Ebook Financial Stability And Monetary Policy – A Framework
Monetary Policy has been extremely successful during the past 15 years: Worldwide, consumer price stability has been reduced steadily during that period; inflation seems to be well under control. Judging by the criterion of fighting inflation, the performance of central banks has been stunningly impressive. Whereas for a long time they have been accused to suffer from the problem of dynamic inconsistency (the temptation to give in to incentives to carry out surprise inflation), the credibility of central banks now seems to be at their highest level. Following the advice of modern macroeconomic theory which provides a sound welfare theoretical framework for price stability, most modern central banks try to stabilise the price level by steering aggregate demand via changes in nominal respectively real interest rates. The New Neoclassical Synthesis (see Michael Woodford 2003) provides a well established framework for this way of monetary policy, pointing out the crucial role of commitment in order to effectively influence long term real interest rates by signalling in advance the intended path of nominal rates. According to prominent proponents of this framework like Woodford, money supply plays no significant part in that context.
But just at a time when central bank practise seems to converge with theory, there is increasing concern among practitioners that an excessively generous provision of liquidity contributes to excessive asset price movements (increases in equity and housing prices) endangering financial stability. The fear that loose monetary policy contributes to a rise in asset price with the risk of a serious breakdown poses a new challenge for monetary policy. The paper tries to sketch a macro framework to think about the impact of stability concerns on monetary policy. As an extension of recent work by Hyun Shin (2005), it provides a stylized model as a base for understanding the relation between monetary policy and financial stability. The model demonstrates that recent financial innovations may have made financial markets more efficient on average, but they are likely to result in more drastic failures if things go really wrong. Public provision of liquidity by central banks in periods of financial distress can prevent inefficient liquidation; but it may aggravate the problem: Relying on support in times of financial distress will encourage leveraged institutions to engage in even greater risks.
During the last decades, a surge of innovations in the theory of finance and unprecedented growth in information technologies expanded dramatically the ability of the financial sector to spread risks. One might conjecture that the evolution towards more efficient and globally integrated financial markets makes the world a safer place. Recent trends in financial innovation, including the substantial expansion of access to consumer credit and the capacity for homeowners to borrow against the equity in their homes, the greater use of financial instruments for transferring and mitigating risk all these features seem to move financial intermediation closer towards the neoclassical paradigm of smooth and frictionless markets as modelled a long time ago in the Arrow Debreu paradigm.
But even though recent advances in information technology enlarge the scope for risk sharing and so contribute towards smoothing and absorbing real shocks in normal times, there is a crucial difference to the paradigm of frictionless markets: Incentive problems prevalent in inter-temporal delegation prevent the implementation of standard contingent contracts. It is well known that the threat of inefficient liquidation present in standard debt contracts may provide an adequate incentive scheme in the presence of asymmetric information. The use of debt contracts allowing for inefficient liquidation in some contingencies gives incentives to report correct information about the true state of the world. More generally, a fragile capital structure is meant to encourage conservative risk attitudes (see Diamond/Rajan 2005). Informational frictions also motivate the use of high powered contracts. Managers rewarded by performance related payments have an incentive to engage in a high leverage ratio, even if this runs the risk to overemphasise short term concerns. When paid according to relative performance, managers may engage in herding behaviour.
Debt contracts provide powerful amplification mechanisms: Changes in current or expected monetary policy, by affecting asset values, have a direct impact on balance sheets of financial institutions. But the change in balance sheet conditions leads to responses aggravating the initial impact on asset prices. Since Bernanke/Gertler (1989), it is well known that balance sheet effects may aggravate fluctuations. High asset prices raise the value of collateral and so lower the cost of financing additional investment. This financial accelerator may cause pro cyclical feedback effects. More efficient instruments to assess the market value of financial claims allow for a much speedier transmission of asset price movements into balance sheets, resulting in stronger feedback effects. In itself, this need not be a matter of concern: Monetary policy could comfortably rely on more powerful transmission mechanisms. As long as the central bank is aware of amplified responses, it can dampen volatility efficiently. By fine tuning interest rate movements, amplification effects are smoothed, allowing for effective stabilisation policy.
The key problem, however, is a crucial asymmetry: under certain conditions, a fall in asset prices, by forcing inefficient liquidation resulting in the breakdown of key financial institutions, may have dramatic repercussions on the whole economy. So there is the danger that, beyond some threshold, the virtuous cycle turns into vicious cycle – the risk of a financial meltdown. The recent trend towards securitisation, at first sight, seems to get around some of these problems, shifting risks towards long term investment institutions with highly diversified portfolios. So risks should to be passed on to those who have the best abilities to cope with them, reducing the need for inefficient liquidation. It turns out, however, that exactly those highly leveraged institutions which are issuing these securitised papers usually increase their exposure to systemic risk (for empirical evidence, see Franke/Krahnen 2005). Securitisation has a stabilising impact with respect to systemic risk only if that risk is shifted towards non-leveraged agents. It seems, however, that a high share of the most risky portion of the transactions initiated by leveraged financial intermediaries is not diversified away but kept within the leveraged industry. Thus, the shift towards more market oriented financing runs the risk to create a false sense of complacency.
Under normal conditions, the incentive mechanisms of debt contracts help to implement a smoother, more efficient allocation. They work as a powerful disciplinary device in the presence of idiosyncratic risk. In contrast, in the face of aggregate shocks, there are good reasons to try to prevent inefficient liquidation by providing sufficient public liquidity: as long as these shocks cannot be diversified and are not subject to moral hazard concerns, injection of liquidity works as a public good (see Holmström/Tirole 1998 and Goodhart/Illing 2002). The simple distinction between idiosyncratic and aggregate risk, however, becomes blurred in the context of fire sales: When the stability of large leveraged institutions is at stake, the disciplinary device of default, by triggering fire sales, might result in a financial meltdown.
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