Knowledge that Transforms

We surveyed experts from academia, central banks, and other regulatory institutions on the preferred institutional setup of macroprudential policy and the underlying interactions stemming from the conduct of monetary and macroprudential policy. We find substantial support for the integration setup, under which macroprudential policy is entrusted to the central bank and not to a separate institution. The most significant factors driving the respondents’ views are the large degree of interdependence of the two policies, the potential information gains from keeping them “under one roof”, and a greater capability to resolve strategic conflicts. We identify non-negligible heterogeneity in the responses, especially in terms of respondents’ experience, expertise, and position.

This paper estimates unobserved components (UC) models with real and financial trends and business and credit cycles to assess different measures of the credit cycle used by policymakers. The permanent components of the real and financial sectors are a Beveridge–Nelson and local linear trend, respectively. The business and credit cycles evolve jointly as a second-order vector autoregression . Bootstrap methods are applied to UC model estimates retrieved from classical optimization of the predictive likelihood of the Kalman filter . Results indicate the slope of the financial trend better predicts the credit to GDP ratio in the United States than the estimated business and credit cycles and the Basel gap. This suggests policymakers should consider permanent shocks to the financial sector when gauging the state of financial stability .

Using a model of strategic interactions between two countries, I investigate the gains to international coordination of financial regulation policies, and how these gains depend on global lending conditions. When one region – the core – sets global lending conditions, I show that coordinating regulatory policies makes the two regions better-off relative to the case of no cooperation. Global lending conditions set by the core are typically sub-optimal for the other region – the periphery –. To reduce this cost, the periphery can tighten its regulatory policy. Yet, in doing so, it fails to internalise a cross-border externality: when the periphery tightens its regulatory policy, agents in the core reduce cross-border borrowing, which tightens global lending conditions and hurts the periphery. The cooperative equilibrium can improve on this outcome. Both regions take into account the cross-border externality, leading to larger cross-border borrowing and less sub-optimal lending conditions for the periphery.

We study the effect of governments’ fiscal support on banks’ loan loss provisioning during the COVID-19 pandemic. In addition, we decompose fiscal support into direct support and liquidity support to examine the effect of different types of support measures on banks’ loan loss provisioning. Direct support generally refers to cash transfers, tax reliefs, and tax deferrals, while liquidity support generally refers to government-backed loans and equity injections. We find that direct support reduced banks’ loan portfolio risk whereas liquidity support did not. Moreover, we find the effect goes beyond a macroeconomic stabilization effect, suggesting that direct support directly contributed to mitigating banks’ loan portfolio risk during the pandemic. Our results are robust to controlling for other policy interventions, alternative model specifications, and an instrumental variable approach. We further discuss the policy implications of our analysis.

We study the relationship between climate change and financial systemic risk. First, we test whether, to what extent and how quickly the systemic risk of US banking and insurance sectors reacts to billion-dollar weather and climate disasters. We prove that some extreme events can exacerbate financial systemic risk and provide insights about the different timing at which the reaction of the systemic risk measures takes place. Second, we investigate through quantile regressions how the performance of green and brown market indexes affects the systemic risk of the two US financial sectors. We observe that higher levels of the green indexes reduce systemic risk more than a raise in brown indexes, with an increasing magnitude in tail conditions. A raise in the riskiness of the green indexes seems to significantly increase systemic risk, with the effect being stronger than that of an increase in the riskiness of brown indexes. Our results confirm the importance of the adoption of appropriate policies aiming at contrasting the raise in the frequency and severity of climate disasters. Our findings are also important in the perspective of the likely increase (decrease) in the exposure of financial firms towards green (brown) companies, induced by the policy decisions taken to combat climate change, and in terms of the implications for banks’ and insurers’ risk management models and procedures.

