Shadow banking and the economy
Alan Moreira, Alexi Savov 16 September 2014
The prevailing view of shadow banking is that it is all about regulatory arbitrage – evading capital requirements and exploiting ‘too big to fail’. This column focuses instead on the tradeoff between economic growth and financial stability. Shadow banking transforms risky, illiquid assets into securities that are – in good times, at least – treated like money. This alleviates the shortage of safe assets, thereby stimulating growth. However, this process builds up fragility, and can exacerbate the depth of the bust when the liquidity of shadow banking securities evaporates.
Shadow banking, what is it good for? At the epicentre of the global financial crisis, shadow banking has become the focus of intense regulatory scrutiny. All reform proposals implicitly take a stance on its economic value.
According to the prevailing regulatory arbitrage and neglected risks views, it doesn’t have any – shadow banking is about evading capital requirements, exploiting ‘too big to fail’, and marketing risky securities as safe to unwitting investors. The right response is to bring shadow banking into the regulatory and supervisory regime that covers insured banks.
Financial markets Global crisis Macroeconomic policy
shadow banking, banking, financial crisis, global crisis, regulatory arbitrage, liquidity transformation, financial stability, externalities, collateral, business cycle, financial regulation, financial fragility, liquidity, liquidity crunch
Quantifying the macroeconomic effects of large-scale asset purchases
Karl Walentin 11 September 2014
Central banks have resorted to various unconventional monetary policy tools since the onset of the Global Crisis. This column focuses on the macroeconomic effects of the Federal Reserve’s large-scale purchases of mortgage-backed securities – in particular, through reducing the ‘mortgage spread’ between interest rates on mortgages and government bonds at a given maturity. Although large-scale asset purchases are found to have substantial macroeconomic effects, they may not necessarily be the best policy tool at the zero lower bound.
Central banks have used various unconventional monetary policy tools since the onset of the financial crisis yet the debate continues regarding their efficiency. This column attempts to shed light on the ‘bang for the buck’, or the macroeconomic effects, of one such unconventional monetary policy – the Federal Reserve’s large-scale asset purchases of mortgage-backed securities employed during the Fed’s QE1 and QE3 programs.
Global crisis Monetary policy
monetary policy, unconventional monetary policy, large-scale asset purchases, central banking, financial crisis, Federal Reserve, quantitative easing, mortgage-backed securities, term premia, zero lower bound, interest rates, US, UK, Sweden, mortgages, global crisis
To exit the Great Recession, central banks must adapt their policies and models
Marcus Miller, Lei Zhang 10 September 2014
During the Great Moderation, inflation targeting with some form of Taylor rule became the norm at central banks. This column argues that the Global Crisis called for a new approach, and that the divergence in macroeconomic performance since then between the US and the UK on the one hand, and the Eurozone on the other, is partly attributable to monetary policy differences. The ECB’s model of the economy worked well during the Great Moderation, but is ill suited to understanding the Great Recession.
“Practical men…are usually the slaves…[of] some academic scribbler of a few years back” – John Maynard Keynes.
For monetary policy to be most effective, Michael Woodford emphasised the crucial importance of managing expectations. For this purpose, he advocated that central banks adopt explicit rules for setting interest rates to check inflation and recession, and went on to note that:
Global crisis Macroeconomic policy Monetary policy
Taylor rule, forward guidance, great moderation, global crisis, Great Recession, quantitative easing, DSGE models, expectations, tapering, US, UK, Europe, eurozone, ECB, Bank of England, central banking, IMF, unconventional monetary policy
What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis
Stephen Golub, Ayse Kaya, Michael Reay 08 September 2014
Since the Global Crisis, critics have questioned why regulatory agencies failed to prevent it. This column argues that the US Federal Reserve was aware of potential problems brewing in the financial system, but was largely unconcerned by them. Both Greenspan and Bernanke subscribed to the view that identifying bubbles is very difficult, pre-emptive bursting may be harmful, and that central banks could limit the damage ex post. The scripted nature of FOMC meetings, the focus on the Greenbook, and a ‘silo’ mentality reduced the impact of dissenting views.
Financial crises are caused by imprudent borrowing and lending, but as former Federal Reserve chairman William McChesney Martin noted, it is ultimately up to regulators to ‘take away the punch bowl’ when the larger economy is at risk. Indeed, many have criticised regulators for failing to anticipate and prevent the 2008 crash (Buiter 2012, Gorton 2012, Johnson and Kwak 2010, Roubini and Mihm 2010). Little work has been done, however, on why regulatory agencies failed to act despite warnings from prominent commentators (Borio and White 2004, Buffett 2003, Rajan 2005).
Financial markets Global crisis Monetary policy
financial crisis, Federal Reserve, FOMC, global crisis, collateralised debt obligations, Credit Default Swaps, LTCM, CDOs, CDSs, central banking
The role of corporate saving in global rebalancing
Philippe Bacchetta, Kenza Benhima 24 August 2014
Among the various explanations behind global imbalances, the role of corporate saving has received relatively little attention. This column argues that corporate saving is quantitatively relevant, and proposes a theory that is consistent with the stylised facts and useful for understanding the current phase of global rebalancing. The theory implies that, while the economic contraction originating in developed countries has pushed interest rates towards the zero lower bound, the recent growth slowdown in emerging countries could push them out of it.
