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Seminarium Naukowe SENAMEK 13.03.2019 Agata Wierzbowska

Financial stress in euro area: implications for real economy, monetary policy, and financial integration. Seminarium Naukowe SENAMEK 13.03.2019 Agata Wierzbowska Graduate School of Economics, Kobe University. Introduction. Plan of the presentation. Background, motivation, previous studies

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Seminarium Naukowe SENAMEK 13.03.2019 Agata Wierzbowska

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  1. Financial stress in euro area: implications for real economy, monetary policy, and financial integration SeminariumNaukowe SENAMEK 13.03.2019 Agata Wierzbowska Graduate School of Economics, Kobe University

  2. Introduction Plan of the presentation • Background, motivation, previous studies • Concept and developments of financial stress and financial integration • Econometric methodology • Empirical results • Conclusions and implications

  3. Introduction Background and motivation • Global financial crisis and European debt crisis • increase in financial stress • economic downturn • monetary policy easing • financial disintegration • Importance of financial integration in the euro area

  4. Introduction Financial stress • Underestimation of financial stress prior to the crisis (few macroeconomic models implementing the financial markets: e.g., Borio 2011) • Increase in importance of financial markets after the crisis • changes in monitoring and supervision (micro-prudential, macro-prudential) • estimation of composite indicators describing developments on financial markets (e.g., CISS for euro area: ECB - Hollo et al. 2012; IMF; OECD; BIS) • importance of understanding effects of financial stress on economic activity: theoretical and empirical research

  5. Introduction Financial stress and economic activity • Negative impact of financial stress on economic activity (e.g., Mallick and Sousa 2013, Kremer 2015 for euro area, Dovern and van Roye 2014 for US and international transmission of the shocks) • Financial stress depressing output only/ significantly more in high-stress environment (e.g., Aboura and van Roye 2017 for France, Hartman et al. 2015 for euro area, Hubrich and Tetlow 2015 for US, Li and Amant 2010 for Canada, van Roye 2014 for Germany, Hollo et al. 2012 for euro area) • Banking sector distress leading to deeper and longer downturns than stress in securities or foreign exchange markets (Cardarelli et al. 2011) • Bank-based financial systems facilitating impact of financial crisis and producing lower growth (Pagano et al. 2014; Langfield and Pagano 2016)

  6. Introduction Transmission of financial stress to economic activity • “Wait-and-see effect” (Bloom 2009): firms hesitating to invest or reluctant to hire new workers at times of high financial stress • Impact on loan supply: banks more cautious to lend and increasing credit standards (Bonciani and van Roye 2016), negative impact on bank capital and deleveraging, fall in worth of collateral (Bernanke and Gertler 1995, Bernanke et al. 1999, Kiyotaki and Moore 1997) • Higher funding costs of the private sector due to higher interest rate spreads and rising liquidity premia(Gilchrist and Zakrajsek 2012) • Fall in consumption: wealth and income effects (Aboura and van Roye 2017)

  7. Introduction Importance of financial integration in the euro area • Transmission mechanism of monetary policy – via financial markets (money markets, asset prices, banking sector, exchange rate) • Healthy and well-integrated financial system necessary for smooth and effective transmission of monetary policy (ECB 2003) • equal transmission of the common monetary policy decisions to interbank interest rates across all countries equal bank funding costs and retail rates • goal of price stability • Negative impact of financial disintegration on interest rate channel and credit channels (bank lending channel and balance-sheet channel) of monetary transmission (ECB 2012) impairing monetary policy effectiveness in influencing macroeconomic conditions • fall in monetary policy pass-through in the post-crisis period (DarracqParies et al. 2014; Gambacorta et al. 2014; de Sola Perea and van Nieuwenhuyze 2014)

  8. Introduction Research questions (1) • Impact of financial stress on economic activity: • negative • stronger in high-stress environment • What is the impact of financial stress on macroeconomic situation and monetary policy stance in the euro area and how is it changing with time? • impact increasing gradually in the build-up to the crisis? • high impact of the stress even after stress declines (‘trauma’)?

  9. Introduction Research questions (2) • Importance of the financial integration for monetary policy transmission ( focus on money and banking markets) • Financial disintegration in the aftermath on the global financial crisis and the European debt crisis • What is the effect of financial stress on financial integration in the euro area and how does it change with time? • Higher stress higher impact lower integration • Higher stress lower impact on (some measures of) integration if leading to similar reactions across all market participants

  10. Definitions and developments Financial stress • Financial stress: current state of financial instability • financial instability: amount of systemic risk that has already materialized (Hollo et al. 2012) • Features of financial stress (e.g., Hakkio and Keeton 2009, Fostel and Geneakoplos 2008, Caballero and Krishnamurthy 2008): • increase in uncertainty (e.g., concerning asset valuations, behaviour of other investors) • increase in differences of opinion among investors • increase in asymmetry of information between borrowers and lenders (intensifying problems of adverse selection and moral hazard) • reduced preference for holding risky assets (flight-to-quality) and/or illiquid assets (flight-to-liquidity) • Observable symptoms of financial stress: higher asset price volatility, large asset valuation losses, wider default and liquidity risk premia

  11. Definitions and developments Composite Indicator of Systemic Stress (CISS) • Developed at ECB by Hollo, Kremer and Lo Duca (2012) • Measure of the state of systemic financial instability in the euro area • encompassing the main classes of financial markets and intermediaries (sector of bank and non-bank financial intermediaries, money markets, securities: equities and bonds markets, foreign exchange markets) • 3 stress indicators for each market (interest rates, yields, exchange rates, equity volatilities; spreads; emergency lending at central bank, etc.) • capturing time-varying dependence of stress between major segments of the financial system (relatively more weight on situations in which stress prevails in several market segments at the same time)

