Bubbles, Crashes & the Financial Cycle. The Limits to Credit Growth
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1 : The Limits to Credit Growth and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld University WEHIA Sophia Antipolis, May 2015
2 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?
3 Agent Role Activity Household Activity Role Agent ConsGoodFirm Employee labor supply reservation wage Labor Market (search & matching) labor demand wage schedule Employer Consumer cgood demand consumption choice Cons. Goods Market (local malls) cgood supply posted prices Producer Investor asset demand Financial Market savings decision (index bond) InvGoodFirm Producer igood supply vintage menu posted prices Capital Goods Market igood demand vintage choices Investor Bank Credit Market credit supply credit demand Creditor Debtor rank credit risk rank interest (credit rationing) ECB Gov Monetary policy Policy maker
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5 Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement 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:
6 Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement Probability of Default, Interest rate rule 1. Firm s default probability PD f t = max{0.0003,1 e νdf t /Ef t }, ν = Interest rate offered by bank b to firm i r ECB = 0.01 r bf t = r ECB ( 1 + λ B PD f t + εb t ), ε b t U[0,1] λ B = 3: penalty rate for high-risk firm, uniform across banks εt b : bank s ideosyncratic operating costs
7 Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement Capital Adequacy Requirement 1. Risk-exposure of credit request (Expected Loss at Default): rwait b = PD it L it. and RWA b F K (i) t = PD kt L kt, (1) i=1 k=0 2. Constraint 6: Capital Adequacy Requirement (CAR) 3. Risk-exposure "budget" of the bank: 4. Risk-constrained loan demand: RWA b t α E b t, α 0 (2) l b it = V b t := α E b t RWA b t (3) L it if PD it L it Vt b 0 if 0 Vt b PD it L it 0 if Vt b < 0. (4)
8 Mechanisms in the model Capital Adequacy Requirement Reserve Ratio Requirement Reserve Ratio Requirement Constraint 7: Reserve Ratio Requirement (RRR) Excess liquidity "budget" of the bank: Mt b β Dept b, β [0,1] (5) W b t := M b t β Dep b t (6) Loan granted: risk- and liquidity constrained credit request l b i,t if Wt b l b i,t l b i,t = φ l i,t if 0 Wt b l b i,t 0 if Wt b < 0. Possibility of credit rationing: {φ : Wt b φ l b i,t = 0} φ = W t 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) (7)
9 Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth Parameter sensitivity analysis alfa_20_gamma beta_20_gamma_10_alfa Eurostat_output Eurostat_output α-sensitivity: Cap. Adq. Req. Default: α = 32 (3%) Lower: amplitude of recessions increases β-sensitivity: Reserve Req. Default: β = 0.05 (5%) Higher: amplitude of recessions decreases
10 Recessions and expansions Output Quarters
11 Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth Parameter sensitivity analysis full_amplitude_recession Parameter 1 α-sensitivity: Cap. Adq. Req. Basel III: % α = Lower: amplitude of recessions increases β-sensitivity: Reserve Req. EU: β = 0.01, US: β = 0.10, CA: β = 0 Higher: amplitude of recessions decreases
12 Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth Parameter sensitivity analysis 2D-grid beta alpha
13 Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth 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?
14 Amplitude of recessions Prevention and mitigation: The Limits to Credit Growth Prevention and mitigation policies: The Limits to Credit Growth Comparison across regulations A - G full_amplitude_recession full_cumm_loss_recession A B C D E F G Parameters amplitude of recessions (output lost) A B C D E F G Parameters cumulative loss of output (amplitude & duration)
