Procyclicality and the new Basel Accord - banks’ choice of loan rating system

Summary. The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committees latest proposals, in October 2002.Received: 25 October 2003, Revised: 27 April 2004, JEL Classification Numbers: D58, E44, G28. Correspondence to: Dimitrios P. TsomocosThe authors are grateful to Pamela Nickell for carrying out some of the calculations and Nicola Anderson, Charles Goodhart, Andy Haldane, Glenn Hoggarth, Nobu Kiyotaki, William Klein, Alistair Milne, William Perraudin, Hyun Shin, Paul Tucker, seminar participants at the Bank of England XI European Workshop on General Equilibrium Theory, Federal Reserve Bank of Boston, INSEAD, LSE, the University of Oxford and especially H.M. Polemarchakis for helpful comments and remarks. However, all remaining errors are ours. The views expressed here are those of the authors and do not necessarily reflect those of the Bank of England, and the Bank of Spain.     

Limited participation,private money,and credit in a spatial model of money

Summary. The purpose of this paper is to explore the implications of private money issue for the effects of monetary policy, for optimal policy, and for the role of fiat money. A locational model is constructed which gives an explicit account of the role for money and credit, and for limited financial market participation. When private money issue is prohibited, there is a liquidity effect as the result of a money injection from the central bank, but this effect goes away when private money is permitted. Private money issue changes dramatically the nature of optimal monetary policy. With private money, fiat currency is no longer used in transactions involving goods, but currency and central bank reserves play an important part in the clearing and settlement of private money returned for redemption.Received: 5 May 2003, Revised: 1 December 2003JEL Classification Numbers: E4, E5.The author thanks seminar participants at the Federal Reserve Bank of Richmond and Duke University, conference participants at the Texas Monetary Conference at U.T. Austin, February 2002, and the Conference on Recent Developments in Money and Finance at Purdue University, May 2003, as well as Gabriele Camera, Ed Nosal, Will Roberds, and two anonymous referees for their helpful comments and suggestions.     

A simple search model of money with heterogeneous agents and partial acceptability

Summary. Simple search models have equilibria where some agents accept money and others do not. We argue such equilibria should not be taken seriously. This is unfortunate if one wants a model with partial acceptability. We introduce heterogeneous agents and show partial acceptability arises naturally and robustly. There can be multiple equilibria with different degrees of acceptability. Given the type of heterogeneity we allow, the model is simple: equilibria reduce to fixed points in [0,1]. We show that with other forms of heterogeneity equilibria are fixed points in set space, and there is no method to reduce this to a problem in R¹.Received: 4 September 2002, Revised: 23 September 2002JEL Classification Numbers: C78, E40.A. Shevchenko, R. Wright: We thank seminar participants at the Federal Reserve Bank of Cleveland, Indiana University, Purdue University, University of Toronto, the 2002 Midwest Macroeconomics Conference at Vanderbilt University, and the 2001 Conference on Economic Dynamics at the University of Essex. The National Science Foundation and the Federal Reserve Bank of Cleveland provided financial support. Braz Ministerio de Camargo and Gabriel Camera provided some helpful suggestions. Correspondence to: R. Wright     

Zero Lower Bound Monetary Policy’s Effect on Financial Asset’s Correlations

We investigate the hypothesis that zero lower bound monetary policy has an effect on the correlations of financial assets. Using an event-study approach, we evaluate the impact of the zero lower bound monetary policies of the Bank of Japan, the Bank of England, and the Federal Reserve on the bond and equity markets in Japan, the UK, the US, and the Eurozone. We evaluate the bond markets using the Japanese 10-year Sovereign bond (JGB), UK 10-year bond (Gilt), US 10-year Treasury note (T-note), and German 10-year bond (Bund). For the equity markets we use the Nikkei 225, FTSE 100, S&P 500, and Euro STOXX 600 as proxies for each regional market. We also include gold and silver as control commodities. Our analyses demonstrate significant changes not only in the evaluated assets’ correlations with each other, but also in their general behavior. This has major implications for investment portfolio construction and provides useful insight for financial service regulators and the central banks themselves in monitoring the fragility and stability of the financial system.     

