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on Central Banking |
| By: | Buiter, Willem H. |
| Abstract: | The roles of central banks in the advanced economies have expanded and multiplied since the beginning of the crisis. The conventional monetary policy roles - setting interest rates in the pursuit of macroeconomic stability and acting as lender of last resort and market maker of last resort to provide funding liquidity and market liquidity to illiquid but insolvent counterparties - have both been transformed. With official policy rates near or at the effective lower bound, the size of the central bank's balance sheet and the composition of its assets and liabilities have become the new, 'poor man's', monetary policy instruments. The LLR and MMLR roles have expanded to include solvency support for SIFIs and, in the euro area, the provision of liquidity support and solvency support for sovereigns also. Concentrating too many financial stability responsibilities, including macro-prudential and micro-prudential regulation, in the central bank risks undermining the independence of the central bank where it is likely to be useful -- the conventional monetary policy roles. The non-inflationary loss-absorption capacity (NILAC) of the leading central banks is vast. For the ECB/Eurosystem we estimate it at no less than EUR3.2 trillion, for the Fed at over $7 trillion. This is tax payers' money that is not under the effective control of the fiscal authorities. The central banks have used their balance sheets and their NILACs to engage in quasi-fiscal actions that have been essential to prevent even greater financial turmoil and possible disaster, but that also have important distributional impacts between sectors, financial institutions, individuals and nations. The ECB was forced into this illegitimate role by the fiscal vacuum at the heart of the euro area; the Fed by the fiscal paralysis of the US Federal government institutions. |
| Keywords: | Accountability; Central banks; Financial stability; Non-inflationary loss absorption capacity |
| JEL: | E41 E52 E58 E63 G01 H63 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8780&r=cba |
| By: | Repullo, Rafael; Suarez, Javier |
| Abstract: | We develop and calibrate a dynamic equilibrium model of relationship lending in which banks are unable to access the equity markets every period and the business cycle is a Markov process that determines loans' probabilities of default. Banks anticipate that shocks to their earnings and the possible variation of capital requirements over the cycle can impair their future lending capacity and, as a precaution, hold capital buffers. We compare the relative performance of several capital regulation regimes, including one that maximizes a measure of social welfare. We show that Basel II is significantly more procyclical than Basel I, but makes banks safer. For this reason, it dominates Basel I in terms of welfare except for small social costs of bank failure. We also show that for high values of this cost, Basel III points in the right direction, with higher but less cyclically-varying capital requirements. |
| Keywords: | Banking regulation; Basel capital requirements; Capital market frictions; Credit rationing; Loan defaults; Relationship banking; Social cost of bank failure |
| JEL: | E44 G21 G28 |
| Date: | 2012–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8897&r=cba |
| By: | Acharya, Viral V; Mehran, Hamid; Thakor, Anjan |
| Abstract: | We consider a model in which banks face two moral hazard problems: 1) asset substitution by shareholders, which can occur when banks make socially-inefficient, risky loans; and 2) managerial under-provision of effort in loan monitoring. The privately-optimal level of bank leverage is neither too low nor too high: It efficiently balances the market discipline that owners of risky debt impose on managerial shirking in monitoring loans against the asset substitution induced at high levels of leverage. However, when correlated bank failures can impose significant social costs, regulators may bail out bank creditors. Anticipation of this action generates an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. That is, regulatory forbearance itself becomes a source of systemic risk. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution. But this also compromises market discipline by making bank debt too safe. Optimal capital regulation requires that a part of bank capital be invested in safe assets and be attached with contingent distribution rights, in particular, be unavailable to creditors upon failure so as to retain market discipline and be made available to shareholders only contingent on good performance in order to contain risk-taking. |
| Keywords: | asset substitution; bailout; market discipline; systemic risk |
| JEL: | G21 G28 G32 G35 G38 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8822&r=cba |
| By: | Acharya, Viral V; Pedersen, Lasse H; Philippon, Thomas; Richardson, Matthew P |