  12. Definitions and developments CISS – financial stress in the euro area Source: ECB, own markings

  13. Definitions and developments Financial integration – definitions • Baele et al. (2004), basing on the law of one price: financial integration takes place if the following conditions are fulfilled for all the potential market participants with the same characteristics (1) they face a single set of rules when dealing with the financial instruments and/or services, (2) they have equal access to the financial instruments and/or services, (3) they are treated equally when they are active in the market • ECB (2003): “there are no frictions that discriminate between economic agents in their access to – and their investment of – capital, particularly on the basis of their location” Integration de jure (de Sola Perea & Van Nieuwenhuyze 2014)

  14. Definitions and developments Financial integration – measures • Price-based measures • yields of financial instruments: levels, spread with a chosen benchmark asset, cross-sectional dispersion lower spread / dispersion higher integration • Quantity-based measures • amount of international capital flows • stock of international financial assets and liabilities higher amounts higher integration

  15. Definitions and developments Financial integration in euro area – composite indicators Price-based financial integration composite indicators Source: ECB Quantity-based composite indicator

  16. Definitions and developments Financial integration in euro area – money and banking markets Interquartile range of euro area countries average unsecured interbank lending rates Source: ECB, own estimations Dispersion in the euro area retail bank lending rates

  17. Definitions and developments Monetary policy in the euro area Reactions to global financial crisis • Interest rate cuts from 2008 • Support to drying-out interbank markets and tackling bank funding problems from 2007, enhanced credit support (Oct 2009), longer-term refinancing operations (LTROs) with extended maturities, covered bond purchase programme (CBPP) - June 2009 European debt crisis and its aftermath • Securities Markets Programme – May 2010; CBPP2 – Nov 2011 • LTROs: 3-year LTROs in Dec 2011 and Feb 2012, targeted LTROs – Sep 2014 • Outright Monetary Transactions – Sep 2012 [announcement only] • Expanded asset purchase programme: • CBPP3 – Oct 2014 • asset-based securities (ABS) purchase programme – Nov 2014 • public securities purchase programme (PSPP) – Mar 2015 • corporate sector purchase programme (CSPP) – Jun 2016 • Negative deposit facility rate from June 2014

  18. Definitions and developments Monetary policy in the euro area – key interest rates Source: ECB

  19. Definitions and developments Monetary policy in the euro area – ECB assets Source: ECB

  20. Econometric model Econometric analysis - model • TVP-VAR model ; • , matrices of time-varying coefficients • vector of structural shocks • : variance-covariance matrix • Reduced form: • : matrix of time-varying coefficients; • error term vector

  21. Econometric model Econometric analysis - model • Recursive identification – Cholesky decomposition of variance:

  22. Econometric model Econometric analysis - model • : matrix of simultaneous relations , , ,…,: lower triangular elements of

  23. Econometric model Econometric analysis - model time-varying variance of structural shock of variable i , ,…,

  24. Econometric model Econometric analysis - model • Time-varying parameters following random-walk process: ) , , : time-varying variance (diagonal matrices) for

  25. Econometric model Econometric analysis – data and estimation • TVP-VAR estimation: TVP-VAR package for Matlab by Jouchi Nakajima (estimation details: Nakajima 2011) • Markov chain Monte Carlo (MCMC) method • lags: 2 • Data: industrial production, inflation (HICP), CISS, Eonia, ECB total assets, [financial integration indicators] • monthly frequency • period: January 2000 to December 2016

  26. Results Impact of CISS on macroeconomic variables Time development of responses at various horizons IRFs for shocks at various time points • High impact of stress during financial crisis and debt crisis • Output: longer-term (2 years ahead) effects still strong for post-crises period • Inflation: impact diminishing after the debt crisis

  27. Results Impact of CISS on monetary policy IRFs for shocks at various time points Time development of responses at various horizons • Increase in stress leading to monetary policy easing • Interest rate: high impact of stress during financial crisis and debt crisis, declining considerably after debt crisis • ECB assets: high impact of stress during financial crisis and debt crisis but also afterwards

  28. Results Impact of CISS on financial integration IRFs for shocks at various time points Time development of responses at various horizons • Large impact of financial stress on financial integration at the time of debt crisis • Financial integration considerably affected by stress even in the recovery period • Financial crisis extending especially high impact on dispersion in retail bank loan rates

  29. Results Appendix: responses to CISS in constant VAR (1) Note: Estimations based on 5-variable VAR model, all samples estimated with 3 lags (based on AIC) Solid lines: impulse response functions to one-unit shock; dotted lines: bootstrapped 90% confidence interval

  30. Results Appendix: responses to CISS in constant VAR (2) Note: Estimations based on 6-variable VAR model, all samples estimated with 3 lags (based on AIC) Solid lines: impulse response functions to one-unit shock; dotted lines: bootstrapped 90% confidence interval

  31. Conclusions Conclusions, implications, further issues • Financial stress as important driver of economic activity • highest impact during high-stress periods • longer-term impact on output high even in the post-crisis period ‘Trauma’ as one of reasons for slow post-crisis recovery • Monetary policy sensitive to financial stress even after stress declines • special role of the policies expanding the central bank balance-sheet Role of specific policy steps in diminishing financial stress and restoring financial integration

  32. Conclusions Conclusions, implications, further issues • Fall in financial integration due to financial stress • Importance of risk monitoring and institutional framework to prevent episodes of extremely high stress • EU-wide European System of Financial Supervision: macro-prudential supervision (European Systemic Risk Board) and micro-prudential pillar (European Supervisory Agencies) • banking union, capital markets union

  33. Thank you for attention

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