Econ 492: Comparative Financial Crises

Report
Econ 492:
Comparative Financial Crises
Lecture 2
21 September 2011
David Longworth
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Policy Statement.
Financial Crises in the News:
European Sovereign Debt Crisis
• Possible default by Greece
– Solvency or liquidity problem?
– What should EU and IMF do?
– Interconnection with potential banking crisis
• Holding of Greek debt by EU banks (could affect solvency)
• Difficulty in EU banks raising interbank deposits or CDs,
especially in U.S. dollars (liquidity problem)
– Money market funds have stepped back from CP market (“run”)
– Fed and other central banks cooperating to provide liquidity in
U.S. dollars to European banks (policy: lender of last resort)
Economics 492 Lecture 2
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New Reference on Crises:
IMF Global Financial Stability Report
• September 2011, Chapter 3, Macroprudential policies
– Prediction: “Credit growth and asset price growth together
form powerful signals of systemic risk buildup as early as
two to four years in advance of crises”
– Prediction of imminent crises: “Using a combination of the
LIBOR-OIS spread and the yield curve could signal an
imminent crisis”
– Prevention: “Macroprudential policy tools can be used
across countries with different economic characteristics as
long as policymakers understand the source of
shocks….Managed exchange rate regimes that feature
widespread lending denominated in foreign currencies”
require more conservative use of tools
Economics 492 Lecture 2
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New Reference on Crises:
IMF Global Financial Stability Report
• September 2011, Chapter 3, Macroprudential
policies
– Prevention: Empirical work on effectiveness of
macroprudential instruments in reducing
procyclicality of credit and leverage
– Macroeconomic Model with financial and real
sector linkages: allows one to look at effects of
shocks (e.g., on credit growth) and to examine
effectiveness of macroprudential tools (e.g.,
countercyclical capital ratios)
Economics 492 Lecture 2
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Overview
I. Transmission
II. Policy Response During the Crisis
III. Prevention
Note: AG indicates Franklin Allen and Douglas Gale
(2009), Understanding Financial Crises. KA indicates
Charles P. Kindleberger and Robert Aliber (2005),
Manias, Panics, and Crashes. RR indicates Carmen
Reinhart and Kenneth Rogoff (2009), This Time is
Different.
Economics 492 Lecture 2
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l. Transmission
• Outline of Course
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 2
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I. Transmission
• Illiquidity (“and all its friends”)
– Bank runs
– Margin and liquidity spirals
– Fire Sales (Cash-in-the-market pricing)
• Interconnectedness and contagion
• Decline in wealth of private sector: effects on
output and employment
• Zero bound on nominal interest rates takes away
conventional monetary policy channel
• Effect on sovereign debt crises and vice versa
Economics 492 Lecture 2
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I. Transmission
• Illiquidity (“and all its friends”)
– Recall that there is both “funding liquidity” and
“market liquidity”
– “all its friends” include (according to Tirole):
•
•
•
•
•
Market freezes
Fire sales
Contagion
Ultimately, insolvencies and bailouts
I would include “bank runs” (as one cause) and market
liquidity spirals
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Banks have liquid liabilities, illiquid assets
– So banks are susceptible to unexpected liquidity
demands (bank runs)
– Model this by having a liquid asset (short asset) that
doesn’t pay interest, and an illiquid asset that does
– Banks (intermediation) solve mismatch between time
preference and asset maturity
– Typically, markets are incomplete and so can’t provide
an efficient solution to this mismatch problem
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– In a two-period model with no aggregate uncertainty
about liquidity withdrawals, there is an equilibrium in
which the bank provides withdrawals (consumption)
c(1) to its depositors at time 1 and c(2) to its
depositors at time 2, invests x in the long asset and y
in the short asset
– In the same model, if the bank can sell the long asset
early (period 1), taking a discount, a bank run will also
be an equilibrium. This is because, if all depositors,
whether they would normally withdraw to consume
at time 1 or time 2, decide to withdraw at time 1, the
bank cannot possibly pay them all off.
Economics 492 Lecture 2
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Critics of this type of model have argued that
suspension of convertibility of deposits into cash
could stave off bank runs
– But Diamond and Dybvig have shown that a
sequential payout by bank tellers would mean
that they would not find out until too late that a
run was in progress.