| Abstract: | We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be undercapitalized when the system as a whole is undercapitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are ‘taxed’ based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads. |
| Keywords: | bailout; financial regulation; systemic risk; value at risk |
| JEL: | G01 G18 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8824&r=cba |
| By: | Acharya, Viral V; Mehran, Hamid; Schuermann, Til; Thakor, Anjan |
| Abstract: | We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank’s shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy--a buffer for the regulator’s own "model risk" in calculations of needed capital buffers. |
| Keywords: | capital requirements; leverage; market discipline; model risk; systemic risk |
| JEL: | G12 G21 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8792&r=cba |
| By: | Eusepi, Stefano; Giannoni, Marc; Preston, Bruce |
| Abstract: | Under rational expectations monetary policy is generally highly effective in stabilizing the economy. Aggregate demand management operates through the expectations hypothesis of the term structure --- anticipated movements in future short-term interest rates control current demand. This paper explores the effects of monetary policy under imperfect knowledge and incomplete markets. In this environment the expectations hypothesis of the yield curve need not hold, a situation called unanchored financial market expectations. Whether or not financial market expectations are anchored, private sector imperfect knowledge mitigates the efficacy of optimal monetary policy. Under anchored expectations, slow adjustment of interest-rate beliefs limits scope to adjust current interest-rate policy in response to evolving macroeconomic conditions. Imperfect knowledge represents an additional distortion confronting policy, leading to greater inflation and output volatility relative to rational expectations. Under unanchored expectations, current interest-rate policy is divorced from interest-rate expectations. This permits aggressive adjustment in current interest-rate policy to stabilize inflation and output. However, unanchored expectations are shown to raise significantly the probability of encountering the zero lower bound constraint on nominal interest rates. This constraint is more severe the longer is the average maturity structure of the public debt. |
| Keywords: | Expectations Hypothesis of the Yield Curve; Expectations Stabilization; Long Debt; Optimal Monetary Policy; Transmission of Monetary Policy |
| JEL: | D83 D84 E32 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8845&r=cba |
| By: | Adam, Klaus; Woodford, Michael |
| Abstract: | We consider optimal monetary stabilization policy in a New Keynesian model with explicit microfoundations, when the central bank recognizes that private-sector expectations need not be precisely model-consistent, and wishes to choose a policy that will be as good as possible in the case of any beliefs close enough to model-consistency. We show how to characterize robustly optimal policy without restricting consideration a priori to a particular parametric family of candidate policy rules. We show that robustly optimal policy can be implemented through commitment to a target criterion involving only the paths of inflation and a suitably defined output gap, but that a concern for robustness requires greater resistance to surprise increases in inflation than would be considered optimal if one could count on the private sector to have 'rational expectations'. |
| Keywords: | belief distortions; near-rational expectations; robust control; target criterion |
| JEL: | D81 D84 E52 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8826&r=cba |
| By: | Kollmann, Robert; Roeger, Werner; Veld, Jan in't |
| Abstract: | A key dimension of fiscal policy during the financial crisis was massive government support for the banking system. The macroeconomic effects of that support have, so far, received little attention in the literature. This paper fills this gap, using a quantitative dynamic model with a banking sector. Our results suggest that state aid for banks may have a strong positive effect on real activity. Bank state aid multipliers are in the same range as conventional fiscal spending multipliers. Support for banks has a positive effect on investment, while a rise in government purchases crowds out investment. |
| Keywords: | financial crisis; fiscal stimulus; real activity; state support for banks |
| JEL: | E62 E63 G21 G28 H25 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8829&r=cba |
| By: | Bofinger, Peter; Debes, Sebastian; Gareis, Johannes; Mayer, Eric |
