Princeton University Updates: - PowerPoint PPT Presentation

Princeton University Updates: http://scholar.princeton.edu/markus/files/i_theory_slides.pdf

The 2 Components of Systemic Risk preventive  Systemic risk build-up during (credit) bubble  “Volatility Paradox” contemp. measures inappropriate  Financial innovation/liberalization more systematic risk  Spillovers/contagion – externalities crisis management  Direct contractual: domino effect (interconnectedness)  Indirect: price effect (fire-sale externalities) credit crunch, liquidity spirals Fire sales Brunnermeier & Sannikov 2012 Precaution Shock to Loss of + tighter capital net worth margins volatility price  Adverse GE response systemic risk is endogenous 2

Run-ups of Debt – Different Sectors United States Japan 350% 700% Government Financial Institutions 300% 600% Households Corporates 250% 500% 200% 400% 150% 300% 100% 200% 50% 100% Brunnermeier & Sannikov 2012 0% 0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009  Different sectors  Japan 1980s: non-fin. business sector + financial  United States 2000s: 3 household sector + financial

Brunnermeier & Sannikov 2012 U.S. Financial Sector Debt 200% 250% 100% 150% 50% 0% 1960 1962 1964 Traditional Banking Net Shadow Banking Net GSE Bank Holding Company 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 4

Financial Stability Price Stability Debt Sustainability Liquidity spiral Financial Regulators De/inflation Central Bank Brunnermeier & Sannikov 2012 Fiscal Fiscal Monetary Authority Dominance 5

Liquidity Concepts  Financial instability arises from the fragility of liquidity A L Technological liquidity Funding liquidity   Reversibility of investment Maturity structure of debt  Can’t roll over short term Market liquidity debt  Specificity of capital  Sensitivity of margins Price impact of capital sale  Margin-funding is recalled Brunnermeier & Sannikov 2012 Maturity mismatch 6

Liquidity Mismatch  Financial instability arises from the fragility of liquidity A L Technological liquidity Funding liquidity   Reversibility of investment Maturity structure of debt  Can’t roll over short term Market liquidity debt  Specificity of capital  Sensitivity of margins Price impact of capital sale  Margin-funding is recalled Brunnermeier & Sannikov 2012 Maturity mismatch  Liquidity mismatch index = response indicator 7

Risk Topography: Data collection joint with Gary Gorton & Arvind Krishnamurthy  Direct responses to 5%, 10%, 15%,… drop in factor to  Δ Value  Δ Liquidity Mismatch Index Maturity mismatch  Predict response  hold out Δ Value  “fire” sell assets Δ LMI  credit crunch (no new loans) Brunnermeier & Sannikov 2012

Risk Topography: General equilibrium joint with Gary Gorton & Arvind Krishnamurthy  Direct responses to 5%, 10%, 15%,… drop in factor to  Δ Value  Δ Liquidity Mismatch Index  Predict response  hold out - “fire” sell assets - credit crunch  Derive likely indirect equilibrium response to  this stress factor  other factors Brunnermeier & Sannikov 2012 Find out whether plans were mutually consistent! (if not tail risk)

Financial Stability Price Stability Debt Sustainability Liquidity spiral Financial Regulators De/inflation Central Bank Brunnermeier & Sannikov 2012 Fiscal Fiscal Monetary Authority Dominance 11

Financial Stability Price Stability Debt Sustainability Liquidity spiral Financial Fisher Regulators Deflation spiral Inside De/inflation Central money Bank Π Brunnermeier & Sannikov 2012 Fiscal Fiscal Monetary Authority Dominance 12

Main results  Passive monetary policy A L  Liquidity Spirals Disinflationary spiral  Endogenous risk  Redistributional effects  Active monetary policy  Interest rate Brunnermeier & Sannikov 2012  Current rate  Forward guidance  Asset purchase programs – open market operation  “Stealth” recapitalization 16

Baseline model without intermediaries  Macro shock 𝜇 = arrival rate Government  Idiosyncratic shock Out-money Tax 𝜚 = probability of stealing Productive Households entrepreneurs Risky claims Brunnermeier & Sannikov 2012 21

Introducing intermediaries  Monitor Government  Diversify Out-money Tax  Maturity/liquidity Intermediaries transformation Inside Risky money Productive claims households entrepreneurs Net worth Risky claims Brunnermeier & Sannikov 2012 22

