The Big Questions Eurace@Unibi Model Simulation Results Conclusions Bubbles, Crashes & the Financial Cycle: The Limits to Credit Growth Sander van der Hoog and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld University WEHIA Sophia Antipolis, 21-23 May 2015 Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Simulation Results Conclusions The Big Questions ◮ Which micro- or macro-prudential banking regulations are beneficial to financial stability ? ◮ Prevention and mitigation policies: ◮ How to prevent severe downturns from occurring? ◮ How to mitigate the cumulative economic losses? Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Agent Role Activity Activity Role Agent Household ConsGoodFirm Labor labor supply Market labor demand Employee Employer (search & reservation wage wage schedule matching) C o n s . G o o d s cgood demand cgood supply P r o d u c e r Consumer M a r k e t consumption posted prices (local malls) choice Financial asset demand I n v e s t o r Market savings decision (index bond) I n v G o o d F i r m C a p i t a l igood supply i g o o d d e m a n d G o o d s I n v e s t o r Producer vintage menu v i n t a g e c h o i c e s M a r k e t posted prices B a n k C r e d i t credit supply credit demand M a r k e t Creditor D e b t o r rank credit risk (credit rank interest rationing) v E C B G o Monetary Policy policy maker E u r a c e @ U n i b i
The Big Questions Mechanisms in the model Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Ratio Requirement Conclusions Mechanisms in the model 1. Probability of Default (PD): Internal Risk-Based approach (IRB) 2. Interest rate rule for commercial banks 3. Debt-equity transformation: Insolvency / Illiquidity 4. Dividend payout rule 5. Credit rationing rule 6. Capital Adequacy Requirement (CAR) 7. Central Bank Reserve Ratio Requirement (RRR) 8. Future research: Capital Conservation Buffers & Counter-Cyclical Capital Buffers: Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Mechanisms in the model Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Ratio Requirement Conclusions Probability of Default, Interest rate rule 1. Firm’s default probability t = max { 0 . 0003 , 1 − e − ν D f t / E f PD f t } , ν = 0 . 1 2. Interest rate offered by bank b to firm i = r ECB � 1 + λ B · PD f � r bf t + ε b , ε b t ∼ U [ 0 , 1 ] t t r ECB = 0 . 01 λ B = 3: penalty rate for high-risk firm, uniform across banks ε b t : bank’s ideosyncratic operating costs Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Mechanisms in the model Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Ratio Requirement Conclusions Capital Adequacy Requirement 1. Risk-exposure of credit request (Expected Loss at Default): K ( i ) F rwa b RWA b ∑ ∑ it = PD it · L it . and t = PD kt · L kt , (1) i = 1 k = 0 2. Constraint 6: Capital Adequacy Requirement (CAR) RWA b t ≤ α · E b t , α ≥ 0 (2) 3. Risk-exposure "budget" of the bank: V b t := α · E b t − RWA b (3) t 4. Risk-constrained loan demand: if PD it · L it ≤ V b L it t ¯ ℓ b if 0 ≤ V b it = 0 t ≤ PD it · L it (4) if V b 0 t < 0 . Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Mechanisms in the model Eurace@Unibi Model Capital Adequacy Requirement Simulation Results Reserve Ratio Requirement Conclusions Reserve Ratio Requirement ◮ Constraint 7: Reserve Ratio Requirement (RRR) M b t ≥ β · Dep b t , β ∈ [ 0 , 1 ] (5) ◮ Excess liquidity "budget" of the bank: W b t := M b t − β · Dep b (6) t ◮ Loan granted: risk- and liquidity constrained credit request ¯ t ≥ ¯ ℓ b if W b ℓ b i , t i , t ℓ b φ · ¯ t ≤ ¯ ℓ b if 0 ≤ W b ℓ b i , t = (7) i , t i , t if W b 0 t < 0 . t − φ · ¯ t / ¯ Possibility of credit rationing : { φ : W b ℓ b i , t = 0 } → φ = W b ℓ b i , t ◮ Illiquid banks stop lending to all firms (bank lending channel) ◮ Risky firms cannot get loans (borrower’s balance sheet channel) Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Amplitude of recessions Simulation Results Prevention and mitigation: The Limits to Credit Growth Conclusions Parameter sensitivity analysis alfa_20_gamma beta_20_gamma_10_alfa 1.0 2.0 4.0 8.0 16.0 32.0 0.01 0.02 0.05 0.10 0.20 0.50 5000 5000 4000 4000 Eurostat_output Eurostat_output 3000 3000 2000 2000 0 200 400 600 800 1000 0 200 400 600 800 1000 Months Months α -sensitivity: Cap. Adq. Req. β -sensitivity: Reserve Req. ◮ Default: α = 32 (3 % ) ◮ Default: β = 0 . 05 (5 % ) ◮ Lower: amplitude of recessions ◮ Higher: amplitude of recessions increases decreases Sander van der Hoog Bubbles, Crashes & the Financial Cycle
Recessions and expansions 9000 8500 8000 Output 7500 7000 6500 6000 0 20 40 60 80 100 120 Quarters
The Big Questions Eurace@Unibi Model Amplitude of recessions Simulation Results Prevention and mitigation: The Limits to Credit Growth Conclusions Parameter sensitivity analysis −2000 −2000 full_amplitude_recession −4000 −4000 −6000 −6000 −8000 −8000 0.00 0.01 0.02 0.05 0.10 0.20 0.50 0.90 0.99 1.00 Parameter 1 α -sensitivity: Cap. Adq. Req. β -sensitivity: Reserve Req. ◮ Basel III: 4 . 5 − 10 . 5 % ◮ EU: β = 0 . 01, US: β = 0 . 10, CA: α = 22 . 2 − 9 . 5 β = 0 ◮ Lower: amplitude of recessions ◮ Higher: amplitude of recessions increases decreases Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Amplitude of recessions Simulation Results Prevention and mitigation: The Limits to Credit Growth Conclusions Parameter sensitivity analysis 2D-grid 1.00 −700 0.90 0.45 −800 0.35 −900 beta 0.25 −1000 0.10 −1100 0.02 −1200 0.00 4.0 6.0 8.0 10.0 12.0 16.0 20.0 24.0 28.0 32.0 alpha Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Amplitude of recessions Simulation Results Prevention and mitigation: The Limits to Credit Growth Conclusions Prevention and mitigation policies: The Limits to Credit Growth Proposed regulations to limit excesses in banking (eg. Admati & Hellwig, 2013): A. Default regulation: Capital ratio 12 . 5 % , Reserve ratio 10 % . B. Banning bank dividend payouts → Increases bank equity capital C. Using non-risk-weighted capital ratios → Prevents abuse of risk-weights ("risk-weight management optimization") D. Cutting-off funding to all financially unsound firms → Prevents leverage E. Cutting-off funding to Ponzi firms only → Prevents further leverage F. Combined effect of BCD → Does it help to prevent bubbles? G. Combined effect of BCE → Does it help to prevent bubbles? Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Amplitude of recessions Simulation Results Prevention and mitigation: The Limits to Credit Growth Conclusions Prevention and mitigation policies: The Limits to Credit Growth Comparison across regulations A - G −500 −500 −2000 −2000 −1000 −1000 full_cumm_loss_recession full_amplitude_recession −4000 −4000 −1500 −1500 −6000 −6000 −2000 −2000 −8000 −8000 −2500 −2500 −10000 −10000 −3000 −3000 A B C D E F G A B C D E F G Parameters Parameters amplitude of recessions cumulative loss of output (output lost) (amplitude & duration) Sander van der Hoog Bubbles, Crashes & the Financial Cycle
The Big Questions Eurace@Unibi Model Simulation Results Conclusions Main Conclusions ◮ To prevent large cumulative losses that follow from recessions, it is required to cut-off funding to all financially unsound firms (speculative and Ponzi firms). ◮ Mere capital ratios, and increasing them incrementally, do not help to prevent credit bubbles. ◮ Imposing strict limits to growth on the excessive supply of credit seems to work best to mitigate the severity of economic downturns. Sander van der Hoog Bubbles, Crashes & the Financial Cycle
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