| Abstract: | Can monetary policy trigger pronounced boom-bust cycles in house prices and create persistent business cycles? We address this question by building heuristics into an otherwise standard DSGE model. As a result, monetary policy sets off waves of optimism and pessimism ('animal spirits') that drive house prices, which, in turn, have strong repercussions on the business cycle. We compare our findings to a standard model with rational expectations by means of impulse responses. We suggest that a standard Taylor rule is not well-suited to maintain macroeconomic stability. Instead, an augmented rule that incorporates house prices is shown to be superior. |
| Keywords: | animal spirits; housing markets; monetary policy |
| JEL: | D83 E32 E52 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8804&r=cba |
| By: | Corsetti, Giancarlo; Kuester, Keith; Meier, André; Müller, Gernot |
| Abstract: | This paper analyzes the impact of strained government finances on macroeconomic stability and the transmission of fiscal policy. Using a variant of the model by Curdia and Woodford (2009), we study a 'sovereign risk channel' through which sovereign default risk raises funding costs in the private sector. If monetary policy is constrained, the sovereign risk channel exacerbates indeterminacy problems: private-sector beliefs of a weakening economy may become self-fulfilling. In addition, sovereign risk amplifies the effects of negative cyclical shocks. Under those conditions, fiscal retrenchment can help curtail the risk of macroeconomic instability and, in extreme cases, even stimulate economic activity. |
| Keywords: | fiscal policy; monetary policy; risk premium; sovereign risk; zero lower bound |
| JEL: | E32 E52 E62 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8779&r=cba |
| By: | Chudik, Alexander; Fratzscher, Marcel |
| Abstract: | The paper analyses the transmission of liquidity shocks and risk shocks to global financial markets. Using a Global VAR methodology, the findings reveal fundamental differences in the transmission strength and pattern between the 2007-08 financial crisis and the 2010-11 sovereign debt crisis. Unlike in the former crisis, emerging market economies have become much more resilient to adverse shocks in 2010-11. Moreover, a flight-to-safety phenomenon across asset classes has become particularly strong during the 2010-11 sovereign debt crisis, with risk shocks driving down bond yields in key advanced economies. The paper relates this evolving transmission pattern to portfolio choice decisions by investors and finds that countries' sovereign rating, quality of institutions and their financial exposure are determinants of cross-country differences in the transmission. |
| Keywords: | advanced economies; capital flows; emerging market economies; global financial crisis; high dimensional VARs; liquidity; risk; sovereign debt crisis; transmission |
| JEL: | C5 E44 F3 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8787&r=cba |
| By: | Devereux, Michael B; Senay, Ozge; Sutherland, Alan |
| Abstract: | Over the one and a half decades prior to the global financial crisis, advanced economies experienced a large growth in gross external portfolio positions. This phenomenon has been described as Financial Globalization. Over roughly the same time frame, most of these countries also saw a substantial fall in the level and variability of inflation. Many economists have conjectured that financial globalization contributed to the improved performance in the level and predictability of inflation. In this paper, we explore the causal link running in the opposite direction. We show that a monetary policy rule which reduces inflation variability leads to an increase in the size of gross external positions, both in equity and bond portfolios. This is a highly robust prediction of open economy macro models with endogenous portfolio choice. It holds across many different modeling specifications and parameterizations. We also present preliminary empirical evidence which shows a negative relationship between inflation volatility and the size of gross external positions. |
| Keywords: | Country Portfolios; Financial Globalization; Nominal stability |
| JEL: | E52 E58 F41 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8830&r=cba |
| By: | Giannone, Domenico; Lenza, Michele; Pill, Huw; Reichlin, Lucrezia |
| Abstract: | This paper analyses the impact on the macroeconomy of the ECB’s non-standard monetary policy implemented in the aftermath of the collapse of Lehman Brothers in the Fall of 2008. We study in particular the effect of the expansion of the intermediation of transactions across central bank balance sheets as dysfunctional financial markets seize up, which we regard as a key channel of transmission for non-standard monetary policy measures. Our approach is similar to Lenza et al., 2009 but we introduce the important innovation of distinguishing between private intermediation of interbank transactions in the money market and central bank intermediation of bank-to-bank transactions across the Eurosystem balance sheet. We do this by exploiting data drawn from the aggregate Monetary and Financial Institutions (MFI) balance sheet which allows us to construct a new measure of the ‘policy shock’ represented by the ECB’s increasing role as a financial intermediary. We find that bank loans to households and, in particular, to non-financial corporations are higher than would have been the case without the ECB’s intervention. In turn, the ECB’s support has a significant impact on economic activity: two and a half years after the failure of Lehman Brothers, the level of industrial production is estimated to be 2% higher, and the unemployment rate 0.6 percentage points lower, than would have been the case in the absence of the ECB’s non-standard monetary policy measures. |
