Monetary Policy and Financial Stability, Is There a Conflict?

1. Monetary Policy and Financial Stability, Is There a Conflict? Yoram Landskroner* 16th Dubrovnik Economic Conference 25 June 2010 *coauthored with E. Barnea & M. Sokoler updated 21.06.10

2. Presentation • Outline • Introduction • The model • Equilibrium Characteristics (FOC) • Interaction of monetary policy and financial stability

3. Introduction

4. Introduction • The recent crisis posed challenges for monetary policy and has motivated thinking about the interconnection between financial stability and monetary policy • Prior to the recent crisis, some common views on price and financial stability and related policies : • They are complimentary “there is no general trade-off between monetary and financial stability” (Issing, 2003).

5. Introduction • central bank “that was able to maintain price stability would also incidentally minimize the need for lender-of-last-resort intervention” (Anna Schwartz, 2000) 2. the basic tool of monetary policy, the policy interest rate and the financial stability tools such as reserve and bank capital requirements were viewed as orthogonal. 3. conducting monetary policy and the regulation and supervision of banks and capital markets under one roof creates a potential for a conflict of interest

6. Introduction • Important lessons of the financial crisis: monetary and financial stability, and the instruments that are used to achieve them, are much more interrelated than thought previously : • ”The Federal Reserve's participation in the oversight of banks … significantly improves its ability to carry out its central banking functions, including making monetary policy, lending through the discount window, and fostering financial stability," Bernanke (2010) • “Monetary policy and concerns about the structure and condition of banks and the financial system more generally are inextricably intertwined“ Paul Volcker (2010) .

7. Introduction • “One roof regulation” is back, the UK government announced (06/10) restructuring of its regulatory system that will consolidate power within the Bank of England , abolishing the FSA.

8. Introduction • The purpose of this paper is • to develop an analytical framework where systemic risk is endogenous, • examine the effectiveness of the transmission mechanism of monetary policy • Consider the interaction between inflation and financial stability and • the relationship between Central Bank’s (CB) monetary policy (monetary rate) and financial stability policy tools (capital and reserve requirements) in obtaining its goals of inflation target and financial stability

9. Introduction • Our approach is how a financial crisis (stemming from systemic risk) can be prevented as opposed to the "benign neglect" approach that argues that it is better to pick up the pieces after a crisis has occurred

10. The Model

11. The Model • We consider an overlapping generation model in which there exists a storable good that can either be consumed or be stored as a capital good, k. a. Individuals • Each generation lives two periods and each young individual is endowed with wunits of the storable good. • Old individuals rely in their consumption on their previous period’s savings and investment returns.

12. The Model: Individuals • There are two types of young individuals : “patient” individuals who get more satisfaction from consumption when they are old and “impatient” ones who prefer consumption when young. • The young individuals decide how much physical capital to invest in the production process a period later (when old). • Accordingly, old individuals in period t, have access to production process, f(k),

13. The Model • The production process is subject to uncertainty as follows • The special feature of uncertainty is increasing marginal risk : probability of success λ decreases as investment increases, • This feature reflects an externality, individuals and FI don’t take this into their consideration This is why have possibility of systemic risk

14. The Model • There are three financial assets: • money (cash balances), mt, issued by the Central Bank (CB) • inherited financial intermediaries’ (FI) equity, that is non-tradable • bank deposits d, earning a rate rd • Also young individuals can borrow from FI, lt, at a nominal interest, il

15. The Model: Financial Intermediaries b. Financial Intermediaries (FI) • FI (banks) operate in an imperfect competitive loan market (assumed identical). • the market for deposits is perfectly competitive • FI extend one-period loans to investors at an interest rate, that reflects the risk of the investments. • FI has equity capital, FKt from past shareholder’s endowments and the accumulation of retained earnings.

16. The Model: Financial Intermediaries • FI can either borrow from the CB a one-period monetary loan, Lm, which the CB supplies perfectly elastically at a policy rate im. • Collateral constraint: the amount borrowed from CB is limited to the total reserves they hold at the CB. • The FI Balance sheet :rrD+ L=D+ Lm+FKt If rrD=Lm→ ΔL= ΔD (otherwise ΔL= (1-rr)ΔD) • The arrangement is expansionary • An increase in rr increases liquidity without reducing L.

17. The Model: Financial Intermediaries • FI’s are subject to two financial stability regulations set by the CB: • (i) reserve requirement at a rate of rr, in the form of deposits at the CB. We assume total reserves equal required reserves, • (ii) a required capital ratio - expected end-of-period equity capital, EtFKt+1 to total assets at time t of percent, • Note that in period t, the financial intermediary has no control over the existing stock of financial capital, FKt, and thus we enter the end-of-period FKt+1 into the capital constraint of time t.

