Stabilization Policies: Equity Injections into Banks or Purchases of Assets?

Stabilization Policies: Equity Injections into Banks or Purchases of Assets? Michael Kühl 27-28 October 216 Annual Global Conference of the European Banking Institute The presentation represents the personal opinion of the author and does not necessarily reflect the views of the Deutsche Bundesbank.

Diabolic loop in a financial crisis Annual Global Conference of the European Banking Institute1

Measures to cope with a financial crisis Annual Global Conference of the European Banking Institute2

Main questions for policy makers Central problem in financial crisis: private sector s borrowing conditions worsen and reduce investment and production. Questions for policy makers: How can a financial system be stabilized when the financial market is under stress? Does the source of financial stress matter? Which measures should be used to mitigate the tensions if bank financing dominates? Evaluate asset purchases and equity injections in a financial crisis situation as unconventional measures when dominance of bank loans. Annual Global Conference of the European Banking Institute3

Framework Use of a dynamic stochastic general equilibrium (DSGE) model. standard macro model with an important role for financial sector. banking sector central for financial intermediation. borrowers in the non-financial sector can default on their obligations. bank cannot default. bank equity and entrepreneurial net worth play important roles. investigation of two types of financial sector shocks! Annual Global Conference of the European Banking Institute4

Two-side financial contracting Annual Global Conference of the European Banking Institute5

Crisis situation 1: entrepreneurial risk shock First scenario: entrepreneurial risk shock riskiness of entrepreneurs expected losses Output Investment.5.1.15.5 1.2 5 1 15 2 25 3 35 4 1.5 5 1 15 2 25 3 35 4 Credit spread (aggregate) Credit premium (aggregate) 1 Annualized BP from ss 5 Annualized BP from ss 1 5 5 1 15 2 25 3 35 4 5 1 15 2 25 3 35 4 Risk free spread (aggregate) Bank profits Annualized BP from ss 2 1 1 5 1 15 2 25 3 35 4 2 2 5 1 15 2 25 3 35 4.5 Inside equity bank.2 Leverage ratio (banks).5 from ss.2.4 5 1 15 2 25 3 35 4.6 5 1 15 2 25 3 35 4 Annual Global Conference of the European Banking Institute6

Crisis situation 2: bank-specific shock Second scenario: bank-specific shock returns of banks exogenous reduction in returns Output Investment.1.2.5 1 5 1 15 2 25 3 35 4 1.5 5 1 15 2 25 3 35 4 Credit spread (aggregate) Credit premium (aggregate) Annualized BP from ss 25 2 15 1 5 Annualized BP from ss 12 1 8 6 4 2 5 1 15 2 25 3 35 4 5 1 15 2 25 3 35 4 Risk free spread (aggregate) Bank profits Annualized BP from ss 8 6 4 2 5 1 15 2 25 3 35 4 1 2 3 5 1 15 2 25 3 35 4 Inside equity bank Leverage ratio (banks).2 1 2 3 from ss.15.1.5 4 5 1 15 2 25 3 35 4 5 1 15 2 25 3 35 4 Annual Global Conference of the European Banking Institute7

Comparison of crisis situations Risk shock vs. bank-specific shock Investment.5 1 1.5 5 1 15 2 25 3 35 4 Credit premium (aggregate) Annualized BP from ss Annualized BP from ss 1 5 1 5.2 5 1 15 2 25 3 35 4 Credit spread (aggregate) 5 1 15 2 25 3 35 4 Leverage ratio (banks) from ss.1 5 1 15 2 25 3 35 4 Risk shock Bank profit shock Annual Global Conference of the European Banking Institute8

Pure effects of asset purchases Output Investments Channels from the model in which non-market-based debt dominates: Bond prices, yields on bonds impulse on bank equity + loans more profitable.3.2.1.1.2.2.1 1 2 3 4 Spreads 1 2 3 4 Profits (banks) credit supply loan rate bank profits, bank equity bank leverage ratio Annualized BP from ss 2 4 6 8 1 credit premium credit spread risk free spread 1 2 3 4 5 1 1 2 3 4 investments and production but need for bank to deleverage reinforces situation in which bank equity under stress! from ss Leverage ratio (banks).1.5.5 from ss.5 1 1.5 2 Bank Equity 1 2 3 4 2.5 1 2 3 4 Annual Global Conference of the European Banking Institute9

Pure effects of equity injections Output Investments.4 Channels from the model in which non-market-based debt dominates: bank equity credit supply yields on bonds and loan rates borrowing conditions for non-fin. firms investments and production but need for bank to deleverage loan rate, bank profits but: leverage ratio driven by equity injections! Annualized BP from ss from ss.3.2.1 2 4 6 8 1.1.2.3.4 1 2 3 4 Spreads credit premium credit spread risk free spread 1 2 3 4 Leverage ratio (banks) from ss.2.15.1.5 1 1 1 5 1 2 3 4 Profits (banks) 1 2 3 4 4Bank x 1 Equity Overall Public.5 1 2 3 4 1 2 3 4 Annual Global Conference of the European Banking Institute1

Evaluation: welfare Entrepreneurial risk shock: Welfare gain in consumption equivalents.1.5.5.1.15 Equity Injection Corp. Bond Purchases Gov. Bond Purchases.5.1.15 % of GDP Welfare gain in consumption equivalents.1.5.5.1.15 1 1.5 2 2.5 3 3.5 4 % of GDP Welfare perspective: E t= βt u (C t, N t) = E t= βt u ( (1 + λ c t ) C, N ) with λ c t as the consumption equivalent. Annual Global Conference of the European Banking Institute11

Evaluation: welfare (2) Bank-specific shock Welfare gain in consumption equivalents.25.2.15.1.5.5 Equity Injection.1 Corp. Bond Purchases Gov. Bond Purchases.15.5 1 1.5 % of GDP Welfare gain in consumption equivalents.25.2.15.1.5.5.1.15 1.5 2 2.5 3 3.5 4 4.5 5 % of GDP Welfare perspective: E t= βt u (C t, N t) = E t= βt u ( (1 + λ c t ) C, N ) with λ c t as the consumption equivalent. Annual Global Conference of the European Banking Institute12

Conclusion Bond purchases and equity injections are both measures to support a non-market-based economy in a financial crisis situation, but...equity injections are more efficient for financial stress that stems from the banking sector....equity injections are not per se welfare improving because they induce additional volatility at some time....asset purchases are not per se welfare improving because of moral hazard effects and costs for public intermediation. Equity injections help to mitigate the consequences of a banking crisis because......they relax banks borrowing constraint, i.e. foster bank equity....they reduce the borrowing conditions of the real sector. asset purchases put banks equity under pressure. Annual Global Conference of the European Banking Institute13

Thanks for your attention! Annual Global Conference of the European Banking Institute14