| Keywords: | interbank market; Non-standard monetary policy measures |
| JEL: | E5 E58 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8844&r=cba |
| By: | Acharya, Viral V; Merrouche, Ouarda |
| Abstract: | We study the liquidity demand of large settlement (first-tier) banks in the UK and its effect on the Sterling Money Markets before and during the sub-prime crisis of 2007-08. Liquidity holdings of large settlement banks experienced on average a 30% increase in the period immediately following 9th August, 2007, the day when money markets froze, igniting the crisis. In the UK, unlike in the US until October 2008, the remuneration of reserves accounts provides strong incentives for banks to park liquidity at the central bank rather than lend in the market. We show that following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and for banks with greater credit risk. We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise and volumes to decline, an effect virtually absent in the pre-crisis period. This liquidity effect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds. Further, using bilateral data we show that the effect was more strongly linked to lender risk than to borrower risk. |
| Keywords: | cash; contagion; counterparty risk; funding risk; money markets; rollover risk; systemic risk |
| JEL: | E42 E58 G21 G28 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8859&r=cba |
| By: | Demange, Gabrielle |
| Abstract: | An intricate web of claims and obligations ties together the balance sheets of a wide variety of financial institutions. Under the occurrence of default, these interbank claims generate externalities across institutions and possibly disseminate defaults and bankruptcy. Building on a simple model for the joint determination of the repayments of interbank claims, this paper introduces a measure of the threat that a bank poses to the system. Such a measure, called threat index, may be helpful to determine how to inject cash into banks so as to increase debt reimbursement, or to assess the contributions of individual institutions to the risk in the system. Although the threat index and the default level of a bank both reflect some form of weakness and are affected by the whole liability network, the two indicators differ. As a result, injecting cash into the banks with the largest default level may not be optimal. |
| Keywords: | bankruptcy; contagion; Contagion in financial networks : a threat index; financial linkages; systemic risk |
| JEL: | G01 G21 G28 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8793&r=cba |
| By: | Fecht, Falko; Grüner, Hans Peter; Hartmann, Philipp |
| Abstract: | This paper studies the implications of cross-border financial integration for financial stability when banks' loan portfolios adjust endogenously. Banks can be subject to sectoral and aggregate domestic shocks. After integration they can share these risks in a complete interbank market. When banks have a comparative advantage in providing credit to certain industries, financial integration may induce banks to specialize in lending. An enhanced concentration in lending does not necessarily increase risk, because a well-functioning interbank market allows to achieve the necessary diversification. This greater need for risk sharing, though, increases the risk of cross-border contagion and the likelihood of widespread banking crises. However, even though integration increases the risk of contagion it improves welfare if it permits banks to realize specialization benefits. |
| Keywords: | financial contagion; Financial integration; interbank market; risk sharing; specialization |
| JEL: | D61 E44 G21 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8854&r=cba |
| By: | Adrian Pop (LEMNA - Laboratoire d'économie et de management de Nantes Atlantique - Université de Nantes : EA4272); Diana Pop (GRANEM - Department of Law, Economics, and Management - Université d'Angers) |
| Abstract: | The philosophy behind the debt market discipline approach to banking regulation presumes that the pricing of bank debt securities, if accurate, conveys reliable signals to supervisors. In this paper, we take a critical look at the feasibility of such an approach by exploring empirically the possibility that markets may price differently the risk profile of bank issuers along the empirical distribution of credit spread. The paper proposes a quantile regression framework to draw novel inferences about the functioning of market discipline and the quality of private monitoring in European banking and provides a more comprehensive picture of the distribution of spreads conditional on its main explanatory factors. We find that the spread-risk relationship is systematically steeper and more significant at the "right-tail" of the conditional distribution of credit spread, which suggests that the market is somewhat tougher with "high-risk" banks. |
