Paradox of Prudence & inkage between Financial & Price Stability Markus Brunnermeier Reserve Bank of South frica Pretoria, South frica, Oct 26 th, 2017
Overview 1. From Risk in Isolation to Systemic Risk Volatility Paradox Direct Spillovers domino effects Indirect Spillovers amplifiers vs. absorbers Paradox of Prudence (becoming an amplifier) 2. From Separation Principles to Interlinkages across stability concepts and redistributive monetary policy 3. International: Safe assets and cross-border capital flows From a Buffer pproach to a Rechanneling pproach
The 2 Components of Systemic Risk 1. Systemic risk build-up during (credit) bubble and materializes in a crisis time-series Volatility Paradox contemp. measures inappropriate ow VaR low margins high margins high leverage low risk-weights less capital high leverage Shock leads to large adjustment High VaR Procyclicality Countercyclical puffer See paper More subtle: better idiosyncratic risk sharing higher endogenous risk
The 2 Components of Systemic Risk 1. Systemic risk build-up during (credit) bubble and materializes in a crisis time-series Volatility Paradox contemp. measures inappropriate ow VaR low margins high margins high leverage low risk-weights less capital high leverage Shock leads to large adjustment High VaR Procyclicality Countercyclical puffer See paper More subtle: better idiosyncratic risk sharing higher endogenous risk
The 2 Components of Systemic Risk 1. Systemic risk build-up during (credit) bubble and materializes in a crisis time-series Volatility Paradox contemp. measures inappropriate ow VaR low margins high margins high leverage low risk-weights less capital high leverage Shock leads to large adjustment High VaR Procyclicality Countercyclical puffer See paper More subtle: better idiosyncratic risk sharing higher endogenous risk
crisis management The 2 Components of Systemic Risk 1. Systemic risk build-up during (credit) bubble and materializes in a crisis time-series Volatility Paradox contemp. measures inappropriate 2. Spillovers/contagion cross sectional Direct contractual: domino effect network Network effects Bankruptcy of bank leads to default of B 1 st, 2 nd, 3 rd round effects Random recovery rate Data implications: Position data High frequency High granularity 6preventive
crisis management preventive The 2 Components of Systemic Risk 1. Systemic risk build-up during (credit) bubble and materializes in a crisis time-series Volatility Paradox contemp. measures inappropriate 2. Spillovers/contagion cross sectional Direct contractual: Indirect: domino effect - network price effect (fire-sale externalities) credit crunch, liquidity spirals Shock to capital oss of net worth Precaution + tighter margins Fire sales nonlinearity dverse GE response volatility price amplification, persistence 7
bsorbers vs. amplifier Direct Contractual links oss through bankruptcy/default Indirect Virtual links Similar exposure than other levered players Position data Shock absorber Response indicator - expectations/ constraints Distribution exogenous endogenous Shock amplifier Fat tail8
bsorbers vs. amplifier Response Indicator iquidity mismatch not maturity mismatch Technological Illiquidity - Irreversibility Market Illiquidity - Price Impact Fund Illiquidity - Maturity - Haircut/margin sensitivity Micro-prudential Macro-prudential Market Illiquidity exogenous depends on funding structure of other holders See Brunnermeier, Gorton & Krishnamurthy (2012)
From Risk in Isolation to Spillover Risk From VaR to ΔCoVaR
Paradox of Prudence Fallacy of Composition in Risk Space 1. Keynes Paradox of Thrift 2. Paradox of Prudence Brunnermeier & Sannikov (Handbook chapter 2017) Each institution tries to reduce risk exposure (micro-prudent) Increases endogenous (systemic) risk (macro-imprudent) iquidity spirals, fire-sales, Disinflationary spirals,
Overview 1. From Risk in Isolation to Systemic Risk Volatility Paradox Direct Spillovers domino effects Indirect Spillovers amplifiers vs. absorbers Paradox of Prudence (becoming an amplifier) 2. From Separation Principles to Interlinkages across stability concepts and redistributive monetary policy 3. International: Safe assets and cross-border capital flows From a Buffer pproach to a Rechanneling pproach
Separation Principles Perspectives Separation of task and accountability
Interlinkages Perspectives From YouTube video: Money and Banking by Markus.Economicus
Interlinkages Perspectives From YouTube video: Money and Banking by Markus.Economicus
Interlinkages: MacroPru & MoPo iquidity spiral, fire sales Disinflationary spiral Endogenous systemic risk
Interlinkages: MacroPru & MoPo In EME many MacroPru = MoPo measures Inside money creation by private banks Central bank balance sheet Reserve holding due to liquidity regulation (CR)
