5.9 financial markets and central bank online test
duty13
Econ3507-Week24-2021.pptxWeek 24
The global financial crisis:
Applying the model, the zero lower bound on nominal rates.
A narrative of the crisis;
understanding events via the 3-equation model.
ECON3507
Chapter 6
Learning outcome
Facts about the financial cycle, the role of banks and the housing market
Asset price bubbles and the financial accelerator
The housing and bank leverage-centered positive feedback processes
Balance sheet recessions
Chapter 5: Money, banking and the macro-economy
financial cycle
Financial Cycle household based: House-price based
Downswing: Insolvent households (House value < Mortgage value) →
Unpaid mortgages → Insolvent banks → Banking crisis (‘plain vanilla’)
In the recent global financial crisis, the banking crises in Ireland and Spain were of the plain vanilla variety.
Chapter 6: The Financial Sector and Crises
The upswing does not continue forever. At a certain point, house prices begin to fall.
The central role of banks in the macroeconomy arises because they provide credit to households
and small and medium sized firms. The financial system is like the beating heart of
the economy; a systemic banking crisis is akin to a cardiac arrest and puts the economy as a
whole in serious danger. Up to this point, we have assumed that the financial system func—
tions smoothly and that households and firms can optimize their spending decisions by using
the credit facilities and payment services provided by banks. In this chapter we reassess this
assumption and lift the lid on the potentially destabilizing features of the financial system,
such as the financial accelerator and asset price bubbles, which can amplify and propagate
shocks through the economy.
We introduce the concept of a financial cycle to provide a framework for better understanding
the relationship between key financial variables, such as house prices and private
credit, and the macro-economy. Figure 6.1 illustrates the upswing and downswing of a financial
cycle centred on borrowing by households from banks to finance housing. In the
upswing phase, there is a house price boom. This increases the market value of houses,
which means households can borrow more from banks based on the increased value of
their housing collateral. This step is shown in the top box, which says ’Household borrowing
increases’. The extra borrowing by households, which is based on the higher house prices, in
turn allows households to buy more housing, which feeds back into higher house prices and
the upswing of the financial cycle continues. For example, when house prices rise, a family
can sell their house and use the capital gain they have made to borrow more and fund the
purchase of a yet higher priced house.
The upswing does not continue forever.
3
financial cycle
Financial Cycle: Bank based
Different driving force: Borrowing by banks to buy financial assets.
The financial assets in question are called securitized assets and include assets based on mortgages. The name for this class of risky assets is asset-backed securities (ABS).
Valuation of balance sheet of banks
‘Mark-to-market’ accounting:
Asset value in bal. sheet = Mkt. value
Asset prices the bank’s assets balance sheet strengthens.
banks borrow more.
The downswing of the financial cycle for banks has the same form as the house price one
for households.
In the context of a "plain vanilla" banking crisis, the term refers to a financial crisis primarily driven by fluctuations in house prices and the subsequent impact on the banking sector, without the involvement of complex financial instruments or exotic financial products. These crises are often characterized by a boom and bust cycle in the housing market, where rapidly rising prices lead to speculative behavior, excessive lending by banks, and an unsustainable buildup of debt.
In the recent global financial crisis, the banking crises in Ireland and Spain exemplify the "plain vanilla" variety. Both countries experienced significant housing bubbles during the mid-2000s, fueled by easy credit conditions, low interest rates, and lax lending standards. As house prices soared, borrowers took on increasingly large mortgages, often with little regard for their ability to repay.
4
Bank Behaviour and the Macro-Economy
Global Financial Crisis: The financial system can no longer be ignored in macroeconomic modelling.
Banks are a special case for policy makers:
Economic dependence of core banking services (e.g running the payments system).
