Monetary Policy and the Risk-Taking Channel: Theory and Policy Implications

Giovanni Dell’Ariccia (IMF and CEPR)

The views expressed here are those of the authors and do not necessarily represent those of the IMF or the IMF Board

CEPR, London, June 2013

Presentation roadmap

Per-crisis view

How the crisis changed the consensus

A survey of theoretical views

Policy implications

Macro literature: Financial intermediation seen as macro neutral

Asset prices (including property prices) did matter. They could accentuate the

cycle through financial accelerators

But macro model largely ignored their impact on bank risk taking. In equilibrium, no bank defaults

Banking literature Focused on excessive risk taking by intermediaries operating under limited liability

and asymmetric information

Defaults/crises in equilibrium

But there was little attention to macro and monetary policy conditions

Before the crisis … A theory gap

Monetary policy to focus on inflation (and output gap): “divine coincidence”

Asset prices and credit aggregates a concern only through their impact on GDP and inflation (exceptions RBA, Riksbank, some EMs)

Benign neglect approach to boom/busts:

Bubbles difficult to identify

Costs of clean up limited and policy effective

→ Better clean up than prevent

Bank risk taking important, but job of regulators

Before the crisis …A policy gap

Regulatory policy focused on individual institutions

Limited attention to credit aggregates or asset price dynamics

Ill equipped to deal with booms:

Correlated risk taking

Fire sales and other externalities

Few regulators had necessary tools (exceptions: Spain/Colombia)

Before the crisis … A policy gap

Before crisis … Macro looked OK

-3

-2

-1

0

1

2

2000 02 04 06 08:Q4

Output Gap2Core CPI Inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2000 02 04 06 08:Q4

Euro area United States Average of other economies1

1 Japan omitted.2 Estimate of output gap using rolling Hodrick-Prescott filter.

9

Figure 8. Credit Growth and Monetary Policy(Selected countries that had a boom in the run-up and a crisis in 2007-08)

Sources: IMF International Financial Statistics, World Economic Outlook; staff calculations.Notes: Credit is indexed with a base value of 100 five years prior to the crisis.

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

United Kingdom 2007

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Ireland 2008

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Spain 2008

Core inf lationCredit (right axis)

0

50

100

150

200

250

0

1

2

3

4

T-5 T-4 T-3 T-2 T-1 T

Greece 2008

Core inf lationCredit (right axis)

Credit Growth and Core Inflation

Standard policies rapidly hit their limits

Limited effectiveness of less traditional policies

Large fiscal and output costs

Multiple banking crises; especially in countries with their own credit and real estate booms

Then the crisis came …

9

LVA

EST

LTU

IRL

UKR

JPN

RUS

DNK

HKG

SWE

SVN

GBR NLD

SVK

ESP

BGR

MYS

BOL

THA PHL

AUS

IND

KAZ

PAN

URY

DOM

NPL

VNM

BGD

MOZ CHL MAR

SUR IDN

CHN

y = -1.2852x + 12.969 R² = 0.14

-50

-25

0

25

50

75

100

-30 -20 -10 0 10 20 30

Cha

nge

in c

redi

t-to-

GD

P ra

tio fr

om 2

000

to 2

006

Change in GDP from 2007 to 2009

Credit Growth and Depth of Great Recession

Bubble size shows the level of credit-to-GDP ratio in 2006.

House boom/busts and great recession

AUS

AUT

BGR

CANCHN

HRV

CYP

CZEDNK

EST

FIN

FRA

GRC

HUN

ISL

IND

IRL

ITA

KOR

LVALTU

NLD

NZL

NOR

POL

PRT

SVN

ZAFESP

SWE

CHE

UKR

GBRUSA

y = -0.0416x - 4.1152R² = 0.1496

-30

-20

-10

0

10

-20 0 20 40 60 80 100 120 140 160 180 200 220 240

Cum

ulat

ive

decl

ine

in G

DP

fro

m s

tart

to e

nd o

f rec

essi

on

Change in house prices f rom 2000 to 2006

Figure 2. House Price Run-Up and Severity of Crisis

Source: Claessens et al (2010).

Bubble size shows the change in bankcredit f rom 2000 to 2006.

AK AL AR

AZ CA

CO

CT DC DE

FL

GA

HI

IA

ID

IL

IN KS KY

LA

MA

MD

ME MI

MN

MO

MS

MT

NC ND

NE

NH

NJ

NM

NV

NY

OH OK

OR

PA

RI

SC SD TN

TX

UT VA

VT

WA

WI

WV

WY

y = 1.1159x + 20.457 R² = 0.5501

-50

0

50

100

150

200

250

0 20 40 60 80 100 120 140 160

Cha

nge

in m

ortg

age

delin

quen

cy ra

te, 2

007-

09

House price appreciation, 2000-06

Subprime Boom and Defaults

Bubble size shows the percentage point change in the ratio of mortgage credit outstanding to household income from 2000 to 2006.