Inside equity HH Net worth The I Theory of Money Technologies b Outside Money Pass through Outside Money Technologies a Money Inside Money (deposits) B 1 Net worth Money 1 Intermediaries Can diversify within sector b Monitoring Create inside money Maturity/liquidity transformation
Inside equity HH Net worth Shock impairs assets: 1 st of 4 steps Technologies b Outside Money Pass through Technologies a Money Inside Money (deposits) B 1 Net worth osses Money 1
Inside equity HH Net worth Shrink balance sheet: 2 nd of 4 steps Technologies b Deleveraging Deleveraging Technologies a Money Outside Money Pass through Inside Money Inside Money (deposits) (deposits) B 1 1 Net worth osses Money 1 Switch Paradox of Prudence
Inside equity HH Net worth iquidity spiral: asset price drop: 3 rd of 4 Technologies b Money Deleveraging Outside Money Deleveraging Pass through Inside Money Inside Money (deposits) (deposits) Technologies a B 1 1 Net worth osses Money 1
Inside equity HH Net worth Disinflationary spiral: 4 th of 4 steps Technologies b Deleveraging Deleveraging Technologies a Money Outside Money Pass through Inside Money Inside Money (deposits) (deposits) B 1 1 Net worth osses Money 1
Redistributive MoPo: I Theory of Money Reserves ong-term Bonds Pass through Inside Money (deposits) Net worth N t Monetary policy Interest rate cut long-term bond price sset purchase asset price stealth recapitalization - redistributive risk premia iquidity & Deflationary Spirals are mitigated
Redistributive MoPo: I Theory of Money Reserves ong-term Bonds Pass through Inside Money (deposits) Net worth N t dverse shock iquidity & Deflationary Spirals Monetary policy Interest rate cut long-term bond price sset purchase asset price stealth recapitalization - redistributive risk premia iquidity & Deflationary Spirals are mitigated
Redistributive MoPo: I Theory of Money Reserves ong-term Bonds Pass through Inside Money (deposits) Net worth N t dverse shock iquidity & Deflationary Spirals Monetary policy Interest rate cut long-term bond price sset purchase asset price stealth recapitalization - redistributive iquidity & Deflationary Spirals are mitigated risk premia MoPo with risk premium focus
Redistributive MoPo: I Theory of Money Reserves ong-term Bonds Pass through Inside Money (deposits) Net worth N t dverse shock iquidity & Deflationary Spirals Monetary policy Interest rate cut long-term bond price sset purchase asset price stealth recapitalization - redistributive iquidity & Deflationary Spirals are mitigated risk premia MoPo with risk premium focus
Difference to New Keynesian View Consumption Boost approach to Bottleneck approach (New) Keynesian Demand Management Stimulate aggregate consumption Substitution effect I Theory of Money Risk (premium) management lleviate balance sheet constraints Income/wealth effect Woodford Tobin (1982) BruSan Price stickiness Perfect capital markets Representative gent Cut i Reduces r due to price stickiness Consumption c rises Both Cut i Changes bond prices Redistributes from low MPC to high MPC consumers Heterogeneous gents Financial Frictions Incomplete markets - -
Difference to New Keynesian View Consumption Boost approach to Bottleneck approach (New) Keynesian Demand Management I Theory of Money Risk (premium) management Stimulate aggregate consumption Substitution effect lleviate balance sheet constraints Income/wealth effect Woodford Tobin (1982) BruSan Price stickiness Perfect capital markets Both Financial Frictions Incomplete markets Representative gent Heterogeneous gents Cut i Reduces r due to price stickiness Consumption c rises Cut i Changes bond prices Redistributes from low MPC to high MPC consumers Cut i Changes asset prices Ex-post: Redistributes to balance sheet impaired sector QE - -
Difference to New Keynesian View Consumption Boost approach to Bottleneck approach (New) Keynesian Demand Management I Theory of Money Risk (premium) management Stimulate aggregate consumption Substitution effect lleviate balance sheet constraints Income/wealth effect Woodford Tobin (1982) BruSan Price stickiness Perfect capital markets Both Financial Frictions Incomplete markets Representative gent Heterogeneous gents Cut i Reduces r due to price stickiness Consumption c rises Cut i Changes bond prices Redistributes from low MPC to high MPC consumers Cut i Changes asset prices Ex-post: Redistributes to balance sheet impaired sector QE - US: QE1 & QE3: MBS - Japan 1990: corporate bonds
Difference to Monetarist View Target broad money supply measure When private/inside money creation contracts replace missing inside money with outside money Ignores that Private financial institutions diversify some risk away If these institutions contract more risk in the system Money demand rises Outside vs. Inside money Inside money allows banks to diversify idiosyncratic risk Outside money doesn t