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Equilibrium bank runs:
• Impossible to predict
• Coordination among individuals facilitated by
“sunspots” (extraneous variables, not “fundamental”)
• If “the probability of a bank run is sufficiently small,
there will exist an equilibrium in which the bank is
willing to risk a run because the cost of avoiding the run
outweighs the benefit.” (AG, p.82)
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Are bank runs associated with the business cycle (and
not “sunspots”)? Potential paper. Also, how correlated
is the leverage cycle (C/Y) with the business cycle (Y)?
• Some support for a yes answer: Gorton’s 1988 study of U.S.
(1865-1914)
• Indeed, if bank runs are part of transmission of crises, and
crises are typically associated with the credit cycle, which is
highly correlated with the business cycle, this would not be a
surprise
• Many suspect that liquidity problems are associated with
fears of credit problems (some evidence of this in the last
crisis) and perhaps actual credit problems
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I. Transmission
• Bank Runs (AG 3, Diamond & Dybvig)
– Runs in the last crisis weren’t just from banks (like
Northern Rock in the U.K.)
• But from “shadow banking system” as well
– Canadian asset-backed commercial paper, money market
mutual funds, U.S. commercial paper, structured investment
vehicles (SIVs), etc.
– Currently w.r.t. European banks, money market
funds are running from bank commercial paper
and holders of interbank deposits and certificates
of deposit are running too
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I. Transmission
• Margin and Liquidity Spirals
– Financial institutions (and large investors) engage
in securities financing transactions
• Repos (sales and repurchase agreements)
– A “haircut” determines the fraction of the market value that
can be borrowed
• Securities borrowing
– A “haircut” again determines what collateral must be posted
• As well, they engage in derivatives transactions
– Except for large highly-rated banks and securities dealers,
“initial margin” must be posted
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I. Transmission
• Margin and Liquidity Spirals
– When market liquidity becomes lower, it is typically
associated with higher market volatility
– But higher market volatility means that collateral
coverage for a given “haircut” or “initial margin” is
less: haircuts and margins tend to rise in the market
– One tends to get the type of liquidity and margin
spiral shown in the following diagram
• Spiral can work in the opposite direction in boom periods
Economics 492 Lecture 2
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Liquidity Spiral
Liquidity/Margin Spiral
less market making
lower market
liquidity
funding problems
higher margins
losses on existing positions
Adapted from Brunnermeier & Pederson (2009) and
Economics 492 Lecture 2
presentations by Mark Carney and David Longworth
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– First, assume a model with markets only, no banks
– Limited market participation: not everyone
participates in every market (fixed set-up cost)
– Market liquidity depends on amount of cash held by
market participants
– If there is a lack of cash in the market, small shocks
have large effects on prices
• Then prices are not determined by expected present values,
but by ratio of available liquidity to amount of asset supplied
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Amount of cash in market depends on
participants’ liquidity preference, which will
determine the average level of the short-term
asset held
– Changes in liquidity demand relative to liquidity
supply determines price volatility
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– Now add banks to the model
• Small events (e.g., small liquidity shocks) can have a
large impact on the financial system because of how
banks and markets interact: can lead to systemic crises
• If banks have to provide liquidity to customers, they
may have to sell much-less-liquid assets (if they are
running out of liquid ones)
Economics 492 Lecture 2
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I. Transmission
• Fire Sales (Cash-in-the-market pricing)(AG 4,5)
– With banks added to the model:
• Prices in those markets may be determined by cash in
the market
• The resulting “fire sale prices” may be quite low
• Banks have to mark assets held in their trading book to
market. At the end of the quarter, these losses will
show up in the calculation of profits/losses and thus
affect the bank’s capital
– The market anticipates this effects even before quarterly
statements are released.