The Interaction of Financial Fragility and the Business Cycle in Determining Banks’ Loan Losses: An Investigation of the Italian Case

The Basel II capital accord and the recent crises have fostered the debate over the financial stability of the aggregate banking sector. Because loan losses are an important factor for banking stability, this paper aims to gauge the impact of real and financial fragility on default losses of Italian banks. To this end the ratio of non‐performing loans to total loans is regressed on the business cycle and indebtedness. In addition, to capture the joint effect of real and financial fragility, the analysis considers an interaction term, which to our knowledge has never been applied before to Italian default data. Based on the interaction model, results show that the actual impact of financial fragility on default losses depends not only on the business cycle phase but also on the firm's size, whereby in adverse economic conditions, small firms are more significantly affected by financial fragility.     

The Governance of a Fragile Eurozone

When entering a monetary union, member countries change the nature of their sovereign debt in a fundamental way; that is, they cease to have control over the currency in which their debt is issued. As a result, financial markets can force these countries’ sovereigns into defaulting. This makes the monetary union fragile and vulnerable to changing market sentiments. It also makes it possible that self‐fulfilling multiple equilibria arise. I analyse the implications of this fragility for the governance of the Eurozone. I argue that the role of the European Central Bank as a lender of last resort is crucial in reducing the fragility of the Eurozone. In addition, steps towards a budgetary union are key in structurally strengthening the union.     

Inflation,growth and exchange rate regimes in small open economies

Summary. This paper compares the merits of alternative exchange rate regimes in small open economies where financial intermediaries perform a real allocative function, there are multiple reserve requirements, and credit market frictions may or may not cause credit rationing. Under floating exchange rates, raising domestic inflation can increase production if credit is rationed. However, there exist inflation thresholds: increasing inflation beyond the threshold level will reduce domestic output. Endogenously arising volatility may be observed independently of the exchange rate regime. Private information - with high rates of domestic inflation - increases the scope for indeterminacy and economic fluctuations.Received: 26 March 2002, Revised: 29 October 2002JEL Classification Numbers: E32, E44, F33.P.L. Hernandez-Verme: I would like to thank Leonardo Auernheimer, Valerie Bencivenga, Dean Corbae, Scott Freeman, Todd Keister, Beatrix Paal, and Maxwell Stinchcombe for very helpful comments and suggestions. Very special thanks are due to Bruce D. Smith. The paper also benefited from the discussions in the seminars in CIDE, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, Indiana University, ITAM, Purdue University, the Second Annual Missouri Economics Conference, Texas A&M, the University of Missouri and the University of Texas at Austin.     

Monetary policy and the financial decisions of firms

Summary. In this paper we develop a general equilibrium model with heterogeneous, long-lived firms where financial factors play an important role in their production and investment decisions. When the economy is hit by monetary shocks, the response of small and large firms differs substantially, with small firms responding more than big firms. As a result of the financial decisions of firms, monetary shocks have a persistent impact on output. Another finding of the paper is that monetary shocks lead to considerable volatility in stock market returns.Received: 20 November 2003, Revised: 26 August 2004 JEL Classification Numbers: E5, G3.T.F. Cooley, V. Quadrini: We have received helpful comments on earlier versions of this paper from Jeff Campbell, David Chapman, Thomas Cosimano, Joao Gomes, Boyan Jovanovic, José-Víctor Ríos-Rull, and Harald Uhlig. Correspondence to: V. Quadrini     

Reviews

Book reviewed in this article:
Prosperity and Depression in Australia 1887–1897 . By E. A. B oehm .
The Pattern of Australia's International Payments . By J. O. N. P erkins .
The Launceston Bank for Savings 1835–1970. A History of Australia's Oldest Savings Bank . By E. A. B eever .
Melanesia–A Geographical Interpretation of an Island World. By H. C. B rookfield with D oreen H art .
The Theory of Futures Trading . By B. A. Goss.
Oligopoly and Conflict: A Dynamic Approach. By M ichael N icholson .
Economies of Scale in Manufacturing Industry . By C. F. P ratten .
The Economics of Advertising . By R. S chmalensee .     