The increase in global imbalances in the last decade posed a theoretical challenge for international macroeconomics. Why did some less-developed countries with a higher need for capital, like China, lend to richer countries? The inconsistency of standard open-economy dynamic models with actual global capital flows had already been stressed before (e.g. by Lucas 1990), but the sensitivity to this issue became more acute with increasing global imbalances. This stimulated the development of several alternative theoretical frameworks.
International finance International trade
interest rates, global imbalances, capital flows, saving, global crisis, credit constraints, savings glut, zero lower bound, corporate saving, global rebalancing
Bruno Biais, Jean-Charles Rochet, Paul Woolley 21 August 2014
The Global Crisis has intensified debates over the merits of financial innovation and the optimal size of the financial sector. This column presents a model in which the growth of finance is driven by the development of a financial innovation. The model can help explain the securitised mortgage debacle that triggered the latest crisis, the tech bubble in the late 1990s, and junk bonds in the 1980s. A striking implication of the model is that regulation should be toughest when finance seems most robust and when innovations are waxing strongly.
One of the curiosities of the modern economy is why the finance sector is so large. Economists have only recently sought to document and ponder this phenomenon. Empirically, Greenwood and Scharfstein (2013) find that, in the US, financial services, which accounted for 2.8% of GDP in 1950, made up 8.3% of GDP in 2006.
securitisation, financial crises, moral hazard, asymmetric information, financial innovation, global crisis, bubbles, monitoring, shirking, junk bonds, CDOs, CDSs, ETFs
Identifying and quantifying monetary policy transmission through bank balance sheets
Kaoru Hosono, Daisuke Miyakawa 09 August 2014
In the wake of the Global Crisis, several central banks have adopted unconventional monetary policies. This column presents new evidence from Japan on the transmission of monetary policy through banks’ balance sheets. Overall, the evidence suggests that bank net worth affects loan supply, that the effect depends on monetary policy and economic growth, and that this bank balance sheet channel has a significant impact on firms’ financing and investment. Exiting from unconventional monetary policies when bank balance sheets are weak could thus have a severe adverse impact on investment.
How does monetary policy affect firm activities? While there is long-standing literature on this issue, the transmission mechanism of monetary policy is currently attracting renewed attention. The reason is that many central banks – including the US Federal Reserve, the Bank of England, the ECB, and the Bank of Japan – have introduced unconventional monetary policies such as quantitative easing and credit easing in the wake of the Global Crisis, and sooner or later will have to exit from these policies.
Financial markets Global crisis Monetary policy
monetary policy, Japan, global crisis, quantitative easing, unconventional monetary policy, balance sheets, financial accelerator, credit easing, bank lending channel
Economic policies pursuant to the Global Crisis: A critique
Richard Wood 13 July 2014
The Global Crisis triggered a series of medium-term policy changes. This column reviews the effectiveness of some of these monetary, fiscal policies, and internal devaluation policies. Policymakers anchored their strategic thinking in paradigms that became inapplicable to the new problems. An alternative set of macroeconomic policies is suggested.
Interrelated economic problems
Current high public debt burdens are due to three main forces:
Global crisis Macroeconomic policy
global crisis, policy response, overt money financing
R&D internationalisation during the Global Crisis
Bernhard Dachs, Georg Zahradnik 06 July 2014
The Global Crisis brought a halt to three decades of R&D internationalisation, in which foreign firms’ share of total R&D expenditure had increased in almost all countries where data is available. However, this column argues that the crisis did not lead to a new global distribution of overseas R&D expenditure, despite the erosion of the EU’s share. The persistence of R&D expenditure is attributed to the costs of relocating R&D and to the autonomy of foreign subsidiaries.
Foreign firms’ share of total business R&D expenditure increased during the last three decades in almost all countries where data is available, but this trend stopped with the Global Crisis of 2008–2009. In most countries, R&D of foreign firms was more severely affected by the crisis than R&D of domestic firms. However, the crisis did not lead to a new global distribution of overseas R&D expenditure.
Global crisis Productivity and Innovation
R&D, globalisation, multinationals, FDI, innovation, global crisis, persistence, autonomy, subsidiaries
Reform and be re-elected: Evidence from the post-crisis period
Marco Buti, Alessandro Turrini, Paul van den Noord 04 July 2014
Structural reforms are presumed to deteriorate a government’s chance for re-election. This column, which is an update from earlier work, provides evidence of just the opposite – the odds of re-election are larger for reformist than for non-reformist governments. This holds if the financial system is not overly regulated and an adequate social safety net is present.
The former Eurogroup president allegedly said, “We all know what to do but we don’t know how to be re-elected once we have done it” (The Economist 2007). In an earlier VoxEU column (Buti et al. 2008), we argued that the presumed electoral risk for a reformist government – based on the statement by Mr Juncker – is largely unfounded, in particular if a number of conditions are met.
Politics and economics
elections, reforms, global crisis