Entrevista 2: Importador de relevancia Objetivo de la entrevista.

A large chunk of the coverage of the 2007 financial crisis has focused on agency issues, like asym- metry of information between issuer and buyer of securitized products, and opacity of pricing of such securitized products. This section, however, shows that it is possible to find links be- tween the cost of the financial crisis and high levels of home ownership in the absence of agency issues.

The results from this section can also help clarify the 2007 crisis aftermath ex post. Some coun- tries, like the United States and the United Kingdom, have initiated large programs of quantita- tive easing with little impact on inflation. The fact that even with such a large amount of money creation no inflation was generated might mean that the actual monetary contraction due to the 2007 crisis was stronger than in other countries, like France or Germany. One element that could have contributed to this fact is that in 2007, the levels of home ownership were high for the United States and the United Kingdom — around 68% of the population owned real estate — while the level of ownership was lower for France and Germany, 57% in France and 46% in Germany. The model developed in this chapter shows that high levels of ownership can lead after a financial crisis to a deeper monetary contraction compared with the same financial crisis in a country with a lower level of ownership.

Chapter 4

Asset Price Involvement in

Macro-prudential Policy

4.1 Introduction

This section demonstrates a link between asset prices and financial stability before describing my contribution to the financial and macroprudential regulation literature.

4.1.1 Motivation

The global 2007 credit crisis was caused by the deterioration of the U.S. subprime credit market, and its effects are still felt today, four years since it began. Total losses were approximately USD 200 billion in a USD 1 trillion market (Adrian & Shin 2008), which is fairly small compared with the USD 16 trillion capitalization of the US equity market. A loss of USD 200 billion on the US equity market corresponds to a 1% market loss, a daily occurrence. An interesting comparison can be made with the dot-com crash, or the bursting of the Internet bubble, which caused a stock market crash that dropped the market value of companies by USD 5 trillion from March 2000 to October 2002. Both crises were due to some level of market failure that led to the overvaluation of assets, namely, technology stock for the Internet bubble and real estate for the 2007 crisis. However, the social cost of the bursting of the Internet bubble was much smaller than that of the 2007 credit crisis.

The following general question is asked: Why did the crisis that incurred the greater financial 95

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loss not have a greater social cost?

Part of the answer is the fact that the Internet bubble burst was an equity crisis, and the 2007 crisis was caused by debt. I develop an explanatory model that can be used to monitor the econ- omy to avoid high-cost crises. I focus on the argument that an asset price boom coupled with an extension of credit can have a very large social cost, especially compared with an asset price boom not coupled with credit extension. This is due to the critical participation of the financial system and its recent evolution, as with the development of securitization markets.

4.1.2 Contribution

Since the implementation of credible low-inflation policies in the 1980s, credit and asset price booms and busts have become more prominent (Borio & White 2004). An important aspect of such asset price booms and busts is their social cost. A financial crisis can have a significant eco- nomic impact and can damage the economy by disrupting money intermediation, credit flow, and even bank deposits causing high social costs. These financial effects thus have serious im- plications for the real economy, since they disrupt business, reduce investments, and possibly reduce overall wealth because of reductions in deposits. I will focus this work on the social costs due to a financial crisis.

To determine the mechanism of a financial crisis, I draw on the work of Kindleberger & Al- iber (2005), who investigate financial crises throughout history. One common kind of crisis follows the pattern of rapid credit extension driving overinvestment in a type of asset that leads to an asset price boom, and when the bubble bursts, it hurts bank capital, which in turn creates the financial crisis. This pattern is confirmed by Reinhart & Rogoff (2008), who find empirical evidence that banking crises are usually preceded by asset price bubbles and credit booms, affect- ing rich and poor countries alike. From a general perspective, Adrian, Moench & Shin (2010) also find empirical links between asset prices and financial industry balance sheets.

The first research question is then as follows: What is the theoretical link between asset prices and a costly financial crisis?

4.1. INTRODUCTION 97 von Peter’s (2009) macro model can help one understand how asset prices and financial crises are linked, since it links asset price shocks to bank capital. To use this model with a full-fledged financial stability framework, one needs to separate assets fueled by credit extension from other assets. This is why I develop a macro model based on the work of von Peter (2009) that will explore the relation between the price levels of different kinds of assets and the risk of financial crisis.