Structural Changes and the Scope of Inflation Targeting in Korea *

A small, open macroeconomic model that accounts for new financial accelerator effects (the effects of fluctuations in asset prices on bank credit and economic activity) is developed to evaluate various policy rules for inflation targeting. Given the conditions of asset markets and the fragility of the financial sector, monetary policy responses can potentially amplify the financial accelerator effect. Simulations are used to compare various forms of inflation targeting using a model that emphasizes long-term inflation expectations, output changes, and the asset price channels. The simulations suggest that a successful outcome can be obtained by adhering to simple forward-looking rules, rather than backward-looking policy rules. Furthermore, inflation targeting can contribute to price as well as output stability by helping to keep the financial accelerator from being activated. Inflation targeting in emerging economies can provide an environment conducive to long-term capital market development. [E51,F3,F4]     

Money,price dispersion and welfare

Summary. We introduce heterogeneous preferences into a tractable model of monetary search to generate price dispersion, and then examine the effects of money growth on price dispersion and welfare. With buyers search intensity fixed, we find that money growth increases the range of (real) prices and lowers welfare as agents shift more of their consumption to less desirable goods. When buyers search intensity is endogenous, multiple equilibria are possible. In the equilibrium with the highest welfare level, money growth reduces welfare and increases the range of prices, while having ambiguous effects on search intensity. However, there can be a welfare-inferior equilibrium in which an increase in money growth increases search intensity, increases welfare, and reduces the range of prices.Received: 25 July 2003, Revised: 12 December 2003JEL Classification Numbers: E31, D60.B. Peterson, S. Shi: We thank Gabriele Camera, Aleksander Berentsen and an anonymous referee for useful suggestions. We have also received valuable comments from the participants of the workshop at Michigan State, the Purdue Conference on Monetary Theory (2003) and the Midwest Macro Meeting (Chicago, 2003). Shi gratefully acknowledges financial support from the Bank of Canada Fellowship and the Social Sciences and Humanities Research Council of Canada. The opinion expressed here is the authors own and does not reflect the view of the Bank of Canada.Correspondence to: S. Shi     

Reviews

Book reviewed in this article:
Growth Receiving: Economic Change in World History , by E. L. Jones (Oxford University Press, Oxford, 1988)
Review of the State Tax System: Tax worm and NSW Economic Development , New South Wales Tax Task Force (NSW Government Printer, Sydney, August 1988)
Incentive Cooperation and Risk Sharing: Economic and Psychological Perspectives on Employment Contacts . by H.F., Nalbantian (Rowman and Littlefield, New Jersey, 1987)
Alternative Systems of Buaivss Organization and Worked Remuneration . by J.E. Meade (Allen & Unwin, London. 1986)
The Costs of Academic Libraries An Econometric Interpretation . by John R. Brockman (Curtain University of Technology, Perth, 1988)
socialism, Economics and Development . by A. Nove (Allen & Unwin, London. 1986).
Stock Market Anomalies , edited by E. Dimson (Cambridge University Press, Cambridge, 1988)
The Flow of Funds in Theory and Practice: A Flow-Constrained Approach to Monetary Theory and Policy , by J. Cohen, Financial and Monetary Policy Studies 15 (Kluwer Academic Publishers. Dordrecht, 1987)
Technological Change Development and the Environment Socio-Economic Perspectives , edited by Clem Tisdell and Riyatosh Maitra (Routledge, London, 1988)
Dynamic Economic Analysis , by Milton Harris (Oxford University Press, New York. 1987)
Elements of Econometrics , by J. Kmenta (MacMillan. New York. 1986)
The Theory of International Trade , by J.R. Markusen and J.R. Melvin (Harper & Row, New York 1988)
An Assessment of Agricultural Research Priorities: An International Paspective , by J.S. Davis, P.A. Oram and J.G. Ryan (Australian Centre for International Research, Canberra. 1987)
A History of Economics The Past as the Present , by John Kenneth Galbraith (Hamish Hamilton, London 1987)     

