Financial intermediation and the real economy: implications for monetary and macroprudential policies

1. Financial intermediation and the real economy: implications for monetary and macroprudential policies Stefano Neri Banca d’Italia SUERF/Deutsche Bundesbank/IMFS Conference The ESRB at 1 Berlin, 8-9 November 2011 The usual disclaimer applies

2. Outline • The financial crisis and the debate on modelling • Towards a new framework? • Monetary and macroprudential policies in a model with financial intermediation

3. Pre-crisis consensus on macro modelling • New Keynesian framework • Representative agent cash-less economy • nominal rigidities → role for monetary policy • no financial frictions and no intermediaries • “The paradigm that has emerged […] is one that is clearly applicable to normal times[…] in developed, stable economies”, J. Galí (interview for EABCN, 2009) • Estimated models (e.g. Smets and Wouters, 2007) used for policy analysis (e.g. RAMSES at Riksbank )

4. The financial crisis • The crisis showed how • important are the links between financial markets and the real economy • many of the assumptions that characterized the new Keynesian framework were wrong • financial markets are far from beingefficient • financial markets matter in originating and propagating shocks

5. Intense debate on the lessons of the crisis for economics and economic modelling • Buiter, Goodhart, Cecchetti, Spaventa and De Grauwe to mention some of critics of DSGE models • Main missing elements: • financial intermediation • insolvency and default • liquidity • regulation of intermediaries and markets • booms and busts in asset markets

6. The crisis as an opportunity • Crisis as opportunity to modify current framework • Since Kiyotaki and Moore (1997) and Bernanke et al. (1999), few papers have considered financial intermediation in general equilibrium • Intensive research ongoing since 2009 • Angeloni and Faia, Curdia and Woodford, Gertler and Kiyotaki, Bianchi and Mendoza, Jeanne and Korinek,… • They all fall short of modelling systemic risk

7. Towards a new framework? • Setting up a new framework that takes into account the critiques that have been raised will require time • Policy-makers are confronted with questions that require timely answers • Researchers in both academia and central banks to cooperate and develop new models • In the meantime, one possibility is to modify current models and use them for policy analysis

8. Monetary and macroprudential policies in a model with financial intermediation I use the model developed in Gerali et al. (2010) and modified in Angelini et al. (2011) to answer questions related to monetary and macroprudential policies • What was the impact of the financial crisis on economic activity in the euro area? • Should monetary and macroprudential policies co-operate? (BI Discussion paper, no. 801, 2011) • Should macroprudential policy lean against financial cycles?

9. The model • Based on Gerali, Neri, Sessa and Signoretti (2010) “Credit and Banking in a DSGE model of the euro area” • Medium-scale model with: • real and nominal rigidities (Smets and Wouters, 2007) • financial frictions à la Kiyotaki and Moore (1997) • monopolistic competition in banking sector • slow adjustment of bank rates to policy rate • role for bank capital • time-varying risk weights in bank capital regulation • policy rule for bank capital requirement

10. The model (cont’d) • Project started in September 2007 • Model has been estimated using Bayesian methods and data for the euro area over the period 1998-2009 • The model has also been used to study: • impact of a credit crunch on euro-area economy • impact of higher capital requirements (Basel 3) • Model has some of the limitations that I have discussed

11. Modelling monetary and macroprudential policies • Monetary policy: • interest rate rule à la Taylor • Macroprudential policy: • bank capital requirements rule • Xt can be any macroeconomic variable relevant for macroprudential authority

12. What was the impact of the financial crisis on economic activity in the euro area? • The recession in 2009 was almost entirely caused by adverse shocks to banking sector • The sharp reduction of policy rates attenuated the strong and negative effect of the crisis on the euro-area economy

13. Should monetary and macroprudential policies co-operate? • In “normal” times macroprudential policy yields small benefits • If two authorities do not cooperate, policy tools are extremely volatile • Benefits are sizeable when economy is hit by financial shocks and when two authorities cooperate

14. Should macroprudential policy lean against financial cycles? • Agents expect a reduction in aggregate risk in one year time • For a given target for leverage, this provides an incentive for banks to increase lending • Shock does not materialize • Tighter capital requirements can be effective in containing expansion of lending

15. Implications for monetary and macroprudential policies • Aggressive monetary policy can help mitigating negative impact of shocks to banking sector • Monetary and macroprudential policies should closely co-operate • Benefits of macroprudential policy can be sizeable when economy is hit by financial shocks • Risk of coordination failure • Macroprudential policy can be effective in leaning against financial cycles

16. Conclusions • DSGE models have undergone severe criticism • No doubt that modelsmust be improved, but working alternative missing • Intensive research ongoing • Modeling systemic risk is key • Meanwhile, we can adapt current models with a role for financial intermediation to address questions related to monetary and macroprudential policies