Two Polar Regimes without intermediaries Regime Frictions Value of Price of fiat capital money “Money” severe high low “Bliss” small low high Brunnermeier & Sannikov 2012 23

Two Polar Regimes with Intermediaries Regime Frictions Value of Price of Intermediaries’ fiat capital capitalization money “Money” severe high low poor “Bliss” small low high well  Role of intermediaries Brunnermeier & Sannikov 2012  Monitoring and thereby reduce friction from 𝜚 to 𝜚  Have to take on productive agent’s equity risk to have incentive to monitor  Depends on their ability to absorb risk  Diversify  Maturity/liquidity transformation 24

Introducing intermediaries  Monitor Government  Diversify Out-money Tax  Maturity/liquidity Intermediaries transformation Inside Risky money Productive claims households entrepreneurs Net worth Risky claims Brunnermeier & Sannikov 2012 25

Adverse shock  Split in 3 steps Government 1. Shock impair assets Out-money Tax 2. Balance sheet shrink 3. Real value of deposit Intermediaries Inside Risky money Productive claims households entrepreneurs Risky claims Brunnermeier & Sannikov 2012 26

Shrink balance sheet – sell off of assets Government Out-money Tax Intermediaries money Productive Risky claims households entrepreneurs Risky claims Brunnermeier & Sannikov 2012 27

Disinflation effect – value of liabilities expand Government Out-money Tax Intermediaries money Productive Risky claims households entrepreneurs Risky claims Brunnermeier & Sannikov 2012 28

After adverse shock  Intermediary net worth ↓  Capital: ↓ Liquidity spiral  fire sales, price q  Allocation efficiency ↓  Money:  Lending + deposits ↓ Disinflation  value of money p ↑ spiral ↓  Multiplier  Banking  Hit on both sides of balance sheet Brunnermeier & Sannikov 2012  Externality among banks  Competition ↓  Amplification/persistence endogenous risk wealth redistribution 32

Monetary Policy  So far, “Gold Standard”  outside money supply is fixed  pays no interest  no central bank  Government issues long-term (perpetual) bonds  pays fixed interest (in money)  Monetary policy Brunnermeier & Sannikov 2012  Central bank pays interest 𝑠 𝑢 ≥ 0 on money (by printing)  Sets total outstanding value 𝑐 𝑢 𝐿 𝑢 of perpetual bond  By changing interest 𝑠 𝑢  Additional Quantitative Easing/Open market operations 33

Money (incl. bonds) + physical capital  Total wealth in the economy: 𝑞 𝑢 𝐿 𝑢 + 𝑟 𝑢 𝐿 𝑢 Value 𝑐 𝑢 𝐿 𝑢 Perpetual bonds: • pay in money (at unit rate) money Capital • endogenous price 𝐶 𝑢 (in money) Brunnermeier & Sannikov 2012 Value 𝑞 𝑢 𝐿 𝑢 Value 𝑟 𝑢 𝐿 𝑢  Implies a complete yield curve 34

Observations  As interest rate are cut in downturns, bonds held by intermediaries appreciate, this  protects intermediaries against shocks  increases the supply of asset that can be used as storage (weakens deflation)  Because downturns are softened, for all η  drop in financial sectors’ capitalization conditional on a shock ↓ ↑  price of capital  money multiplier ↑ Brunnermeier & Sannikov 2012 ↓  price of money ↑  intermediary allocation to capital ↓  household allocation to capital  risk premia (and thus the rate of recovery, conditional on no shocks) ↓ 42

Ex-post Objective of Monetary Policy  Mitigate redistributional effects from endogenous risk/amplification  Targeted redistribution  US 2000s: Household sector  Japan 1980s: non-financial business sector Brunnermeier & Sannikov 2012 44

Interest rate cut ≠ Forward guidance/LSAP  Interest rate cut  Increase long-term fixed assets  Widen term-spread benefits banks’ net income  Forward guidance / LSAP  Lowers 10-1 yrs term spread hurts banks’ net income  Widens 25-10 yrs term spread hurts insurance/pension funds  LSAP on MBS Brunnermeier & Sannikov 2012  mortgage credit spread  Reduces debt service burden (if can refinance)  Increases house prices (fall less) Redistributional effects are very different 45