Countercyclical Macro Prudential Countercyclical Macro Prudential Policies in a Supporting Role to Policies in a Supporting Role to Monetary Policy Monetary Policy Istanbul Istanbul Istanbul Istanbul October 8 October 8 , 2012 , 2012 Papa N’Diaye Papa N’Diaye Asia and Pacific Department Asia and Pacific Department International Monetary Fund International Monetary Fund
Motivation Motivation Explore how prudential regulation can Explore how prudential regulation can support monetary policy. support monetary policy. Blend standard model for monetary policy Blend standard model for monetary policy Blend standard model for monetary policy Blend standard model for monetary policy analysis and model for assessing financial analysis and model for assessing financial sector vulnerability. sector vulnerability. 2
Plan of the Talk Plan of the Talk Macro Macro-Financial Linkages Financial Linkages Contingent claims analysis Contingent claims analysis Model overview Model overview Illustrative scenario Illustrative scenario Conclusions Conclusions 3
Macro Macro-Financial Linkages Financial Linkages Gauge the role of macroprudentials in a richer, Gauge the role of macroprudentials in a richer, dynamic macroeconomic model that incorporates a dynamic macroeconomic model that incorporates a contingent claims approach to capture movements contingent claims approach to capture movements in household, corporate and bank balance sheets. in household, corporate and bank balance sheets. The underlying idea of the modeling strategy The underlying idea of the modeling strategy follows the tradition of the financial accelerator follows the tradition of the financial accelerator model, in that borrowing costs depend on an model, in that borrowing costs depend on an “external finance premium” or spread that reflects “external finance premium” or spread that reflects borrowers net worth borrowers net worth 4
Contingent claims analysis (CCA) Contingent claims analysis (CCA) Contingent claims analysis (CCA) is a generalization of the Contingent claims analysis (CCA) is a generalization of the option pricing theory pioneered by Black option pricing theory pioneered by Black-Scholes Scholes (1973) (1973) and Merton (1973). and Merton (1973). CCA combines balance sheet information with finance and CCA combines balance sheet information with finance and risk management tools to construct marked risk management tools to construct marked-to to-market market balance sheets that better reflect underlying risk. balance sheets that better reflect underlying risk. The underlying risk is estimated using option pricing tools The underlying risk is estimated using option pricing tools that model liabilities as claims on stochastic assets. that model liabilities as claims on stochastic assets. See Gray and Malone (2008) See Gray and Malone (2008) 5
CCA: Framework CCA: Framework Financial distress risk depends Financial distress risk depends Asset Exp. asset ��������������������������� Value value path on the expected variation on the expected variation Distance to (volatility) of assets over an (volatility) of assets over an Distress: horizon relative to the promised horizon relative to the promised standard deviations asset payments on liabilities. payments on liabilities. value is from � � � � debt distress debt distress barrier The uncertainty in asset value is The uncertainty in asset value is Distress Barrier represented by a probability represented by a probability or promised payments distribution at time horizon T. At distribution at time horizon T. At Probability of Default time T the value of the asset may time T the value of the asset may � ���� be above or below the promised be above or below the promised payment (distress barrier payment (distress barrier comprising firm’s liabilities). comprising firm’s liabilities). Default happens when assets Default happens when assets cannot service debt payments, cannot service debt payments, that is that is— —e.g. when asset value fall e.g. when asset value fall below the distress barrier. below the distress barrier. 6
Model Overview Model Overview On the macro side, the model includes an IS curve, On the macro side, the model includes an IS curve, a Phillips curve, an Okun’s law relationship, a a Phillips curve, an Okun’s law relationship, a monetary rule, a yield curve, a modified uncovered monetary rule, a yield curve, a modified uncovered interest parity, a labor income relationship, and interest parity, a labor income relationship, and several identities. several identities. On the financial side, the model includes balance On the financial side, the model includes balance sheets of corporate, households, and banks. Asset sheets of corporate, households, and banks. Asset prices: equity and property prices. prices: equity and property prices. 7
Model Overview Model Overview Monetary authority that Monetary authority that – Target inflation and smooth output fluctuations when Target inflation and smooth output fluctuations when exchange rate is flexible exchange rate is flexible – – Or target a fixed exchange rate Or target a fixed exchange rate Prudential Prudential-regulatory agency limits the extent of Prudential-regulatory agency limits the extent of Prudential regulatory agency limits the extent of regulatory agency limits the extent of leverage in households’, corporates’, and banks’ leverage in households’, corporates’, and banks’ balance sheets in each economy: balance sheets in each economy: – Households and corporates are subject to limits on the Households and corporates are subject to limits on the loans to value ratios, loans to value ratios, – Banks face limits on their capital adequacy ratio Banks face limits on their capital adequacy ratio (measured in the model as equity over assets). The (measured in the model as equity over assets). The capital limits depend on the cycle (output gap) capital limits depend on the cycle (output gap) 8
Model Overview Model Overview 9
Model Overview: Balance Sheet Linkages Model Overview: Balance Sheet Linkages 10 10
Countercyclical Role of Macroprudentials: An Countercyclical Role of Macroprudentials: An Illustrative Scenario Illustrative Scenario Scenario: domestic demand expands for a couple Scenario: domestic demand expands for a couple of quarters. of quarters. Compare the paths of output and asset prices when Compare the paths of output and asset prices when countercyclical prudential regulations are put in countercyclical prudential regulations are put in place and when they are not. place and when they are not. 11 11
Countercyclical Role of Macroprudentials: Countercyclical Role of Macroprudentials: An Illustrative Scenario An Illustrative Scenario 0.25 0.25 30 30 Illustrative Changes in Capital Requirement Policy Interest Rates and External Finance Premium "Spread" 25 (Difference With and Without Capital Adequacy Rule, bps) 25 0.20 0.20 20 20 Spread 15 15 0.15 0.15 0.15 0.15 10 10 5 5 0.10 0.10 0 0 -5 -5 0.05 0.05 Policy Rate -10 -10 0.00 0.00 -15 -15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 12 12
Countercyclical Role of Macroprudentials: Countercyclical Role of Macroprudentials: An Illustrative Scenario An Illustrative Scenario 8 8 0.15 0.15 Equity Price Inflation Output Gap and CPI Inflation (Difference With and Without Capital Adequacy Rule, (Difference With and Without Capital Adequacy Rule) 6 6 Percentage Points) 0.1 0.1 Output Gap 4 4 0.05 0.05 2 2 0 0 0 0 -2 -2 -0.05 -0.05 -4 -4 -0.1 -0.1 CPI Inflation -6 -6 -8 -8 -0.15 -0.15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 13 13
Conclusions Conclusions Countercyclical Countercyclical macroprudential macroprudential measures could measures could be useful complements to monetary policy. be useful complements to monetary policy. How? How? Limiting borrowers’ leverage and increasing Limiting borrowers’ leverage and increasing Limiting borrowers’ leverage and increasing Limiting borrowers’ leverage and increasing lenders’ capital, in particular, can be effective in lenders’ capital, in particular, can be effective in limiting asset price cycles and promoting limiting asset price cycles and promoting macroeconomic stability. macroeconomic stability. Reducing the strength of the financial accelerator. Reducing the strength of the financial accelerator. 14 14
Conclusions Conclusions But there might be daunting difficulties in But there might be daunting difficulties in implementing countercyclical implementing countercyclical macroprudentials macroprudentials – Capital adequacy requirements might not always be Capital adequacy requirements might not always be binding. binding. binding. binding. 15 15
Thank you. Thank you. 16 16
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