Contagion: Spillovers from one bank affect the whole system (e.g Lehman Brothers in 2008 lead to gfc)
Bank bankruptcy is a special case vs other industries: → Expectation that govt. bails out failing banks to prevent crisis
Thus, policy makers face a trade-off between:
Maintaining the continuity of core banking services
Avoiding moral hazard on the part of households and banks
Bank Behaviour and the Macro-Economy
The positive probability that an insolvent bank would be bailed out creates a wedge between the private and social cost-benefit calculus of the bank's decisions. Banks do not take into account the negative externalities of its decisions (e.g. in excessive risk taking)
There is also an information problem: The govt. may impose capital regulation (s.t. bank risks are at the socially optimal level), but this requires that risks are accurately observable.
Banking Activities:
In our model, we distinguish between 2 types of bank activity:
Retail banking: Deposit-taking, lending, mortages etc.
Investment Banking (IB): Trading in financial products (securitized assets, derivatives etc.)
Also assume: Assets are ‘marked-to-market’ , risk-neutral IBs follow a Value at Risk (VaR) business model.( we don’t go into details for Value at Risk (VaR) in this course
The positive probability that an insolvent bank would be bailed out creates a wedge between the private and social cost-benefit calculus of the bank's decisions. The downside
risk is partly 'socialized’ in the sense that taxpayers normally bear the risk in the case of a bail-out were it to occur. This would be predicted to affect behaviour and make banks less sensitive to extra risk than would be the case if the bank (owners, managers, bond—holders, depositors) had to face the full cost of bankruptcy.
In addition to these two reasons for special treatment of the financial sector, policy makers must take into account an important market failure in bank behaviour. When an individual
bank makes commercial decisions, it does not take into account the effect of its decisions on overall risk in the financial system, and of the costs to the economy of a financial crisis that might ensue.
6
Financial Crises and their Costs to the Economy
Our focus: Systemic Banking Crises
Crises that “lead to the closure, merging or takeover by the public sector of one or more financial institutions”.
Run on the Rock: when queues of panicked savers formed outside Northern Rock branches in 2007 it was the first run on a British bank since the collapse of Overend & Gurney, in 1866.
7
Financial Crises and their Costs to the Economy
Our focus: Systemic Banking Crises
Crises that “lead to the closure, merging or takeover by the public sector of one or more financial institutions”.
Key characteristics of financial crises (R&R 2009):
Deep and prolonged asset price collapses( e.g. real house price fall of 35% over 6 years)
Large and lasting adverse impacts on output and employment (e.g. real output contract 9% over 2 years)
Exploding government debt due to lower taxes, counter-cyclical fiscal policy, bank bailout costs (secondary). ( e.g. real gov. debt stock increase 86% in 3 years following crisis)
Financial Cycle vs Business Cycle: Business cycles are based on GDP fluctuations; Financial cycles based on key financial variables (e.g. credit, house prices)
1. Deep and prolonged asset price collapses: declines in real house prices average 35% over a period of six years and declines in equity prices average 55% over a period of three to
four years.
2. Large and lasting adverse impacts on output and employment: on average, real GDP per capita contracts 9% (from peak to trough) over two years and unemployment rises seven percentage points over four years.
3. Governmentdebt explodes: in real terms, the government debt stock rises 86% on average in the three years following a banking crisis.4 This is primarily due to the collapse in
tax revenues associated with the deep output contraction and the implementation of counter-cyclical fiscal policy. Bank bailout costs are usually second order.
These characteristics highlight the sheer magnitude of the impact financial crisis on the real economy. economy. The IMF (2009) report provides further evidence; analysing 122
recessions in 21 advanced economies they found that recessions associated with financial crises are more severe and long-lasting than those recessions associated with other shocks.
The global recession of 2008—09 was extremely damaging, as it was not only associated with a financial crisis, but was highly synchronized across the major advanced economies.
The GDP ofthe advanced economies contracted by 3.5% in 2009 alone and the cumulative cost of lost output over the crisis was even larger.