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Interconnectedness: banks hold many liabilities of
other banks (short-term deposits—including those
for settling payments, shares, repos, derivative
instruments)
• Therefore the failure or weakness of one bank could
translate into the failure or weakness of other banks
• As well, the failure of one bank may lead to loss-sharing
arrangements being invoked in payments systems and
central counterparties (for repos or OTC derivatives)
– By their current design, such losses should be limited
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Contagion (usually used only for across regions or across
countries) can arise from a number of factors:
• Interconnectedness as described above
• Concern about common exposures, with fire sales potentially driving
down prices
• Contagion of bubbles: “when money flows from one country to
another and adjustments automatically occur both in the countries
that receive these funds and in the countries that are the sources of
them.” (KA, p.143)
– Example from KA, pp. 142-3(: From real estate and stock market bubble in
Japan (late 1980s) to real estate and stock market bubbles in Nordic countries
(late 1980s) and to markets in south-east Asia (mid 1990s) and to tech stocks
in the U.S. (late 1990s)Potential topics: (1)What is the analogue in the most
recent crisis and how did it compare with previous crises? (2) How were
various emerging market economies affected in the current crisis when
international banks cut back in foreign lending, particularly in trade finance
(why, and what were the effects?)
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– Potential topic: why was there more contagion
from the U.S. to continental Europe and the U.K.
than to other regions? Why was there financial
contagion at all to countries such as Japan and
Canada?
Economics 492 Lecture 2
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I. Transmission
• Interconnectedness and contagion(KA8, AG10)
– AG have a model of U.S. regional contagion
• “even though the initial shock occurs only in one
region, which can be an arbitrarily small part of the
economy, it can nevertheless cause banks in all regions
to go bankrupt.”
• Results depend on the nature of the network of
interbank deposits across institutions
– AG cite a number of references to studies of the
actual nature of interbank relationships in
certain countries.
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I. Transmission
• Decline in wealth in private sector: effects on
income and employment
– Lower wealth arises from fire sales, bursting of
bubbles, lower valuation of financial sector firms
– Wealth effects on consumption (standard
consumption function)
– Through financial accelerator, lower collateral means
can borrow less, so lower consumption and housing
expenditure (and investment by businesses)
– Through bank capital channel, less lending by banks,
which means less consumption, housing, and
investment expenditure
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I. Transmission
• Decline in wealth in private sector: effects on
income and employment
– Spreads increase between interest rates on
loans/market debt and government yields (even
separately from bank capital channel), lowering
housing and investment spending
– In New Keynesian models, lower aggregate demand
leads to lower employment
– Spillovers across borders from lower import demand
in countries suffering declines in wealth and income
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I. Transmission
• Zero bound on nominal interest rates takes away
conventional monetary policy channel
– Normally, the response of monetary policy authorities
to the decline in wealth, income, and employment
would be to lower the policy interest rate because of
the downward pressure on inflation
– When the policy interest rate gets to zero (or near
zero), that option is no longer available
– Central bank must turn to unconventional policy
instruments (discussed in the next section)
– ZLB in history: BoJ; recent crisis: Fed, BoE, BoJ, BoC,
ECB, Riksbank
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I. Transmission
• Effect on sovereign debt crises and vice versa
– Government bailouts or payouts to insured
depositors increase sovereign debt
– Fall in GDP leads to decline in government
revenue and increase in sovereign debt
– If sovereign debt was high before banking crisis, a
sovereign debt crisis may occur
– Banks hold lots of sovereign debt, so a sovereign
debt crisis can lead to a banking crisis
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I. Transmission
• Potential topic: relationship between banking
crises and sovereign debt crises over history.
What is the direction of transmission/
causation (leads, lags, simultaneity)? Has the
direction changed?
– See RR. See also RR (2011, AER). Also Piergiorgio
Alessandri & Andrew G. Haldane (2009), “Banking
on the State,” Bank of England, November.
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II. Policy Response During the Crisis
(Prediction)
Causes
Transmission
Prevention
Policy
Response
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II. Policy Response During a Crisis
•
•
•
•
Guarantees and closures
Domestic lender of last resort: liquidity policy
Monetary Policy
International lender of last resort: IMF, EU,
etc.
