Discussion of Meh and Moran “The Role of Bank Capital in the Propagation of Shocks”

1. Discussion of Meh and Moran“The Role of Bank Capital in the Propagation of Shocks” Andrea Gerali Bank of Italy 2nd BI Conference on Macro Modeling in the Policy Environment Rome, July 1st, 2009

2. Praise • As we all learned in the past two years, this is an incredibly relevant topic “in the policy environment”: • Existing macromodels have not been designed to address the key questions (on credit and, in particular, banking) that policy-makers are asking now • Bank capital is affected by macro conditions as well as affecting them. • There is a potential for adverse feedback loop • Incentives coming from financial regulation seem to play a role in exacerbating this feedback loop • We need both theoretical advances and quantitative evaluation on the nexus between finance and the macro economy 01/07/2009 Discussion of Meh and Moran

3. Praise • It is not an easy problem to crack: • Long tradition of studying banks in microeconomic and/or partial equilibrium settings (Freixas & Rochet 1997) • Much less in quantitative general equilibrium models: • Christiano, Motto, Rostagno: combine a banking system à la GMcC with financial accelerator à la BGG • Van den Heuvel: a role for bank capital and regulatory requirements • Gerali, Neri, Signoretti, Sessa: rate-setting banks and bank capital 01/07/2009 Discussion of Meh and Moran

4. Outline • Model recap • Empirical issues • Policy implications 01/07/2009 Discussion of Meh and Moran

5. More praise • The authors have succeeded in doing an important step forward: • They started from an empirically sound NK macro model (Christiano, Eichenbaum and Evans, JPE 2005) • Keep all the basic structure except for investment, which is now assumed to be plagued by credit market frictions and agency problems. • End up with an equally empirically sound model that: • gets rid of the ad hoc “investment adjustment costs”, replacing them with more micro-founded mechanisms (moral hazard problems in the financial industry) • is well suited to study the feedback loops between the financial and the real side of the economy 01/07/2009 Discussion of Meh and Moran

6. The key innovation • Entrepreneurs (owners of capital goods) need external finance to invest and cannot obtain funds directly from hh’s • Banks enter two financial contracts (one with hh’s and one with entrepreneurs) under private information and hence moral hazard: • To prevent entrepreneurs from undertaking inferior projects, banks need to monitor • To convince hh’s that they will indeed monitor, banks need to invest their own wealth (bank capital) in the project • The size of final investment ends up being linked to bank capital end entrep. net worth, both accumulated out of retained earnings: 01/07/2009 Discussion of Meh and Moran

7. Difference with dominant approach • The emphasis on principal-agent problems in credit market is similar to Bernanke, Gertler and Gilchrist “financial accelerator” approach • Difference is in the form of the optimal contract • Here, different from BGG, the total amount of financing required is an equilibrium object specified in the financial contract • As a result, the size of investment depends on financial markets conditions (severity of moral hazard and the like) • Not so in BGG, where financial contract mainly determines the price of investment (the external finance premium) 01/07/2009 Discussion of Meh and Moran

8. Difference with dominant approach • Pro: • Delivers hump-shaped response of Investment w/o adjustment costs • More intuitive and parsimonious approach • Cons: • More based on unobservables (like size of private benefits, shares of profits from investment projects …) 01/07/2009 Discussion of Meh and Moran

9. Empirical issues • I find that the paper only sketches the implications from introducing this “double moral hazard” structure • Two related issues: • The “empirical success” of the model • Changes of the dynamic properties wrt CEE model 01/07/2009 Discussion of Meh and Moran

10. Empirical success ? • The authors report delayed & persistent responses as well as unconditional correlations evidence. But: • All the CEE “bells and whistles” (habits, sticky pt and wt, var. cap. util.) are in! This already ensures hump-shaped IRFS in main macrovars (except possibly for I(t)) • Unconditional correlations are based on two shocks only (MP and tech.), whose relative sizes (and params) are not estimated. 01/07/2009 Discussion of Meh and Moran

11. Dynamic properties of the model • Further investigation of the model behavior under alternative “polar” parametrizations (no moral hazards, RBC plus banks, etc…) is needed to disentangle the different contributions • For example, when the authors switch off the contribution of bank capital (hence moral hazard in the banks-hh’s relationship), I(t) is still hump-shaped! (figure 5) • Estimate it ! 01/07/2009 Discussion of Meh and Moran

12. Policy implications • The model of banks, although sophisticated, leaves out a lot: • No financial markets, only banks  effects of bank-related shocks are maximized • Banks cannot go out and raise capital, or choose a dividend policy • No bank failures • No role for uncertainty over asset values (because of risk neutrality): a serious shortcoming if we want to use the model to understand the current crisis (1st and 2nd moments effects) • Still it is interesting to dig a bit into what does this model say to policy makers in the current juncture 01/07/2009 Discussion of Meh and Moran

13. Policy implications • Monetary policy: inflation rises (so MP under Taylor is tightened) after the credit crunch. This is very counterfactual, looking at the past two years • Fiscal & unconventional policies: the model says that resources should flow to replenish net worth of bankers and entrepreneurs. And indeed: • US Treasury has engaged in massive equity injection into the banking system • Fed and other major central banks have expanded their balance sheets to directly channel credit to the private sector • Optimal (?) banking regulatory policy: changing capital regulatory requirements to make them countercyclical might not be a good idea. 01/07/2009 Discussion of Meh and Moran

14. Figure 6 Discussion of Meh and Moran

15. Conclusions • Very nice paper • The suggested addition to the standard NK framework seems promising and definitely deserves further scrutiny • At this stage of development, difficult to judge its empirical relevance • First step forward will be to estimate the model 01/07/2009 Discussion of Meh and Moran