Difference to Monetarist View Target broad money supply measure When private/inside money creation contracts replace missing inside money with outside money Ignores that Private financial institutions diversify some risk away If these institutions contract more risk in the system Money demand rises Outside vs. Inside money Inside money allows banks to diversify idiosyncratic risk Outside money doesn t
Interaction between MoPo & MacroPru Redistributive MoPo insures Moral Hazard MacroPru complements MoPo Not substitutes Good MacroPru enables more aggressive MoPo More redistribution ex-post More risk-transfers/insurance ex-ante
Overview 1. From Risk in Isolation to Systemic Risk Volatility Paradox Direct Spillovers domino effects Indirect Spillovers amplifiers vs. absorbers Paradox of Prudence (becoming an amplifier) 2. From Separation Principles to Interlinkages across stability concepts and redistributive monetary policy 3. International: Safe assets and cross-border capital flows From a Buffer pproach to a Rechanneling pproach
Safe assets Good friend analogy - like reserve assets Safe/available at any horizon - when it counts Precautionary buffer held in addition to more risky assets Risk demand for safe assets Safe asset tautology safe because it is perceived to be safe safe independent of fundamentals US Treasury downgrade by S&P in 2011 yield German CDS spread yield during Euro crisis Multiple equilibria Bubble
Safe assets Good friend analogy - like reserve assets Safe/available at any horizon - when it counts Precautionary buffer held in addition to more risky assets Risk demand for safe assets Pool of Risky assets Safe asset Deposits Equity
Safe assets Good friend analogy - like reserve assets Safe/available at any horizon - when it counts Precautionary buffer held in addition to more risky assets Risk demand for safe assets Safe asset tautology safe because it is perceived to be safe safe independent of fundamentals US Treasury downgrade by S&P in 2011 yield German CDS spread yield during Euro crisis Multiple equilibria Bubble Pool of Risky assets Safe asset Deposits Equity 37
Flight to Safety Risk-on, Risk-off Flight to safe asset If asymmetrically supplied by E Flight to safety cross-border capital flows Who insures whom? (rich the poor?) t times of global crisis issue new debt - for E: at inflated prices - for EME: at depressed prices Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset 38
Flight to Safety Risk-on, Risk-off Flight to safe asset If asymmetrically supplied by E Flight to safety cross-border capital flows Who insures whom? (rich the poor?) t times of global crisis issue new debt - for E: at inflated prices - for EME: at depressed prices Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset 39
Flight to Safety Risk-on, Risk-off Flight to safe asset If asymmetrically supplied by E Flight to safety cross-border capital flows t times of global crisis, issuance of new debt For US at inflated prices eases conditions For EME at depressed prices worsens conditions Question: Who insures whom? (rich the poor OR poor the rich?) Correct insurance only if buffer is large (and debt long-term) enough so that no new debt issuance needed & sale off safe asset 40
Different pproaches to Counter Risks Buffer pproach (public) IMF Facilities pproach Swapline pproach Rechanneling pproach
Different pproaches to Counter Risks Buffer pproach (public) IMF Facilities pproach Swapline pproach Rechanneling pproach
Buffer pproach Buffers (public) more private imbalances Irrelevance theorem in BruSan2017 International Monetary Theory: Mundell-Fleming Redux International banks approach central bank as ender of ast Resort in a Foreign Currency New additional rationale for Central Banks foreign reserve (safe asset) holding (in dollar) Moral Hazard problem: banks hold fewer safe asset (in dollar) and rely on OR of CB 43
Rechanneling pproach Buffers (public) more private imbalances Rechannel away from cross-border capital flows 44 44
Pooling Rechanneling pproach Buffers (public) more private imbalances Rechannel away from cross-border flows With ESBies in Europe (SBBS = sovereign backed securities) sovereign bonds ESBies Junior Bond Tranching 45 45
Pooling Global Safe sset (GS) - without a Passport Rechannel flight to safety via GloSBBieS (Global SBBS) Now, GS junior bond Both are international Shift to a new equilibrium Sovereign Bonds (+ currency swap) GS in $ Junior Bond in $ Tranching Difference to ESBies junior bond also has to absorb currency risk 46
Conclusion 1. From Risk in Isolation to Systemic Risk Volatility Paradox Direct Spillovers domino effects Indirect Spillovers amplifiers vs. absorbers Paradox of Prudence (becoming an amplifier) 2. From Separation Principles to Interlinkages across stability concepts and redistributive monetary policy 3. International: Safe assets and cross-border capital flows From a Buffer pproach to a Rechanneling pproach Global Safe sset - GloSBBS