Financial market frictions, macro models and policy

Continuing the recent theme of looking at the financial market and incorporating it into macroeconomics considerations, a paper from the New York Federal Reserve[1] has provided some guidance on specific areas of focus. The authors, Adrian & Shin (hereafter A&S), direct their attention to security broker-dealers – the part of the financial sector that includes the investment banks. Traditionally, they note, attention was only paid to commercial banks and because of the efficient market hypothesis discussed last week, the remainder of the financial sector was viewed as benign. The work from A&S reveal that the behaviour of broker-dealers needs to be brought into both macroeconomic models and policy deliberations.

What did they do?

Most models in macroeconomics had frictions that originate in the ‘real’ economy, such as price ‘stickiness’. The work of A&S suggest another type of friction that needs to be accounted for in these models, that is, frictions in the supply of credit. The source of this friction comes from security broker-dealers, which they place in the context of the ‘market-based banking system.’ This distinction is important, as compared to traditional banks, the balance sheets of these financial intermediaries are ‘marked to market’. This marking to market means that the dynamics of these balance sheets matter for the supply of credit and can also signal trouble ahead with the increased risk of a dramatic deleveraging.

Leverage is procyclical – high in expansions and low in contractions

Figure 6 from A&S displays this procyclicality point well. It may seem intuitive that leverage increases when balance sheets are larger, but some explanation is required. For investment banks, an increase in asset prices will bolster their net worth and reduce leverage. With a desire to minimise equity, as perhaps the return on equity is low, the investment bank will borrow to buy more of the assets it holds, thus increasing leverage. Within this cycle, positive and negative shocks are amplified, as a positive shock to asset prices, increases the size of balance sheets, leading to increased leverage and higher asset prices.

procyclical leverage

When the leverage cycle goes pop – repos and haircuts

With procyclical leverage, problems can occur when this continues unabated. The repurchase, or repo, market is illustrative here. Repos, which are the primary source of funding for market-based banking institutions, are market transactions where a borrower sells a security below the current price with an agreement to buy it back at a later date. The difference between the price it is sold at and the market price is referred to as the ‘haircut’ – it can be thought of as the deposit on buying a house. The haircut fluctuates with funding conditions in the market. This, in turn, determines the leverage. If an institution borrows $98 for $100 of securities pledged, then to hold $100 of securities, $2 of equities is needed. This results in a leverage ratio of 50.

The danger comes from a potential sudden rise in the haircut, or a margin call, where the lender asks for more collateral to be given over for the loan. This may occur at the peak of the leverage cycle.  As the system as a whole has a maturity mismatch, if this happens on masse, a major deleveraging event can occur.

Implications for the real economy

A&S show that the behaviour of these financial intermediaries have a non-negligible impact on the real economy, especially those areas that are sensitive to credit supply. In regression analysis of growth rates of GDP components, A&S find that growth rate of security-broker dealer assets has the strongest significance on the growth rate for future housing investment and durable consumption. This suggests that the mechanisms that determine the liquidity and leverage of broker-dealers affect the supply of credit, which plays a significant role in areas like housing investment and durable consumption.

As an indication of potential future research, A&S point out the difference in their work from that of Bernanke & Gertler. Through a ‘financial accelerator’ Bernanke & Gertler focused on the borrower side of the credit relationship, where improving asset prices on the borrower side make borrowing easier and encourage that feedback loop. Conversely, A&S focuses on the lender side and the self-fulfilling process on this side of the credit equation. When both of these accelerate at the time, it can be dangerous.

How does Lo’s AMH fit with this work from A&S?

As a brief digression, this cyclical balance sheet behaviour also fits in with Lo’s AMH, particularly the notions of adaption and survival. As asset prices increase for broker-dealers, they could let their leverage fall, but they borrow more to increase leverage. With the chase for returns so competitive, they would be losing out if they did not follow the crowd and increase leverage. This becomes less rational and more about maintaining their survival as a profit making institution the longer the leverage cycle goes on.

The disorderly unwinding of leverage – implications for monetary and macroprudential policy

 On policy matters, A&S state clearly that their work implies that financial market stability cannot be conducted separately to monetary policy. In other words, these financial market frictions need to be considered alongside what is happening in the real economy. They emphasise that the movement of short rates is not only important for expectations of future short rates, but they also determine the leverage and balance sheet dynamics of systemically important intermediaries. This supports the view of Blanchard that both areas should be considered in the same institution.

In terms of the conduct of monetary policy, their work suggests that considerations of excessive leverage should make policymakers wary during the expansion phase of monetary policy. This sounds reasonable of course, but I think there will may be a dilemma where the real economy calls for more expansion, while the leverage concern calls for it to end. In this case, I would like to think that the macroprudential tools discussed by the UK FPC would be utilised to allow the expansionary phase to continue.

In terms of macroeconomic modelling, A&S have identified the balance sheet dynamics and leverage that seems most relevant to the broader economy. By articulating that leverage is procyclical and demonstrating the disorderly nature of sudden deleveraging, these balance sheet dynamics could be necessary additions to macro models. They could be incorporated into existing DSGE models, as well as being explored in the ‘disequilibrium’ models currently being considered around the world.


[1] Adrian, T & Shin, H, S. (2008). Financial Intermediaries, financial stability and monetary policy. Staff report no. 346.

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