• Other policies (not the focus of this seminar:
fiscal policy, structural policy, debt
management policy)
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II. Policy Response During a Crisis
• Guarantees and closures
–
–
–
–
–
–
Deposit insurance introduced or limits increased
Bank bond debt guaranteed (e.g., Ireland)
Bank holiday (cannot withdraw funds)
Markets closed (especially stock markets)
Short-selling of bank stocks banned temporarily
Resolution of bank (range of possibilities)
• Government injects capital or nationalizes (with or without paying)
• Bank taken over by deposit insurance fund to be wound down
(only insured depositors paid off in first instance, then other
creditors)
– Issues: effectiveness, moral hazard, benefit/cost (including
exposure of the tax payer)
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Central bank policy existing before recent crisis
• “Discount window” lending against good collateral (bonds, paper)
with haircut (reduction from market value) and small penalty rate
• Repo (purchase and resale agreement) of good bonds and paper
with haircut
• These provided additional liquidity for banks needing it
– Broad (ECB) vs. narrow (BoC, Fed) in normal times
• Potential topic: Does a broad list of collateral in normal times lead
to moral hazard and to major problems in crisis times?
– Expansion in recent crisis was initially in frequency of repo
operations, size of operations, length of period, and range
of eligible collateral
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Because of “stigma” attached to discount window in
U.S., a Term Auction Facility was introduced that had a
wider range of collateral than repo operations. In
Canada, the non-mortgage loan portfolio of banks was
eligible for a TAF-like facility
• BoE has changed auctions of liquidity so that they always
happen—this is to avoid stigma in a crisis
– Central banks also introduced liquidity facilities to
deal with problems in specific financial markets (as
opposed to financial institutions). The Fed did this in
particular for the commercial paper market.
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Domestic lender of last resort: liquidity policy
– Making foreign currency liquidity available: central
bank FX swap lines
– Potential topic: Why did the range of special
liquidity facilities vary across countries? Why were
special liquidity facilities not needed in previous
crises?
Economics 492 Lecture 2
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II. Policy Response During a Crisis
• Monetary Policy
– Conventional monetary policy, reducing policy interest rate
(incentive to get to ZLB quickly in some instances)
– Unconventional monetary policy
• Conditional or unconditional commitment regarding future policy
interest rate
• Expansion of excess bank reserves (settlement balances) purchasing
government debt or repos (“QE”)
– If particular maturities of government debt is purchased, it is also a form of
debt-management policy
– If private sector debt is purchased, it is also a form of fiscal policy (credit
policy)
– In these two cases, there is a question of governance/coordination
• Potential topic: What was the effectiveness of unconventional
monetary policy across countries in the recent crisis (e.g., QE2 vs. QE1
in the U.S.)?
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II. Policy Response During a Crisis
• International Lender of Last Resort
– IMF, or EU, or bilateral sovereign loans
– Typically in an exchange crisis (fixed exchange rates)
– But also could be in cases where there is extreme
pressure on exchange rates; or significant associated
fiscal problems
– The history of IMF loans in the last 30 years has been
about the appropriate “conditionality” of loans
– Current episode: EU and IMF loans: Greece, Ireland,
Portugal and …. (will there be more?)
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III. Prevention
(Prediction)
Causes
Transmission
Prevention
Policy
Response
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
• Contingent capital and bail-in debt
• Monetary policy
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Focuses on the safety and soundness of the financial
system as a whole, as opposed to the safety and
soundness of individual financial institutions
– Macroprudential tools: deal with market failures
associated with procyclicality of aspects of the
financial system, as well as the interconnections and
similar exposures across financial institutions (crosssectional aspect) (recall market failures from last
week)
• Possible topic: How do financial cycles compare with “real
cycles and inflation cycles” across countries? How should one
measure a “financial cycle”? Implications?
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Objective: avoiding significant financial
F
instability
r
Goals: dampening procyclicality and
a
reducing potential effects of contagion
m
e
Policy Instruments: Macroprudential
w instruments, advice on policies, warnings
o
r
Activities: Data Collection, Surveillance,
k
Analysis, Risk Assessment, Stress Testing
Powers
42
III. Prevention
Proximate Object Excessive
of Concern:
Credit
Creation
Macroprudential
Instrument:
Capital
√ (total or
Requirements
sectoral)
Pigovian Taxes
√
Constraints on
quantities, or
on credit
conditions
Insufficient
Liquidity
Continuation
of a Bank
√ (maturity
√ (Contingent
mismatch)
capital)
√ (on non-core √
deposits)
√ (Cred; RR √ (BCBS
on assets) Liquidity)
√ (Haircuts, √ (Haircuts,
43
LTV)
LTV)
III. Prevention
• Macroprudential policy
– Capital requirements, leverage requirements, and liquidity
requirements are being dealt with in Basel III
• Higher capital requirements, capital buffer built up, countercyclical
requirements (typically linked to credit) (Note that effects overall
depends on extent to which Modigliani-Miller theorem violated.)
