Knowledge that Transforms

We analyze the competitive effects of government bail-out policies in two models with different degrees of transparency in the banking sector. Our main result is that bail-outs lead to higher risk-taking among the protected bank’s competitors, independently of transparency. The reason is that the prospect of a bail-out induces the protected bank to expand, which intensifies competition in the deposit market, depresses other banks’ margins, and thereby increases risk-taking incentives. Contrary to conventional wisdom, protected banks may take lower risks when transparency in the banking sector is low and the deposit supply is sufficiently elastic.

We analyse the optimal response of monetary policy to house prices in a New Keynesian framework. A positive wealth effect from housing is derived from liquidity constrained consumers. Housing equity withdrawal allows them to convert an increase in housing value into consumption and we show that monetary policy should react to house prices due to their effect on consumption by constrained agents. Moreover, we allow the share of liquidity constrained consumers to vary with house prices. Consequently, the optimal weights on expected inflation, the output gap and house prices in the optimal interest rate rule vary over time too.

An unsustainable weakening of credit standards induced a US mortgage lending and housing bubble, whose consumption impact was amplified by innovations altering the collateral role of housing. In countries with more stable credit standards, any overshooting of construction and house prices owed more to traditional housing supply and demand factors. Housing collateral effects on consumption also varied, depending on the liquidity of housing wealth. Lessons for the future include recognizing the importance of financial innovation, regulation, housing policies, and global financial imbalances for fueling credit, construction, house price and consumption cycles that vary across countries.

We analyze financial support for the entrepreneurial sector. State support can raise welfare by relaxing financial constraints, but it can also reduce lending standards if entrepreneurs substitute public sources of collateral for their own assets, if it encourages excessive entrepreneurial entry, or if it undermines bank monitoring incentives. We derive a “pecking order” for support schemes: support funds should be channeled first to credit guarantee schemes and then, when entrepreneurs start to substitute public for private collateral, to co-funding entrepreneurial projects. The optimal level of credit guarantee is diminishing in the costs of incentivising bank monitoring. We show in an extension that the long-term effect of public subsidies may be to impair the private sector’s initiative to uncover cost savings.

We analyse the behaviour of euro area corporate sector probabilities of default under a wide range of domestic and global macro-financial shocks. Using the Global Vector Autoregressive (GVAR) model and constructing a linking satellite equation for firm-level Expected Default Frequencies (EDFs) we show that, at the aggregate level, the median EDFs react most to shocks to GDP, exchange rate, oil prices and equity prices. Intuitive variations to these results occur when sector-level median EDFs are considered. The satellite-GVAR model emerges as a useful tool for linking global macro-financial scenarios with micro-level information on expected defaults.

We argue herein that there is a fundamental and an important difference between the market risk and the potential market risk in financial markets. We also argue that the spectrum of smooth Lyapunov exponents can be used in (λ,σ2)-analysis, which is a method to measure and monitor these risks. The reason is that these exponents focus on the stability properties (λ) of the stochastic dynamic system generating asset returns, while more traditional risk measures such as value-at-risk are concerned with the distribution of asset returns (σ2).

Aggregate prudential ratios have become a mainstay of financial stability analysis. But how reliable are these indicators when it comes to distinguishing between strong and weak banking systems? We address this issue by analyzing the performance of aggregate prudential ratios in systemic banking crises, drawing upon a large cross-country dataset. We caution against sole reliance on these indicators, and advocate supplementing them with other tools and techniques. Nonetheless, our findings offer evidence that some of the ratios can help identify systemic banking problems.

A large body of literature has shown that small firms experience difficulties in accessing the credit market due to informational asymmetries. Banks can overcome these asymmetries through relationship lending, or at least mitigate their effects by asking for collateral. Small firms, especially if they are young, have little collateral and short credit histories, and thus may find it difficult to raise funds from banks. In this paper, we show that even in this case, small firms may improve their borrowing capacity by joining Mutual Guarantee Institutions (MGI). Our empirical analysis shows that small firms affiliated to MGIs pay less for credit compared with similar firms. We obtain this result for interest rates charged on loan contracts which are not backed by mutual guarantees. We then argue that our findings are consistent with the view that MGIs are better at screening and monitoring opaque borrowers than banks are. Thus, banks benefit from the willingness of MGIs to post collateral since this implies that firms are better screened and monitored.

This paper presents a framework for analyzing an economy's resilience to exchange rate risk using the balance sheet approach (BSA), which is gaining prominence worldwide in the surveillance of financial stability. The framework is applied to Israel's economy, by using an unique and extensive dataset: a combination of new national balance sheet data and foreign currency balance sheet data. The analysis using the BSA shows that Israel's economy was highly vulnerable to a depreciation of the shekel in 1997, but from then until 2005 it became more resilient. The improvement was due mainly to the lowering of the business sector's high level of exposure to depreciation and its greater financial strength. This, together with higher capital adequacy in the banking system, made the latter more resilient to indirect damage that could be caused by depreciation. The analysis shows further that despite the heavy exposure of the economy as a whole and most sectors within it to appreciation of the shekel at the end of 2005, the economy was quite resilient to such appreciation, as the private sector and the banks suffered little direct or indirect damage through it. The analysis stresses the central, but not exclusive, role played by the banks’ resilience in the economy's financial stability, and thus also favors the continuation of the process of reducing the banks’ dominance in financing the business sector, so that their indirect exposure to financial risks will fall. The findings yielded by the BSA are highly significant, because an analysis using the traditional approach leads to very different results, viz., that in 1997 the economy was not vulnerable to changes in the exchange rate, and that in 2005 it was highly vulnerable to shekel appreciation. The conclusions in the paper support the use of the balance sheet approach as an important instrument in surveillance of financial stability, the formulation of other similar frameworks for analyzing financial risks, and the provision of more detailed data in the national balance sheet that would enable a deeper analysis of overall economic risks and the risks in the major sectors.