Using unique hand-collected data for 336 large banks across 48 countries, together with values of national culture, our empirical analysis uncovers three new robust findings. First, variations of bank risk-taking across national culture and CEO power are more pronounced when cultural values and CEO power indicators are high. Second, while the individualism dimension of national culture has a moderating influence, the uncertainty avoidance dimension has a reinforcing effect, on the relationship between CEO power and bank risk-taking. In more detail, the results for the average marginal effect of CEO power on risk for different cultural values show that CEO power has a negative (positive) or insignificant impact on bank risk-taking when the value of individualism (uncertainty avoidance) is low; however, the impact becomes positive (negative) and statistically significant as the value of individualism (uncertainty avoidance) increases. Third, intra-cultural diversity matters: ‘tight’ cultures (e.g., strong social norms) are more pronounced than ‘loose’ cultures (e.g., heterogeneous values) in influencing bank risk.

The financial intermediation wedge of the banking sector used to co-move positively with the federal funds rate, but the post-GFC era saw a disconnect between them. We develop a flexible price dynamic general equilibrium with banks’ liquidity creation to offer an explanation. In a corridor system, the financial wedge and policy rate are shown to co-move, and the pass-through of monetary policy onto both inflation and output obtains. However, the post-GFC floor system obviates the need for the financial wedge to cover the cost of obtaining reserves, so the wedge and the policy rate indeed disconnect in equilibrium; furthermore, we show that the disconnect obstructs monetary expansions from generating inflation. In this environment, tightening bank capital requirement leads to disinflationary pressure. Money-financed fiscal expansions that subsidise non-bank sectors’ borrowing costs improve output and reduce default risks but increase inflation. The model uses banks’ liquidity creation via credit extension to provide a rationale for both the pre-pandemic disinflation and the post-pandemic inflation. The results hold both on the dynamic paths and in the steady state, and the role of money enlarges the Taylor rule determinacy region.

We present a new framework combining current methods of bank solvency stress tests with a model of fire sales. We apply the framework to the stress tests conducted by the European Banking Authority. Fire sales are described by an equilibrium model balancing leverage improvements and drops in security prices. Additional bank losses caused by fire sales are significant and go beyond the trivial fact that with fire sales we will get bigger losses. Ignoring potential fire sales effects may lead to a false sense of resilience by assuming that institutions, which are in fact fragile, are resilient.

In response to the Covid-19 crisis, EU leaders agreed on the creation of a €750bn recovery fund (the Next Generation EU, NGEU). We investigate the short-term impact of this landmark deal on bank stocks, sovereign credit default swaps (CDS) and bank CDS. First, we find that stock market investors firmly welcomed the agreement as we find sizeable positive abnormal returns in bank stocks as a response to the NGEU proposal by the European Commission. Spreads on sovereign and bank CDS significantly declined, with more pronounced movements for heavily indebted countries and those that strongly advocated the creation of the recovery fund and for the banks located in these economies. Second, we show that banks’ sovereign exposures towards other European countries, especially those with weaker financial conditions and limited fiscal capacity, play a key role in driving the strength of the stock market reaction. Overall, financial markets responded positively to the credibility of the NGEU policy as an extraordinary common effort to support the post-Covid-19 recovery and enhance economic growth in the region.

Can countercyclical bank capital buffers reduce the negative effects of global liquidity shocks? We use the Lehman Brothers bankruptcy as a natural experiment to document the role of the banking system as a transmission channel of global financial disturbances to the real economy. Using central bank administrative data, our results suggest that in the aftermath of the Lehman collapse the banking channel is responsible for 1.44% of the aggregate drop in investment and 0.58% of the drop in aggregate employment. In order to evaluate the effectiveness of counter-cyclical macroprudential policies, we model an open-economy with a banking sector. We compare the drop in actual GDP during the 2008 financial crisis against the counterfactual GDP had Basel III style counter-cyclical capital buffers (CCyB) been in place. We find that the GDP drop in the counterfactual scenario would have been 6 p.p. lower than in the data. We also demonstrate the beneficial effects of the CCyB in mitigating tail risk (GDP at Risk). We show that, over a 3–5 year horizon, the GDP distribution with an operational CCyB would have a higher mean and a much thinner left tail when compared to an economy without a CCyB.