Ebook Financial Intermediaries and Monetary Economics
In conventional models of monetary economics commonly used in central banks, the banking sector has not played a prominent role. The primary friction in such models is the price stickiness of goods and services. Financial intermediaries do not play a role, except perhaps as a passive player that the central bank uses as a channel to implement monetary policy.
However, financial intermediaries have been at the center of the global financial crisis that erupted in 2007. They have borne a large share of the credit losses from securitized subprime mortgages, even though securitization was intended to parcel out and disperse credit risk to investors who were better able to absorb losses. Credit losses and the associated financial distress have figured prominently in the commentary on the downturn in real economic activity that followed. Recent events suggest that financial intermediaries may be worthy of separate study in order to ascertain their role in economic fluctuations.
The purpose of this chapter in the Handbook of Monetary Economics is to reconsider the role of financial intermediaries in monetary economics. In addressing the issue of financial factors in macroeconomics, we join a spate of recent research that has attempted to incorporate a financial sector in a New Keynesian DSGE model. Woodford and Curdia (2008) and Gertler and Karadi (2009) are recent examples. However, rather than phrasing the question as how financial ]frictions( affect the real economy, we focus on the financial intermediary sector itself. We explore the hypothesis that the financial intermediary sector, far from being passive, is instead the engine that drives the boom1bust cycle. To explore this hypothesis, we propose a framework for study with a view to addressing the following pair of questions. What are the channels through which financial intermediaries exert an influence on the real economy (if at all), and what are the implications for monetary policy?
In the framework proposed to explore our hypothesis, financial intermediaries play the role of the engine of the financial cycle through their influence on the determination of the price of risk. Quantity variables 1 especially the components of financial intermediary balance sheet 1 emerge as important economic indicators in their own right due to their role in reflecting the risk capacity of banking sector balance sheets, the pricing of risk, and hence on the level of real activity. Ironically, our findings have some points of contact with the older theme in monetary economics of keeping track of the money stock at a time when the money stock has fallen out of favor among monetary economists. The common theme between our framework and the older literature is that the money stock is a balance sheet aggregate of the financial sector.
Using the language of ]frictions(, our results suggest a second friction, in addition to sticky prices. This second friction originates in the agency relationships embedded in the organization of financial intermediaries, which are manifested in the way that financial intermediaries manage their balance sheets. This is a friction in the supply of credit. We are certainly not the first to study frictions in the supply of credit, and there has been an extensive discussion of financial frictions within monetary economics, as we will describe in more detail below. However, it would be fair to say that financial frictions have received less emphasis in recent years (at least, until the eruption of the financial crisis).
When we examine balance sheet measures that reflect the underlying funding conditions in capital markets, we find that the appropriate balance sheet quantities are of institutions that are marked to market. In this regard, broker1dealer assets are more informative than commercial bank assets. However, as commercial banks begin to mark more items of their balance sheets to market, commercial bank balance sheet variables are likely to become more important variables for studying the transmission mechanism.
There are implications for the conduct of monetary policy. According to the perspective outlined here, fluctuations in the supply of credit arise from how much slack there is in financial intermediary balance sheet capacity. The cost of leverage of market1based intermediaries is determined by two main variables y risk, and short term interest rates. The expected profitability of intermediaries is proxied by spreads such as the term spread and various credit spreads. Variations in the policy target determine short term interest rates, and have a direct impact on the profitability of intermediaries. Moreover, for financial intermediaries who tend to fund long1term assets with short1term liabilities, movements in the yield curve may also have valuation effects due to the fact that assets are more sensitive to discount rate changes than liabilities.
Monetary policy actions that affect the risk1taking capacity of the banks will lead to shifts in the supply of credit. Borio and Zhu (2008) have coined the term risk1taking channel( of monetary policy to describe this set of effects working through the risk appetite of financial intermediaries. For these reasons, short term interest rates matter directly for monetary policy. This perspective on the importance of the short rate as a price variable is in contrast to current monetary thinking, where short term rates matter only to the extent that they determine long term interest rates, which are seen as being risk1adjusted expectations of future short rates. Current models of monetary economics used at central banks emphasize the importance of managing market expectations. By charting a path for future short rates and communicating this path clearly to the market, the central bank can influence long rates and thereby influence mortgage rates, corporate lending rates and other prices that affect consumption and investment.
The expectations channel( has become an important consideration for monetary policy, especially among those that practice inflation targeting. The expectations channel is explained in Bernanke (2004), Svensson (2004) and Woodford (2003, 2005). Alan Blinder (1998, p.70) in his book on central banking phrases the claim in a particularly clear way.
Contents
1 Introduction
2 Financial Intermediaries and the Price of Risk
- 2.1 Model
2.2 Pricing of Risk
2.3 Shadow Value of Bank Capital
2.4 Supply of Credit
3 Changing Nature of Financial Intermediation
- 3.1 Shadow Banking System
3.2 Relative Size of the Financial Sector
4 Empirical Relevance of Financial Intermediary Balance Sheets
5 Central Bank as Lender of Last Resort
6 Role of Short Term Interest Rates
- 6.1 Risk1Taking Channel of Monetary Policy
7 Concluding Remarks
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