values. The most important predictors are credit growth and the yield curve slope, both domestically and globally. A flat or inverted yield curve is of most concern when interest rates are low and credit growth is high. In such zones of heightened crisis vulnerability, it may be valuable to deploy macroprudential policies.
Credit default swaps (CDS) have a notoriously bad reputation. Critics refer to CDS as a “global joke” that should be “outlawed”, not at least due to the opaque market structure. Even the Vatican labelled CDS trading as “extremely immoral”. But could there be a brighter side to these swaps? In theory, CDS contracts can reduce risks in financial markets by providing valuable insurance. In a recent paper, I show that CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.
In a recent post, my co-author and I showed some charts suggesting that investors have been accepting less compensation for bearing credit risk. This type of risk can be very costly when it materialises, but the probability of that happening is typically very low. A similar risk is inherent in deeply out-of-the-money options. Here too, investors seem to be accepting less compensation for risk.
Earlier this year, a number of financial market participants, commentators and regulators suggested that investors have been accepting less compensation for bearing given amounts of credit risk. This short post presents two charts in support of that view.
Cross-border bank lending fell dramatically in the aftermath of Lehman Brothers’ failure as funding constraints forced banks to reduce their foreign exposures. While this decline was partly driven by lower demand for international bank credit, it was substantially aggravated by a retrenchment of international banks from cross-border lending. But banks did not cut their cross-border lending in a uniform manner. Instead, they reallocated their foreign portfolios towards countries that were geographically close, in which they had more experience, in which they had close connections with domestic banks or in which they operated a subsidiary. The crisis thus showed that deeper financial integration is associated with more stable cross-border credit when large global banks are hit by a funding shock.
Francesc R. Tous, Puriya Abbassi, Rajkamal Iyer, José-Luis Peydró.
What are the consequences of proprietary trading? Banks typically hold and trade a significant amount of securities, and during the financial crisis, many of these securities suffered strong price declines. How did banks react? This is precisely what we investigate for the case of Germany in a recently published paper. We find that some banks increased their investments in securities, especially for those securities that suffered price drops. This strategy delivered high returns; but at the same time, these banks pulled back on lending to the real economy, since during the financial crisis they could not easily raise new (long-term) funding. Our findings suggest that proprietary trading during a crisis can lead to less lending to the real sector.