Discussion Laurent Clerc (Banque de France) 13th Conference of the ECB-CFS Research Network

1. Session 2: Applied research into the sources, transmission channels and real effects of financial crises Discussion Laurent Clerc (Banque de France) 13th Conference of the ECB-CFS Research Network

2. The 3 papers • Merrouche & Nier: “what caused the global financial crisis? Evidence on the drivers of financial imbalances” • Monnin & Jokipii: “The impact of banking sector stability on the real economy” • Kapadia & al.: “Liquidity risk, cash flow constraints and systemic feedbacks”…an overview of RAMI (risk assessment model of systemic institutions)

3. Introduction (1/2) • 3 very different papers but important contributions for the design and the implementation of macro-prudential policies • Focus on the empirical characteristics of financial crises with a particular application to the most recent episode

4. Introduction (2/2) • Identification of: • Main channels, main indicators • Main players (intermediaries & markets) • Policy tools (models for policy scenarios) • Raise important issues regarding the challenges facing policy makers: • Data paucity • Financial system complexity • Multilateral dimension of financial fragility

5. Outline of the discussion • An overview of the main mechanisms underlying the recent financial crisis • The build up of financial imbalances • Policy challenges

6. 1. An overview of the main channels Asset prices Banks Supervisory authorities US current account Capital flows into US US interest rates Leverage Wealth effects Imports form emerging countries Aggregate demand inflation Central banks

7. A first set of questions/issues • The story holds for the US but what about other countries? • The 3 papers provide different answers: • Paper 1&2: similar transmission channels captured through panel data regressions on a set of OECD countries • Paper 3 does not really take a stance but assumes similar banking/funding features • Nothing is really said about contagion, counterparty risks stemming from toxic assets eventually bought by foreign banks

8. Too narrow a focus? • Paper 1 (Nier & Merrouche) focuses on “home grown” financial imbalances which sounds paradoxical in the context of the “global financial crisis” it attemps to describe • The methodology by construction is restricted to the “within dimension” • This bias is potentially addressed by year-fixed effects (that should take care of global developments)

9. Too narrow a focus? • Some surprising results: • Stringency of capital requirements does not seem to play a significant role • Nor differences in financial structures • Paper 2 (Monnin & Jokipii) presents similar drawbacks • Both papers focus on narrow banking, thus do no factor in “shadow banking system” • It is not clear if clusters are accounted for

10. Too narrow a focus? • Third contribution (Kapadia et al.) has a broader perspective (encompassing model) with a focus on liquidity stress • Still under development • Second round effect still missing • But shocks stem from the macro block (BVAR) not from banks’ balance sheets which may be interrelated in the context of the global economy (counterparty risk with foreign banks)

11. Complexity of financial systems • The 3 papers try to account for the complexity of financial systems • Try to address non-linearities (trough state dependence) • Factor in complex interactions between key explanatory variables • Account for the interactions between markets (funding and asset markets) and institutions • And finally the interaction between financial systems and the real economy

12. Complexity of financial systems • However, financial fragility measured by a rather crude indicator in paper 1: • Ratio of bank credit/deposits • But wholesale funding is vague: foreign / domestic? Secured/ unsecured? Short-term/long term? Presumption that growing reliance on short term unsecured is a source of financial stability • Multilateral dimension is missing (better accounted for by the concept of “danger zone” in paper 3)+ usual indicators in probability crises models

13. Complexity of financial systems • In paper 2, financial fragility (or instability) measured by distance to default • The papers tries to make the point of the informational advantage of he central banks especially when it factors in confidential supervisory information about banks health • Here, single indicator fully derived from public available information as the main determinants of the distance to default indicator are unobservable (A, D, σ)

14. 2. The build up of financial imbalances • Great Moderation: • Good luck: no commodity price shocks • Good Policies: stabilization policies (monetary policy) • Good Practices: inventories, IT • Financial Crisis • Bad luck: commodity prices shocks, asset price bust • Bad policies: too lax monetary policies and supervision • Bad practices: Moral hazard, search for yield

15. Second set of questions/issues • Are we talking about the same period? • Missing information from the financial sphere? • Presence of a structural break? • Perception in paper 1 & 2 that something is different but this is related to the state of the economy (booms vs busts or stable vs unstable periods) • One could then question paper 1 sample (why starting from 1999? Signs of breaks around 2004 (China, GSE’s, Basel 2 announcements)

16. Paper 2 highlights the role of banking sector stability for real output growth • Looking at the results tend however to show that the effect is short-lived and most of the time almost cancelled out the following period: no or rather small permanent effect of this variable on output growth and no relation with inflation: why should the central bank then consider banking sector stability in its decision making process?

17. 3. Policy challenges • Data paucity • The lack of relevant data on the banking sector stems from the 3 contributions • fragile indicators of financial fragility! • need to calibrate banks behaviour on US data for paper 3 or “use rule of thumbs based on other information or extrapolation on the basis of our knowledge of bank similarities to fill in the data gaps” • Nothing really on banks’ balance sheet exposure across countires

18. Policy challenges • Financial system complexity • Banking crises are (fortunately!) rare events: need to work on panel data to obtain more information • Reliance on core indicators, but usually reduced to the banking sector and derived from supervisory requirement (capital, leverage, maturity mismatch) but still searching for macro-prudential indicators • Few candidate emerge: current account deficit, credit to GDP gap (but dominated by house prices)

19. Policy challenges • Multilateral dimension of financial instability • Liquidity and solvency intrinsically related (mark to market) • Institutions and markets: source of instability? Location of risks? • Interrelation with other policies in particular regarding the future countercyclical component (fiscal and monetary)