| Keywords: | Banking regulation and supervision; Market discipline; Subordinated debt; Private monitoring; Credit spreads; Quantile regression |
| Date: | 2012–03–14 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-00678943&r=cba |
| By: | Bacchetta, Philippe; Benhima, Kenza; Kalantzis, Yannick |
| Abstract: | Motivated by the Chinese experience, we analyze a semi-open economy where the central bank has access to international capital markets, but the private sector has not. This enables the central bank to choose an interest rate different from the international rate. We examine the optimal policy of the central bank by modelling it as a Ramsey planner who can choose the level of domestic public debt and of international reserves. The central bank can improve savings opportunities of credit-constrained consumers modelled as in Woodford (1990). We find that in a steady state it is optimal for the central bank to replicate the open economy, i.e., to issue debt financed by the accumulation of reserves so that the domestic interest rate equals the foreign rate. When the economy is in transition, however, a rapidly growing economy has a higher welfare without capital mobility and the optimal interest rate differs from the international rate. We argue that the domestic interest rate should be temporarily above the international rate. We also find that capital controls can still help reach the first best when the planner has more fiscal instruments. |
| Keywords: | Capital controls; International reserves |
| JEL: | E58 F36 F41 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8753&r=cba |
| By: | Acharya, Viral V; Naqvi, Hassan |
| Abstract: | We examine how the banking sector may ignite the formation of asset price bubbles when there is access to abundant liquidity. Inside banks, to induce effort, loan officers are compensated based on the volume of loans. Volumebased compensation also induces greater risk-taking; however, due to lack of commitment, loan officers are penalized ex post only if banks suffer a high enough liquidity shortfall. Outside banks, when there is heightened macroeconomic risk, investors reduce direct investment and hold more bank deposits. This ‘flight to quality’ leaves banks flush with liquidity, lowering the sensitivity of bankers’ payoffs to downside risks and inducing excessive credit volume and asset price bubbles. The seeds of a crisis are thus sown. |
| Keywords: | bubbles; flight to quality; moral hazard |
| JEL: | E32 G21 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8851&r=cba |
| By: | Ralph De Haas (EBRD); Neeltje Van Horen (De Nederlandsche Bank) |
| Abstract: | After Lehman Brothers filed for bankruptcy in September 2008, cross-border bank lending contracted sharply. To explain the severity and variation in this contraction, we analyse detailed data on cross-border syndicated lending by 75 banks to 59 countries. We find that banks that had to write down sub-prime assets, refinance large amounts of long-term debt, and experienced sharp declines in their market-to-book ratio, transmitted these shocks across borders by curtailing their lending abroad. While shocked banks differentiated among countries in much the same way as less constrained banks, they restricted their lending more to small borrowers. |
| Keywords: | Crisis transmission, cross-border lending, syndicated loans |
| JEL: | F36 F42 F52 G15 G21 G28 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:ebd:wpaper:142&r=cba |
| By: | María J. Nieto (Banco de España) |
| Abstract: | This paper focuses on market discipline as a necessary condition to preserve the signaling content of balance sheet indicators and market prices as macroprudential tools. It argues that market discipline enhances the information content of market prices by reflecting the expected private cost of financial distress, including the systemic importance of particular firms. This paper also argues that three conditions are necessary for market discipline to be effective: adequate and timely information on financial institutions’ risk profiles; financial institutions’ creditors must consider themselves at risk; and the reaction to market signals needs to be observable. The paper relies on the existing financial literature and it is particularly timely because policymakers are considering structural measures of banks’ systemic importance as a benchmark for macroprudential policy. |
| Keywords: | Financial crisis, international financial markets, financial regulation, financial institutions, bankruptcy, liquidation |
| JEL: | G17 G19 G21 G29 G34 |