Why is there money? Endogenous derivation of `money' as the most liquid asset: a class of examples

Summary. The monetary character of trade, use of a common medium of exchange, is shown to be an outcome of an economic general equilibrium. Monetary structure can be derived from price theory in a modified Arrow-Debreu model. Two constructs are added: transaction costs and market segmentation in trading posts (with a separate budget constraint at each transaction). Commodity money arises endogenously as the most liquid (lowest transaction cost) asset. Government-issued fiat money has a positive equilibrium value from its acceptability for tax payments. Scale economies in transaction cost account for uniqueness of the (fiat or commodity) money in equilibrium. Received: February 15, 2002; revised version: August 12, 2002 RID="*" ID="*" This paper has benefited from seminars and colleagues' helpful remarks at the University of California - Santa Barbara, University of California - San Diego, NSF-NBER Conference on General Equilibrium Theory at Purdue University, Society for the Advancement of Behavioral Economics at San Diego State University, Econometric Society at the University of Wisconsin - Madison, SITE at Stanford University-2001, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Minneapolis, Midwest Economic Theory Conference at the University of Illinois - Urbana Champaign, University of Iowa, Southern California Economic Theory Conference at UC - Santa Barbara, Midwest Macroeconomics Conference at University of Iowa, University of California - Berkeley, European Workshop on General Equilibrium Theory at University of Paris I, Society for Economic Dynamics at San Jose Costa Rica, World Congress of the Econometric Society at University of Washington, Cowles Foundation at Yale University. It is a pleasure to acknowledge comments of Henning Bohn, Harold Cole, James Hamilton, Mukul Majumdar, Harry Markowitz, Chris Phelan, Meenakshi Rajeev, Wendy Shaffer, Bruce Smith, and Max Stinchcombe.     

The role of exchange rate in inflation targeting: the case of Turkey

ABSTRACT

The role of the exchange rates in emerging market economies that have adopted inflation targeting (IT) is a critical and contentious issue in the relevant literature. This article investigates whether an exchange rate-augmented Taylor rule describes the Central Bank of Republic of Turkey’s (CBRT) monetary policy. Covering the period from 2002:1 to 2017:8 it also explores possible nonlinearities in the reaction function of the CBRT by employing a Threshold Vector Autoregressive (TVAR) model. The linear estimation of the model highlighted the importance of the exchange rate in monetary policy under IT. The results of the nonlinear model indicate that the stance of monetary policy was asymmetric with respect to exchange rate movements during the conventional IT period. However, the asymmetric monetary policy stance disappeared in the aftermath of the Global Financial Crisis. Increasing considerations of financial stability undermined the asymmetric policy stance of the CBRT in the post-crisis period.     

What is on the ECB’s mind? Monetary policy before and after the global financial crisis

This paper analyzes the monetary policy of the European Central Bank (ECB) both before and after the outbreak of the global financial crisis in 2008. In the literature, researchers typically select one Taylor rule-based model to analyze monetary policy of central banks and to derive determinants for the interest rate setting. However, uncertainty about the choice of this respective model is typically neglected. In contrast, we apply a Bayesian model averaging (BMA) approach to extend the Taylor rule to account for model uncertainty driven by heterogeneity in the ECB’s decision-making body, the Governing Council. Our results suggest the following: First, the ECB focuses on the inflation rate when setting interest rates. Second, economic activity indicators were in the focus of the ECB before the financial crisis. Third, over the last decade, the role of economic activity decreased, indicating that inflation is the main driver of monetary policy decisions in the post-crisis period. Fourth, when setting interest rates, central bankers appear to consider more than one model.     