8
Key Features of the Financial Cycle
Upswing: House prices ↑ → Household borrowing ↑ → Bank borrowing ↑ (positive feedback process)
Upswings often end with ↓ in house prices & a banking crisis
Downswing: Households & Banks deleverage (↓ indebtedness) → Banks ↑ int. rate spread, ↓ willingness to make loans
Housing boom reverses: Borrower households need to ↑ savings and recover from negative equity
3. and 4. (balance sheet effects) imply a deeper recession
Public sector debt increases sharply
Where the business cycle is based on fluctuations in GDP, upswings and downswings of financial cycles refer to fluctuations in key financial variables, such as credit and house prices.
Unlike the business cycle, there is no widely accepted methodology for measuring the financial cycle.
6. Public sector debt increases sharply when there is a financial crisis because ofthe depth
and length ofthe recession that follows and because of government support forfailing banks.
Public sector debt refers to the total outstanding debt owed by the government at the national, regional, or local level. It encompasses all forms of borrowing undertaken by the government to finance its operations, including expenditures on public services, infrastructure projects, social welfare programs, and debt service obligations.
Public sector debt can be incurred through various means, including issuing government bonds, treasury bills, and other debt securities, as well as borrowing from international organizations, financial institutions, and other governments. The accumulation of debt over time reflects the government's fiscal policies, including decisions on taxation, spending, and borrowing.
9
Stylized Facts about the Financial Cycle
Banks play a key role in the financial cycle through their lending and borrowing behaviour.
The housing sector is procyclical and house purchase is often financed by borrowing from banks
The inter-relationship between banks and housing is central to the fin. cycle; Peak of fin. cycle often followed by banking crisis.
The Bank of International Settlement (BIS) measure of financial cycles uses 3 variables: Private credit, Private credit-to-GDP ratio, Residential property prices
Fluctuations in fin. cycle variables typically longer than business cycle fluctuations in output.
Two mechanisms play an important role in the dynamics of a financial cycle: asset price bubbles and financial accelerators. The latter are based on the effect of asset price changes
on the balance sheets of households and banks. Before explaining these mechanisms, we provide some empirical information about financial cycles.
10
Financial vs Business Cycles in the US
Fin. cycle upswings & downswings are more prolonged
Peaks of the fin. cycles coincide with the onset of banking crises
Preoccupation with stabilizing the business cycle is problematic
Because they may overlook the fact that
a financial cycle upswing can continue during a recession such as that of the early 2000.
The cyclical components of these variables (and of private credit volume) form the financial cycle shown in Fig. 6.3. The cyclical components are estimated relative to trend (i.e. they are the fluctuations in the series around the long—run trend). The trend in both variables was upward sloping until the financial crisis of the late-2000.
11
UK ≈ US
Exception: Germany
Small fin. cycle amplitude: Different housing market (low home ownership rates, no re-mortgaging based on house prices)
∴ Institutions have an impact on both financial and business cycles.
Financial cycles across countries
Key indicators for measuring financial fluctuations
Reinhart and Rogoff (2009a) provides 'signals approach’ for early warning signs for banking crises.
They find that real house price growth is close to the top of the list of reliable indicators
Whereas real stock price growth is relatively less successful at predicting future banking crises. This is because stock price growth produces more false alarms (i.e. peaks of stock price cycles are less often associated with crises).
The cyclical components of these variables (and of private credit volume) form the financial cycle shown in Fig. 6.3. The cyclical components are estimated relative to trend (i.e. they are the fluctuations in the series around the long—run trend). The trend in both variables was upward sloping until the financial crisis of the late-20005.”
For why chose these as the early signs of the financial crisis.
13
Basic mechanisms
Two Basic Mechanisms in Financial Crises:
Asset Price Bubbles;
Financial Accelerator: changes in asset prices (such as for houses or financial assets) affect the balance sheet of an agent, which in turn leads to a change in borrowing and spending.
Asset Price Bubbles
45º line: Price stability condition ()
PDE (Price Dynamic Equation) shows relationship btw. and
Left fig: Non-durable good (fish) has a PDE flatter than the 45º line
Positive shock at time , PDE shows that begins to fall to equilibrium.
