Financial intermediation and the real economy: implications for monetary and macroprudential policies

Stefano Neri

Banca d’Italia SUERF/Deutsche Bundesbank/IMFS Conference The ESRB at 1 Berlin, 8-9 November 2011 The usual disclaimer applies

Outline

1.

The financial crisis and the debate on modelling 2.

Towards a new framework?

3.

Monetary and macroprudential policies in a model with financial intermediation

Pre-crisis consensus on macro modelling • • New Keynesian framework  Representative agent cash-less economy  nominal rigidities → role for monetary policy  no financial frictions and no intermediaries “

The paradigm that has emerged

[…]

is one that is clearly applicable to normal times

[…]

in developed, stable economies

”, J. Galí (interview for EABCN, 2009) • Estimated models (e.g. Smets and Wouters, 2007) used for policy analysis (e.g. RAMSES at Riksbank )

The financial crisis • The crisis showed how  important are the links between financial markets and the real economy  many of the assumptions that characterized the new Keynesian framework were wrong  financial markets are far from being efficient  financial markets matter in originating and propagating shocks

Intense debate on the lessons of the crisis for economics and economic modelling • • Buiter, Goodhart, Cecchetti, Spaventa and De Grauwe to mention some of critics of DSGE models Main missing elements :  financial intermediation  insolvency and default  liquidity  regulation of intermediaries and markets  booms and busts in asset markets

The crisis as an opportunity • • Crisis as opportunity to modify current framework Since Kiyotaki and Moore (1997) and Bernanke

et al

. (1999), few papers have considered financial intermediation in general equilibrium • Intensive research ongoing since 2009  Angeloni and Faia, Curdia and Woodford, Gertler and Kiyotaki, Bianchi and Mendoza, Jeanne and Korinek,… • They all fall short of modelling systemic risk

Towards a new framework? • Setting up a new framework that takes into account the critiques that have been raised will require time • Policy-makers are confronted with questions that require timely answers • Researchers in both academia and central banks to cooperate and develop new models • In the meantime, one possibility is to modify current models and use them for policy analysis

Monetary and macroprudential policies in a model with financial intermediation I use the model developed in Gerali

et al

. (2010) and modified in Angelini

et al.

(2011) to answer questions related to monetary and macroprudential policies 1) What was the impact of the financial crisis on economic activity in the euro area?

2) Should monetary and macroprudential policies co-operate? (BI Discussion paper, no. 801, 2011) 3) Should macroprudential policy lean against financial cycles?

The model • • Based on Gerali, Neri, Sessa and Signoretti (2010) “

Credit and Banking in a DSGE model of the euro area

” Medium-scale model with:  real and nominal rigidities (Smets and Wouters, 2007)  financial frictions à la Kiyotaki and Moore (1997)  monopolistic competition in banking sector  slow adjustment of bank rates to policy rate  role for bank capital  time-varying risk weights in bank capital regulation  policy rule for bank capital requirement

The model (cont’d) • • • • Project started in September 2007 Model has been estimated using Bayesian methods and data for the euro area over the period 1998-2009 The model has also been used to study:  impact of a credit crunch on euro-area economy  impact of higher capital requirements (Basel 3) Model has some of the limitations that I have discussed

Modelling monetary and macroprudential policies • Monetary policy:  interest rate rule à la Taylor

R t

  1  

R

  1  

R

     

t

    

y



y t



y t

 1    

R R t

 1 • Macroprudential policy:  bank capital requirements rule 

t

  1      1      

X t

   

t

 1 

X t

can be any macroeconomic variable relevant for macroprudential authority

What was the impact of the financial crisis • on economic activity in the euro area?

GDP (% dev. from steady state) Investment (% dev. from steady state) 4 The recession in 1.5

3 2 2009 was almost 1 1 0.5

entirely caused by 0 0 -1 adverse shocks to -0.5

-2 -3 -1 • banking sector The sharp -1.5

07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3 -4 -5 07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3 reduction of policy Consumption (% dev. from steady state) Eonia rate (p.p dev. from steady state) rates attenuated 1.5

2 1.5

the strong and 1.0

1 0.5

negative effect of the crisis on the euro-area economy 0.5

0.0

-0.5

-1.0

07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3 0 -0.5

-1 -1.5

-2 07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3 macroeconomic monetary policy banking total

Should monetary and macroprudential policies co-operate?

• In “normal” times macroprudential policy yields small • benefits If two authorities do not cooperate, policy tools are extremely • volatile Benefits are sizeable when economy is hit by financial shocks and when two authorities cooperate 0.2

0.0

-0.2

-0.4

-0.6

0 9.00

8.75

8.50

8.25

8.00

0 9.1

9.0

8.9

8.8

8.7

0 Capital requirements 10 20 Capital/assets ratio 30 10 20 Loans-to-output ratio 30 40 40 0.3

0.2

0.1

0.0

-0.1

0 0.02

0.00

-0.02

-0.04

-0.06

-0.08

0 0.0

-0.1

10 20 Loan rate 30 10 Policy rate 20 Output 30 -0.2

10 20 quarters after shock 30 Cooperative 40 -0.3

0 Non cooperative 10 20 quarters after shock 30 Only monetary policy 40 40 40

Should macroprudential policy lean against financial cycles?

• Agents expect a reduction in aggregate • risk in one year time For a given target for leverage, this provides an incentive for banks • to increase lending Shock does not • materialize Tighter capital requirements can be effective in containing expansion of lending

9.50

9.40

9.30

9.20

9.10

9.00

8.90

0 0.25

0.20

0.15

0.10

0.05

0.00

0 5

Capital requirements

10 15

Output (% dev. from steady state)

20 0.2

0.0

-0.2

-0.4

-0.6

0 1.0

0.5

0.0

0

Policy rate (dev. from steady state)

5 10 15 20 5 10

quarters after shock

15 20 5 10

quarters after shock

15 20

Implications for monetary and macroprudential policies  Aggressive monetary policy can help mitigating negative impact of shocks to banking sector  Monetary and macroprudential policies should closely co-operate  Benefits of macroprudential policy can be sizeable when economy is hit by financial shocks  Risk of coordination failure  Macroprudential policy can be effective in leaning against financial cycles

Conclusions • DSGE models have undergone severe criticism • No doubt that models must be improved, but working alternative missing • Intensive research ongoing • Modeling systemic risk is key • Meanwhile, we can adapt current models with a role for financial intermediation to address questions related to monetary and macroprudential policies