| Date: | 2012–03 |
| URL: | http://d.repec.org/n?u=RePEc:bde:opaper:1202&r=cba |
| By: | Reinhart, Carmen |
| Abstract: | We document that the global scope and depth of the crisis the began with the collapse of the subprime mortgage market in the summer of 2007 is unprecedented in the post World War II era and, as such, the most relevant comparison benchmark is the Great Depression (or the Great Contraction, as dubbed by Friedman and Schwartz, 1963) of the 1930s. Some of the similarities between these two global episodes are examined but the analysis of the aftermath of severe financial crises is extended to also include the most severe post-WWII crises as well. As to the causes of these great crises, we focus on those factors that are common across time and geography. We discriminate between root causes of the crises, recurring crises symptoms, and common features (such as misguided financial regulation or inadequate supervision) which serve as amplifiers of the boom-bust cycle. There are recurring temporal patterns in the boom-bust cycle and their broad sequencing is analyzed. |
| Keywords: | debt; default; financial crises; financial repression |
| JEL: | E6 F3 N0 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8742&r=cba |
| By: | Acharya, Viral V; Gujral, Irvind; Kulkarni, Nirupama; Shin, Hyun Song |
| Abstract: | The headline numbers appear to show that even as banks and financial intermediaries suffered large credit losses in the financial crisis of 2007-09, they raised substantial amounts of new capital, both from private investors and through government-funded capital injections. However, on closer inspection the composition of bank capital shifted radically from one based on common equity to that based on debt-like hybrid claims such as preferred equity and subordinated debt. The erosion of common equity was exacerbated by large scale payments of dividends, in spite of widely anticipated credit losses. Dividend payments represent a transfer from creditors (and potentially taxpayers) to equity holders in violation of the priority of debt over equity. The dwindling pool of common equity in the banking system may have been one reason for the continued reluctance by banks to lend over this period. We draw conclusions on how capital regulation may be reformed in light of our findings. |
| Keywords: | asset substitution; crisis; regulatory capital; risk-shifting |
| JEL: | G21 G28 G32 G35 G38 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8801&r=cba |
| By: | Fratzscher, Marcel; Sarno, Lucio; Zinna, Gabriele |
| Abstract: | This paper provides an empirical test of the scapegoat theory of exchange rates (Bacchetta and van Wincoop 2004, 2011), as an attempt to evaluate its potential for explaining the poor empirical performance of traditional exchange rate models. This theory suggests that market participants may at times attach significantly more weight to individual economic fundamentals to rationalize the pricing of currencies, which are partly driven by unobservable shocks. Using novel survey data which directly measure foreign exchange scapegoats for 12 currencies and a decade of proprietary data on order flow, we find empirical evidence that strongly supports the empirical implications of the scapegoat theory of exchange rates, with the resulting models explaining a large fraction of the variation and directional changes in exchange rates. The findings have implications for exchange rate modelling, suggesting that a more accurate understanding of exchange rates requires taking into account the role of scapegoat factors and their time-varying nature. |
| Keywords: | economic fundamentals; exchange rates; order flow; scapegoat; survey data |
| JEL: | F31 G10 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8812&r=cba |
| By: | Marcos dal Bianco (BBVA Research); Maximo Camacho (Universidad de Murcia); Gabriel Perez-Quiros (Banco de España) |
| Abstract: | We propose a fundamentals-based econometric model for the weekly changes in the euro-dollar rate with the distinctive feature of mixing economic variables quoted at different frequencies. The model obtains good in-sample fi t and, more importantly, encouraging outof-sample forecasting results at horizons ranging from one week to one month. Specifi cally, we obtain statistically signifi cant improvements upon the hard-to-beat random walk model using traditional statistical measures of forecasting error at all horizons. Moreover, our model improves greatly when we use the direction-of-change metric, which has more economic relevance than other loss measures. With this measure, our model performs much better at all forecasting horizons than a naive model that predicts the exchange rate has an equal chance to go up or down, with statistically signifi cant improvements. |
| Keywords: | euro-dollar rate, exchange rate forecasting, State-space model, mixed frequencies |
| JEL: | F31 F37 C01 C22 |
| Date: | 2012–02 |
| URL: | http://d.repec.org/n?u=RePEc:bde:wpaper:1203&r=cba |