Ordinary market result: ↑ → Excess supply → ↓ until
Middle fig: Durable good (tulip bulbs) has a steeper PDE line
Expectation that will increase further (capital gains) → Demand ↑
Self-fulfilling bubble: Prices ↑ indefinitely until expectations change.
Right fig: Combines features of the two → Multiple Equilibria
S-shaped PDE: Economy can be pulled to stable high or low equilibrium
A self-fulfilling bubble, also known as a speculative bubble, is a phenomenon in financial markets where the price of an asset rises far beyond its intrinsic value due to investor speculation and collective expectations of future price increases. In other words, the belief that the asset's price will continue to rise leads investors to buy the asset, which in turn drives the price higher. This creates a feedback loop where rising prices validate investors' beliefs, attracting even more buyers and further inflating the bubble.
Self-fulfilling bubbles can occur in various asset classes, including stocks, real estate, commodities, and cryptocurrencies. While they can generate significant short-term profits for investors, they also pose risks of substantial losses when the bubble eventually bursts. The collapse of a bubble can have adverse consequences for financial markets, economic stability, and investor confidence, highlighting the importance of prudent risk management and vigilant monitoring of market dynamics.
15
Asset Price Bubbles Role of Expectation
S-Shaped PDE:
- PDE process:
- shifts the PDE: Eg. the proportion of
population with a given belief about
(where beliefs depends on )
Initially: High price (A)
Shock: A small prop. of agents expect lower →
PDE shifts down to PDE (Aꞌ), New equilibrium is at B →
Next period, more people adopt the belief of falling →
PDE shifts down until the tipping point (tangency point to 45º line) on PDE (Aꞌꞌ) →
Next period, the high eqbm disappears and the economy is pulled to the low price eqbm C.
*e.g. The housing mkt with self-fulfilling expectations: A housing boom (bust) involves moving to the upper (lower) equilibrium.
Tipping point because in the following period, the middle equilibrium has disappeared economy moved toward C.
16
The big ten financial bubbles
1636: The Dutch Tulip Bulb Bubble
1720: The South Sea Bubble
1720: The Mississippi Bubble
1927-29: The late 19205 stock price bubble
19705: The surge in loans to Mexico and other developing economies
1985-89: The bubble in real estate and stocks in Japan
1985—89: The bubble in real estate and stocks in Finland, Norway and Sweden
1990: The bubble in real estate and stocks in Thailand, Malaysia, Indonesia and several other Asian countries between 1992 and 1997; and the surge in foreign investment in Mexico 1990—99
1995—2000: The bubble in over-the-counter stocks in the United States
2002-07: The bubble in real estate in the United States, Britain, Spain, Ireland and Iceland; and the debt of the government of Greece
Financial Accelerator
Credit-constrained households can borrow based on the value of their collateral, i.e. house value (= market price)
House prices ↑ → can borrow more (relaxed credit constraints)
Household borrowing ↑ (assume households are borrowed up to the limit set by credit constraints)
Borrowing is used for consumption and buying more housing → IS curve shifts rightwards
Increased demand for housing pushes up prices further; the financial accelerator process begins again at step 1.
By definition, a credit—constrained household will spend more when the credit constraint is relaxed.
This provides a connection between a change in asset price, the extent of credit constraints and household spending, that is, between a change in asset price and the IS curve, The financial accelerator is a positive feedback process through which a change in the price of an asset affects the macroeconomy.”
The asset could be a financial asset such as company stocks (shares) or bonds. We illustrate the mechanics of the financial accelerator using the case of housing because this is where the financial accelerator mainly operates for the household sector.1S lts operation can be summarized in the following five steps:
18
Financial Accelerator
Financial Accelerator (exists when there are credit constraints): Positive feedback process where P ↑ → Credit constraints ↓ → Demand ↑ → P ↑ → …
Under no credit constraints: House P ↑ → Temporary shock to permanent income → Small effect on demand → no positive feedback process
The Fin. Accelerator does not have to rest on bubble behaviour: It is driven by credit constraints and collateral effects.