• Study of how systemically important institutions should have
higher capital requirements
• Two types of liquidity requirements
– Liquidity coverage ratio
» “Sufficiently high quality liquid assets to survive a significant stress
scenario lasting one month” (BCBS)
– Net stable funding ratio
» “Incentive for banks to fund their activities with more stable sources
of funding” (BCBS)
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III. Prevention
• Macroprudential policy
– A Study Group that I chaired for the Committee on
the Global Financial System proposed regulating
margin requirements on derivatives and haircuts
on repo transactions on a “through the cycle
basis” to reduce the procyclicality of the margin
cycle
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Several Asian countries regulate loan-to-value ratios
for mortgages (particularly on residential properties)
in an active manner to reduce the cycle in property
prices
• There are several aspects of requirements for mortgage
insurance that could be examined for more active regulation
in Canada (LTV ratios, debt-service-to-income ratio, home
equity loan ratio, amortization period); constant level or
varying countercyclically. Potential topic: How should
macroprudential policy connected to mortgages and housing
prices be carried out, i.e., what should be the proximate goal
and the tools? How would this have worked in previous
housing bubbles?
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III. Prevention
• Macroprudential policy
– Some consider “through the cycle provisioning” for
loan losses (as was used in Spain) to be a
macroprudential policy instrument
– There are other possible macroprudential policy
instruments, such as reserve requirements on
assets and levies (taxes) on non-core deposits
• There is some evidence that in modern financial systems
rapid credit growth has as its counterpart the growth in
non-core deposit liabilities (wholesale deposits,
commercial paper, repos, etc.)
Economics 492 Lecture 2
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III. Prevention
• Macroprudential policy
– Potential topics: Would macroprudential policy “x”
have prevented the recent and other financial
crises? When household debt is high relative to
personal disposable income (e.g., Canada, New
Zealand, Sweden), should the authorities respond
in order to prevent future crises and, if so, how?
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III. Prevention
• Contingent capital and bail-in debt
– To deal with moral hazard of “too big or complex
to fail” as well as the practical issue of having time
to wind down a large institution or to change its
owners
– “Contingent capital is a subordinated security,
such as a preferred share or subordinated
debenture, that converts to common equity under
certain conditions.” (BoC FSR, Dec 2010, p.52)
Economics 492 Lecture 2
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III. Prevention
• Contingent capital (CC) and bail-in debt
– Gone-concern CC converts when supervisor judges
that bank is no longer viable
– Going-concern CC converts well before, for modest
erosions of capital
– Bail-in debt applies to senior debt as well
– Conceptually, “the sum of common equity plus
contingent capital and bail-in senior debt could be
subject to an overall minimum requirement, chosen to
provide for the restoration of prudential capital
requirements” (BoC FSR, Dec 2010, p.54)
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III. Prevention
• Monetary policy
– Giving monetary policy a full-fledged financial stability
objective in addition to, but secondary to, its price
stability objective
• Inflation targeters would implement this by sometimes
returning inflation to target over a longer time period
– Potential topic: What should the role of monetary
policy (or the relative roles of monetary policy and
macroprudential policy) be in maintaining financial
stability? Could monetary policy have prevented the
recent crisis in some countries? At what cost?
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III. Prevention
• Monetary policy
– Or, having monetary policy play a supporting role
where not in conflict with its price stability
objective:
• Choice of target inflation rate (e.g., inclusion of house
prices)
• Price level target versus inflation target (Carney, 2009)
• Making very prominent the uncertainty about the
future interest rate path (note related criticism of Fed
in past decade)
Economics 492 Lecture 2
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This Week
• Prepare one-paragraph topic description for
next class (paper copy necessary)
– What is hypothesis or question to be answered?
– Which crises or countries are being compared?
• Reference list on course web site should be
helpful; also Lectures 1 and 2
• I have office hours this afternoon and
tomorrow morning; or can e-mail me
Economics 492 Lecture 2
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