18. The Model: Financial Intermediaries • FI’s impose a leverage (risk-management) constraint on their borrowers (LTV) • It turns out that this constraint and the Collateral constraint play an important role in our model as they did in reality (binding vs. non-binding before and after crisis) To prevent renegotiations of the debt terms and To avoid a vicious cycle where growth leads to a crisis

19. The Model: The Central bank c. The Central bank pursues two goals: • reducing the deviations of the inflation from its target, by adjusting its monetary (policy) interest rate • maintaining financial stability: policy aimed to prevent the systemic risk of run on banks, the collapse of financial intermediation and financial markets

20. The Model: The Central bank • the CB provides a safety net in the form of partial deposit insurance, which is financed by seigniorage revenues (SR) that the CB collects from issuing cash and imposing reserve requirements.

21. Equilibrium Conditions In equilibrium all markets must clear and therefore we have • Clearing condition for the consumption good market • Systemic risk: the probability of FI failure qt+1 has to be consistent with the bank having sufficient capital to absorb the loan losses where H is the cumulative probability distribution of default of the FI

22. Equilibrium Conditions 3. the CB needs to generate sufficient SR to keep its deposit insurance obligations (in case of realization of systemic risk) credible.

23. Equilibrium characteristics (FOC)

24. Equilibrium characteristics (FOC) a. Individuals 1. we have a separating equilibrium where the “patient” individuals use the bank deposits , while the “impatient individuals” use the investment in the physical capital to smooth consumption. 2. the equilibrium condition for inflation • This is a fisher equation ,Inflation is determined in a portfolio (pricing of assets) framework. • Thus transmission of monetary policy to inflation is through iL!

25. Equilibrium characteristics b. The Financial Intermediaries • the pass-through from the monetary rate to the deposit rate. • Thus the expected deposit interest rate (LHS) is affected not only by the monetary rate (positively) but also by financial stability policy tools ( and rr), and other variables: • φ3isthe shadow price (Lagrange multiplier) of the collateral constraint on monetary loans from the CB

26. Equilibrium characteristics • φ3 is negatively related to im thus reducing the effectiveness of monetary policy: As im↓→iL ↓ (demand for loans)Lm↑→ φ3 ↑ offsetting the effect of im • The shadow price is also inversely related to required reserves rr (more collateral reduces φ3 )

27. Equilibrium characteristics • The issue of Zero Lower Bound (ZLB): Note when themonetary rate approaches zero it ceases to be a policy instrument. • Then the viable monetary policy tools are reserves and capital requirements which in normal circumstances are financial stability instruments.

28. Equilibrium characteristics • Next we derived the transmission mechanism from the im to the lending rate iL. • As with the deposit rate a positive relationships between im , φ3 and iL • Where (λ-(1- λ)) is negatively related to the variance of λ for λ>0.5, thus as the variance increases iL increases • As im increases expected iL increases and expected iD declines→ the expected spread increases (net effect)

29. Interaction of monetary policy and financial stability

30. Interaction of monetary policy and financial stability • To analyze the interaction between the two policies we consider the effects of two external shocks: • a shock to productivity which is translated in our model to a shock to inflation • a shock to risk affecting financial stability. • We examine the CB reaction to the shocks (utilizing policy tools) and how these cross affect inflation and financial stability

31. A Shock to productivity • a positiveshock to productivity (higher fk) increases the demand for kthus lowering λ(k) and yielding a higher iL, under certain conditions reduces inflation • the CB lowers im to maintain the target inflation →The loan rate iL is reduced • In equilibriumthe rate iL is greater than before the shock since fkincreased and inflation is unchanged due to monetary policy • Now to the other side of the coin

32. A Shock to productivity • what is effect of monetary policy on financial stability? : • As the CB lowers its rate im→ both (1-λ(k)) (credit risk) and (1-λ(k))l (loan losses) increase → this may affect q and SR. • Outcome depends on the net effect on the bank’s profits of the reduction in im: increase loans increasing profits but also increasing loan losses reducing profits If profits decline q will increase

33. A Shock to productivity • CONCLUSION monetary policy aimed at achieving inflation target will affect adversely financial stability • Ringing a bell? keeping the monetary rate too low too long may lead to a financial crisis

34. A Shock to risk • Next we examine the effects of a negative shock to λ(k) (increase in credit risk ) • the CB increases the capital requirement κ to increase iL, such that the demand for investment k falls and λ(k) is restored to its pre-shock level. • What about q? increase in κ has opposing effects on expected profits: reducing L thus reducing profits but also reducing (1- λ)L increasing profits  Again a positive net effect will reduce q below its pre-shock level

35. A Shock to risk • However this action of the CB will affect expected inflation that will under certain conditions fall (iL L fk ) • This shock may also reduce SR, to restore its position the CB will lower the reserve requirements rr (m increases) • This decrease will likely cause an increase in iL that will under certain conditions further reduce inflation below its target • CONCLUSION: inflation and financial stability are interconnected and thus CB must coordinate its policies in achieving its goals