Fin. Accelerator: Demand shifts due to ∆ P that increase wealth; Bubbles: Demand shifts on expectations of a rise in future price (self-fulfilling expectations)
Both mechanisms can interact with each other: Bubble bursts → Fin. Accelerator amplifies and propagates the shock.
19
The housing feedback process and the 3-equation model
We use insights from asset bubbles and the financial accelerator to describe a housing positive feedback process.
The 3-equation model is used to show the relationship between: the house-price driven financial cycle, business cycle and the CB.
Start of a house-price feedback process:
Exogenous rise in house prices, or a change in banking regulation (increase in loan-to-value, LTV ratio; relaxing collateral rules)
LTV ratio ↑ → Able to receive larger loans → Mortgage demand ↑
Collateral rules loosened → Easier to borrow → Borrowing for consumption and housing ↑
A bubble may develop: Mortgage demand ↑ → Prices ↑ → Future prices expected to rise further → …
to the loan-to-value ratio they use when making mortgage decisions or collateral rules.
A rise in the loan-to-value (LTV) ratio banks are allowed to use in making mortgages leads to a rise in the demand for mortgages. For an individual borrowing to buy a house, the LTV ratio is calculated as the value of the loan received divided by the value of the
property purchased. For example, if a borrower took out a loan of $160. 000 to buya house
worth $200, 000, then the LTV ratio would be 80%. In the USA, mortgages with LTV ratiosin
excess of 'I 00% became widely available in the mid-20005.17 This meant that borrowers could
receive a loan larger than the value of the property they were buying without providing any
down-payment. These looser lending standards made it possible for lower income groups
to purchase residential property and consequently boosted mortgage demand.
20
3-equation model
Rising House Prices and Bubbles
Rising prices may reflect:
(i) a bubble, or
(ii) changes in the fundamental determinants of price (i.e. supply and demand)
Rising population
Falling size of households
Rising wealth
However, rising house prices do not necessarily reflect a bubble. Instead they could reflect changes to the fundamental determinants of price (i.e. supply and demand). We illustratethis
by comparing two cases, as shown in Fig. 6.8. In the first (shown in the left-hand panel), the supply curve for housing, although inelastic in the short-run, is perfectly elastic in the long
run; in the second (shown in the right-hand panel), supply is inelastic in the long-run as well.
Figure 6.8a could describe a situation in a city surrounded by plenty of space for expansion and where there are no planning impediments to further house building. In this case, we see
demand for housing rising in two consecutive periods, which cause prices to rise from P0 to P1, and then from P1 to P2. This is due to supply being perfectly inelastic in the short-run;
22
Rising House Prices and Bubbles
6.8a: No restriction to supply
A rise in demand increases prices ( → )
Supply is perfectly inelastic in the short-run, fixed at
Supply responds later to the rise in prices, increasing to
Prices revert to long run equilibrium
If steep rises in price is observed, a bubble process is likely (house prices should eventually fall to , but do not)
23
Rising House Prices and Bubbles
6.8b: Binding supply constraint
A rise in demand increases prices ( → )
There is no supply response, so no pressure for prices to fall
House prices can rise persistently without a bubble, e.g. due to rising demand (fundamentals such as increase in population, wealth and etc).
∴ Inelastic Supply Curve: Harder to distinguish a bubble from a price movement based on fundamentals
When these fundamentals are in place, it is possible for house prices to rise persistently
without a bubble. The demand curve is shifted, for example by population inflows or in the
case of London property after 2010, by wealthy citizens of Eurozone crisis countries looking
fora safe place to put their money. This shifts the demand curve for housing upwards. As
long as the demand curve is shifting upwards, the price of housing rises without a bubble and
fuels the financial accelerator. When the supply curve is inelastic, it is harder to distinguish a
bubble from price movements based on the fundamentals.