15 Main 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.
16 Model documentation: Thank you for your attention! Papers: S van der Hoog & H Dawid (2015): Bubbles, Crashes and the Financial Cycle, Working Paper Bielefeld University. H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2014): Agent-Based Macroeconomic Modeling and Policy Analysis: The Eurace@Unibi Model. In: S-H Chen, M Kaboudan (Eds), Handbook on Computational Economics and Finance. Oxford University Press. H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2012): The : An Agent-Based Macroeconomic Model for Economic Policy Analysis. Working Paper University Bielefeld. H Dawid, S Gemkow, P Harting, S van der Hoog & M Neugart (2011): v1.0 User Manual. Working Paper Bielefeld University. H Dawid & P Harting (2012): Capturing Firm Behavior in Agent-Based Models of Industry Evolution and Macroeconomic Dynamics, in: G. Bünstorf (Ed), Applied Evolutionary Economics, Behavior and Organizations. Edward Elgar, pp H Dawid & M Neugart (2011): Agent-based Models for Economic Policy Design, Eastern Economic Journal 37,
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18 Outlook & Future research The Big Questions Macroprudential regulation Systemic risk (SIFIs, SIBs) Bank-firm networks size effects balance sheet contagion Empirically-grounded bank behavior Credit quotas Credit rationing of SMEs Tighter integration of Basel III regulation
19 Scenario: Capital Adequacy Requirement Output Bank activity (α = 2) Firm activity (α = 2) alfa Bank_active_none Bank_active_exposure Bank_active_liquidity Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Eurostat_output Bank_active_multi Firm_insolvency_SL
20 Scenario: Minimum Reserve Requirement Output Bank activity (β = 0.50) Firm activity (β = 0.50) min_cash_reserve_ratio Bank_active_none Bank_active_exposure Bank_active_liquidity Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Eurostat_output Bank_active_multi Firm_insolvency_SL
21 Output Scenario: Capital Adequacy Requirement Bank activity (α = 2) Firm activity (α = 2) alfa Bank_active_none Bank_active_exposure Bank_active_liquidity Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Eurostat_output Bank_active_multi Firm_insolvency_SL alfa alfa alfa Bank_equity F_EARatio Firm_mean_interest Bank equity Firm fragility Mean interest
22 Output Scenario: Minimum Reserve Requirement Bank activity (β = 0.50) Firm activity (β = 0.50) min_cash_reserve_ratio Bank_active_none Bank_active_exposure Bank_active_liquidity Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Eurostat_output Bank_active_multi Firm_insolvency_SL min_cash_reserve_ratio min_cash_reserve_ratio min_cash_reserve_ratio Bank_equity F_EARatio Firm_mean_interest Bank equity Firm fragility Mean interest
23 Firm activity Number of illiquid firms No constraint Capital constraint (α = 2) Liquidity constraint (β = 0.50) Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Firm_insolvency_SL Firm_insolvency_SL Firm_insolvency_SL
24 Bank activity Number of active banks (unconstrained + constrained by equity/liquidity constraint) No constraint Bank_active_none Bank_active_exposure Bank_active_liquidity Capital constraint (α = 2) Bank_active_none Bank_active_exposure Bank_active_liquidity Liquidity constraint (β = 0.5) Bank_active_none Bank_active_exposure Bank_active_liquidity Bank_active_multi Bank_active_multi Bank_active_multi
25 Scenarios: Firm Fragility Firm E/A-ratio = 1/leverage The Big Questions Capital constraint alfa Liquidity constraint min_cash_reserve_ratio F_EARatio F_EARatio
26 Prevention and mitigation - Bank dividend payout full_amplitude_recession full_cumm_loss_recession Parameters Parameters amplitude of recessions cumulative loss
27 Bank accounting 1. Bank profit π b t = r b i L b i r b ( h M b h + i M b i ) + r ECB (M b t D b t ) 2. Bank cash and reserves M b t+1 = Mb t + M b h + Mb i + (1 τ)max[0,π b t ] d b (1 τ)max[0,π b t ]
28 Debt-equity transformation The Big Questions 3a. Insolvency bankruptcy Debt renegotiation is addressed by re-scaling the total debt D f t with a debt rescaling parameter ϕ. Target debt is given by: D = ϕa f t with 0 ϕ 1. (8) After debt restructuring, the equity of the firm is now positive: E = (1 ϕ)a f t > 0. (9) The new debt/equity-ratio is given by the constant D /E = ϕ/(1 ϕ) < 1.
29 Debt-equity transformation The Big Questions 3b. Illiquidity bankruptcy Debt-renegotiation is not necessary per se, rescaling of the debt is either based on the level of total assets or on the level of the original debt: D = { ϕa f t if ϕa f t Df t ϕd f t if ϕa f t > Df t. with 0 ϕ 1. (10) The new debt/equity-ratio is given by the following piece-wise function: D /E = { ϕ/(1 ϕ) if ϕa f t D f t ϕ/(a/d ϕ) if ϕa f t > Df t. (11)
30 Dividend payout rule R f nr : average revenues over previous n R months (n R = 3,6,12) Π f ne : average net earnings (after-tax profits) over the last n E months R f nr = 1 n R 1 n R Rt i f (12) i=0 Π f ne = 1 n E 1 n E Π f t i (13) i=0 Prevent liquidity hoarding by firms: Liquidity Buffer Stock 4. Dividend payout rule: Div f = { d Π f 4 if M f t µ R f 6 Π f 4 if M f t > µ R f 6. d = 0.7, µ = 0.5 (14)
31 Exogenous Credit Rationing The Big Questions 5a. Full/Partial credit rationing is based on the (exogenously prescribed, ex ante) constraints of the bank (CAR, CRR). Full rationing for CAR constraint: l b it = L it if PD it L it Vt b 0 if 0 Vt b PD it L it 0 if Vt b < 0. Partial rationing ("filling up to constraint") for CAR constraint: l b it = L it if PD it L it Vt b Vt b /PD it if 0 Vt b PD it L it 0 if Vt b < 0. (15) (16)
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