Source: Dell’Ariccia, Igan, and Laeven, 2012

Many stories/theories linking interest rates and risk taking

Some compatible others opposite to each other

Often implications for different types of agents/intermediaries

Few entail views about “excessiveness” of risks

Empirically: growing evidence that low rates imply greater risk taking. But magnitudes unclear

The crisis challenged existing consensus

Stylized facts

2.4

2.6

2.8

33.

23.

4R

isk

of l

oan

s (d

etre

nde

d)-2 0 2 4 6

Real Federal Funds Rate (detrended) (in %)

7.5

8 8.

5 9

9.5

Cap

ital-t

o-as

set r

atio

(det

rend

ed) (

in %

)

-2 0 2 4 6 Real federal funds rate (detrended) (in %)

Source: Dell’Ariccia, Laeven, and Suarez, 2013

Many argued that monetary policy provided intermediaries with the wrong incentives (Borio et al., 2008)

Several stories associate low interest rate environment to crisis

Overly loose monetary policy (Taylor, 2009) Abundant liquidity – search for yield (Rajan, 2005) Risk-shifting: what matters are transitions ( Landier et al., 2011) Liquidity risk (Acharya and Naqvi, 2010, Freixas et al., 2011) Adverse selection and strategic effects in credit booms (Allen and Carletti, 2011,

Dell’Ariccia and Marquez, 2006, Ruckes, 2004) Increase in leverage (Adrian and Shin, 2008, 2009…Dell’Ariccia et al., 2011)

Others focus on how expected macro bailout and risk externalities seed

ground for new crises Diamond and Rajan (2010), Farhi and Tirole (2009), Acharya and Yorulmazer

(2007)

The risk taking channel: Theory

Implications for monetary policy Is the “divine coincidence” dead?

We already knew short-term trade-off inflation/output Is there also one between output/inflation eqlb and financial stability? Financial frictions imply that low/stable inflation is not enough any longer

(assuming systemic risk taking is excessive)

Other tools? Macroprudential (LTVs, DTIs, dynamic provisioning, cyclical CARs) But unlikely to work perfectly Potential need to lean against the wind

Many questions:

What metrics (leverage, asset-prices, credit growth,…) Rules versus discretion General overhaul of IT and Taylor rules or case-by-case practical approach?

Relationship with other policies How many agencies in charge of MoP/MaP?

Two instruments (Policy rate, MaP)/ Two objectives (Inflation/output, Stability) Each instrument affects both objectives If perfectly functioning, design does not matter

But, if not, separation improves credibility

Especially if CB’s mandate very clear Similar to fiscal/monetary policy divorce (think Barro/Gordon) At potential cost of second-best policy mix

Example, in a recession: CB cuts rate aggressively to stimulate demand FA reacts by tightening macro-prudential regulation to reduce risk-taking → CB eases even

more → FA …. Result: a policy mix with too low interest rates and too tight macro-prudential measures

Governance issues Outsourcing monetary policy to independent CBs was “easy”

A clear and measurable objective: low and stable inflation (sometimes with some attention to short-term output)

A clearly understood (almost mono-dimensional tool): the policy rate Accountability led to properly designed incentives for central bankers

But financial stability much more complicated

Is there as a too stable banking system? Multiple objectives, difficult to measure Nobody sees the crises that do not happen Accountability complicated, potential for poor incentives Systemic nature makes problem worse than for MiP (no yardstick)

Implications for regulatory design How many agencies in charge of MaP/MiP?

Is it conceivable to keep macroprudential and microprudential regulators separate? MaP could set level of certain ratios over the cycle MiP enforcement and bank level variations

Yet, things are more multidimensional and there can be conflicts Set P(X)=probability that bank X fails Then probability of joint failures: P(X∩Y)=P(Y|X)P(Y)=P(X|Y)P(X) So you could have measures that lower P(X), P(Y), but increase P(X∩Y)

Think about completely separated versus integrated systems (Allen/Gale) Hedging across banks/Cross-border links What kind of strategic game can emerge between MiP and MaP agencies?

Cross-border issues Low interest rates in core countries

Spillovers through capital flows Not a major issue if ER not a target But problem if ER volatility is an issue K-controls and macroprudential measures may help

Are unconventional measures any different? QE1 opposite effect of QE2 & QE3 Not clear if UMP causes more/less spillover than standard interest rate policy

(carry trade?)

Macroprudential policy with open k-accounts? Cyclical CARs vs Basel I Borrower or activity based measures Especially an issues within currency areas

Conclusions Growing evidence and analysis suggest a role of

monetary policy stance in financial sector risk taking

Potentially important implications for the way we want to run MoP and its relationship with MaP/MiP

Yet, channels and magnitudes are much less clear

Effectiveness of MaP also remains unclear

Practical approach based on discretion rather than rules