When a housing bubble bursts, we would predict there to be lots ofempty houses because
of the expansion in supply triggered by the high and rising prices. This was the case in the
USA, Ireland and Spain in the episodes of rising house prices before the global financial crisis.
The problem of over-supply is often exacerbated by the fact that new houses take time to
build. New supply may continue to come on to the market even after house prices have
started to fall. By contrast, when house prices fell in the UK, there were not lots of empty
houses—because of planning constraints, supply had responded weakly to rising demand.
24
Rising House Prices and Bubbles
Figure 1‑8: England region housing stock as a share of population between 2001 and 2015
Source: ONS, author calculation
2001=100
Plain Vanilla Financial Crisis
House-price based boom → Financial Crisis
Not involving novel financial instruments
Summary:
Property bubble bursts, house P ↓ → Household net worth ↓ → Some households unable to service mortgages
Houses are repossessed by bank but sold at a loss (at a price below remaining mortgage value)
Losses on mortgage loans → Net worth of banks ↓
Sufficient exposure to falling prices → Bank asset value (mortgages) shrinks and wipes out its capital cushion → Banks become insolvent.
The Housing Feedback Process
Top: Changes in regulation or collateral rules lead to a house price boom.
Bottom: No direct link between the rise in house prices and the 3-equation model (ie. with AD and π );
The CB just focusses on π –targeting.
The housing feedback process and the 3-equation model
The housing feedback process and the 3-equation model
IS Curve shifts rightwards from a boost in demand due to relaxed borrowing conditions
Inflation increases and the CB tightens monetary policy
The only link to the CB is due to changing inflation coming from the rise in loans and AD.
No link between CB stabilization and house price feedback process: CB’s response does not necessarily dampen the upswing of the financial cycle
Higher int. rates for reducing inflation will dampen demand for mortgages but not necessarily cut off an asset price bubble and the financial accelerator mechanism: example Fig 6.4 in Continuous upswing in US house prices between 1970s to mid-2000s.
Balance sheet recession & the Financial Accelerator
Pre-crash: 2 household types: Savers (consume following PIH), Borrowers (credit-constrained); Output is at .
Crash: House and securitized asset prices fall, then:
Retail banks reduce LTV ratio → AD ↓
Value of housing collateral falls → Consumption loans ↓ → AD ↓
Balance sheet effect:
“ Banks call in loans → Borrowers repay loans by cutting C → savers’ wealth rises from repayment → PIH: savers’ C increases by small amt.”
∴ AD ↓ as fall in borrowers’ C > rise in savers’ C.
Rebuilding target wealth after fall in house & asset prices:
Households save to rebuild wealth → AD ↓ (slows down recovery)
Balance sheet recession & the Financial Accelerator
The bursting of credit-fueled asset bubbles → B/Sheet recession.
Negative impact on AD reduced if savers encouraged to spend.
But the Zero Lower Bound limits expansionary monetary policy
∴ Threat of a deflationary trap (↓ , ↓) in which the paradox of thrift applies (↑ → ↓ → ↓ )
Policy Implications of a balance sheet recession:
Fiscal stimulus can be used to boost AD.
The increase in govt. debt can be repaid once the ‘deleveraging process’ is over.
The balance sheet recession also dampens the multiplier, so the burden on fiscal policy further increases.
Summary:
Banks can take on more risk than socially optimal (externality)
The financial sector amplifies and propagates shocks in the economy via the financial accelerator and asset bubbles.
The house price and financial asset price feedback processes cause IB (investment banks) leverage to increase in a low risk environment.
Low perceived risks that preceded the financial crisis are due to: ↓ macro volatility, ↑ house prices and financial innovation
Rising house and asset prices do not dampen fin. cycle upswings due to the above positive feedback processes.
Balance sheet recessions are slower to recover from due to the deleveraging process by households, firms and banks.