DEVELOPMENT ECONOMICS: A REVIEW ARTICLE

Book reviewed in this article:
H. MYINT, Economic Theory and the Underdeveloped Countries (Oxford University Press, London 1971)
P. T. BAUER, Dissent on Development
A. P. THIRLWALL, Growth and Development with special reference to developing economies
G. RANIS (ed.), The Gap between Rich and Poor Nations (Proceedings of a Conference held by the International Economic Association)
B. WARDS, J. D. RUNNALS AND I-. D'ANJOU (eds.), The Widening Gap
L. G. REYNOLDS, The Three Worlds of Economics
B. BALASSA AND ASSOCIATES, The Structure of Protection in Developing Countries
G. L. HICKS AND G. McNICOLL, Trade and Growth in the Philippines     

European policy and markets: Did policy initiatives stem the sovereign debt crisis in the euro area?

We investigate how European policy initiatives influenced market assessments of sovereign default risk and banking sector fragility during the sovereign debt crisis in four adversely affected countries — Portugal, Ireland, Spain and Italy. We focus on three broad groups of policies: (a) ECB policy actions (monetary and financial support), (b) EU programs (financial and fiscal rules as well as financial support in crisis countries), and (c) domestic austerity programs. We measure immediate market impact effects: what policies changed risk perceptions, using CDS spreads on sovereign bonds and banks in this assessment. We employ dynamic panel and event study methodologies in the empirical work. We find that a number of programs initially stabilized sovereign and bank bond markets (e.g. Outright Monetary Transactions program), although announcement and implementation impacts on markets differed in some cases (e.g. second Covered Market Bond Program). Actions designed to shore up sovereign markets often lowered risk assessments in bank bond markets and policies designed to ensure safety and soundness of the European banking system in some cases significantly impacted sovereign debt markets. Finally, a number of policies designed to stabilize markets had surprisingly little immediate impact on either sovereign or bank bond market risk assessments.     

Evaluating monetary policy with financial stability objective: rules vs. discretion

This article explores whether adding the goal of financial stability to the more traditional goals of output and price stability could improve optimality of monetary policy. A Dynamic Stochastic General Equilibrium model that endogenously incorporates financial frictions is used to derive optimality conditions across rule-based and discretionary monetary policy environments. The results indicate that it is optimal for the Central Bank to keep output below the potential level in the short term so as to dampen the inflationary effects arising from supply and financial shocks. When the economy is exposed to a financial shock, both leverage and credit spread rise significantly, thereby tipping the economy into a financial crisis and raising the probability of macroeconomic risk.     

DO POLITICS CAUSE REGIME SHIFTS IN MONETARY POLICY?

Whether or not politics cause changes in monetary policy is controversial in the literature. This article re‐examines the link between politics and regime shifts in monetary policy using two alternative approaches. First, empirical results show that both the presidential and Federal Reserve Bank (Fed) chairmanship regimes do not influence monetary policy under the assumption that the Fed closely follows an interest rate rule. On the other hand, evidence also suggests that changes in political regimes are able to account for the deviations from the optimal Taylor rule. (JEL E52, E58, D78)     

零利率下限、货币政策与金融稳定?

文章通过构建包含零利率下限约束的D SGE 模型,系统探讨了存在零利率下限时外生不利冲击对经济的影响。研究结果表明：(1)当名义利率触及零利率下限时,宏观经济和金融体系的不稳定性和脆弱性会显著增加,外生不利冲击对产出、通胀、信贷等经济变量的影响也会明显放大。(2)当存在零利率下限时,传统泰勒规则已无法有效稳定经济,最优的货币政策规则不仅应盯住产出缺口和通胀缺口,还应对资产价格和信贷给予重点关注并做出适度反应。(3)货币政策更适于保持产出缺口和通胀缺口的稳定,但难以有效减缓房价和信贷的波动。只有将逆周期监管的宏观审慎政策和货币政策有效搭配,才能保证经济系统和金融系统的全面稳定。为了应对不利冲击,我国应进一步完善宏观审慎监管框架,并将其与货币政策有效搭配以保持宏观经济的全面稳定。