This contribution should be categorized within the macroprudential literature and should help in formulating financial stability recommendations. I show that by imposing certain macro- prudential conditions, a relation exists between asset price inflation and the overall leverage a banking system. From a macroeconomic perspective, the financial system is very procyclic; that is, it tends to amplify the existing economical cycle. The macroprudential recommendation of the Working Group on Macroprudential Policy (2010) is to lean against the procyclic features of the financial system, and one of the elements they recommend examining is leverage. The relation between price dynamics and overall leverage developed in this chapter could be used as a macroprudential tool and thus allow regulators to put in place rule-based recommendations.

The second research question in this case is the following: How should the overall leverage of the banking system cope with asset price dynamics?

Another contribution of this thesis is the development of a tool to help understand the cause of costly asset price bubbles, and an additional tool to forecast them. I explore different numerical methods of implementing these macroprudential evaluation tools.

4.1.3 Literature Review

This section reviews how asset price bubble spillover can be managed though macroprudential policy, motivated by the change in the banking space’s scope from microprudential to macro- prudential. It reviews the literature on asset price bubbles and the different points of view on appropriate regulator actions. Finally, it review the literature on recent risk management tech- niques to handle bank capital.

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The bank prudential was initially investigated by Dewatripont & Tirole (1994), who developed a theoretical framework to take into account information asymmetry. Their recommendations are mainly at the bank level, involving, for example, capital requirements. Financial stability is the underlying concept behind the bank prudential literature, and although regulations at the bank level are critical, a system perspective needs to be taken into account. Crockett (2000) specifically distinguishes between the microprudential and macroprudential dimensions of fi- nancial stability. The microprudential aspect deals with the soundness of individual institutions, while the macroprudential aspect has to do with the stability of the system as a whole.

The idea that the solvency of individual institutions is enough to ensure the stability of the system overlooks possible spillover effects.1 Each institution may be solvent individually, but the system can be prone to failure since the gain of one institution can create serious issues for the others. Financial macroprudential practices have recently received the attention of the chair- man of the US Board of Governors of the Federal Reserve. At his opening speech at the 2008 Jackson Hole Symposium, Bernanke (2008) argued for the superiority of the macroprudential perspective. From an academic position, the following definition of macroprudential policy can be used. Borio (2009, p. 26) characterizes macroprudential policies according to two objectives:

• A proximate objective, “limit financial system-wide distress”

• An ultimate objective, “avoid output (gross domestic product) costs”

One of the regulation proposals to limit financial systemic risk proposed by Morris & Shin (2009) is a “system-weighted capital requirement”:

The rationale for a leverage ratio derives not from the traditional view that capital is a buffer against loss on assets but, rather, from the stability of liabilities in an interrelated financial system. (Morris & Shin 2009, Summary)

A real-life application of this idea is dynamic provisioning in Spain (Saurina 2009a, Saurina 2009b). The idea is to build up capital reserves during good times for use during hard times.

From the ultimate macroprudential objective of avoiding output (gross domestic product) costs,

1_{This idea is generally rejected by large banks, mainly because it would lead to more regulations and an unwelcome}

4.1. INTRODUCTION 99 Borgy, Clerc & Renne (2009) find evidence that house price booms are more likely than stock price booms to turn into costly recessions. Sarno & Taylor (1999) also examine the 1997 Asian crisis, linking the asset price bubble with dysfunctional financial intermediation. Those empiri- cal evidences leads to an assessment of the cost of asset price bubbles and how regulators should react to them. Even if Mishkin (2008) agrees “that asset price bubbles associated with credit booms present particular challenges because their bursting can lead to episodes of financial in- stability that have damaging effects on the economy,” monetary policy should not try to burst potential asset bubbles. The externalities of the very action of fighting asset price bubbles may be too difficult to estimate: “Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good.” (Mishkin 2008)

On the other hand, Borio & Lowe (2002b) and Borio & White (2004) believe that monetary policy should be used in the fight against asset bubbles as soon as these endanger financial stabil- ity. I side with Borio, since this thesis develops new model and tools to evaluate the implications of such a monetary policy. To substantiate my position, I cite the following work examin- ing monetary policy in dynamic stochastic general equilibrium models, extended by financial intermediaries: (Curdia & Woodford 2008, Gertler & Karadi 2010, Cohen-Cole & Martinez- Garcia 2009, Meh & Moran 2010, Christiano, Ilut, Motto & Rostagno 2008, Dellas, Diba & Loisel 2010)

Finally, current regulations, such as Basel II, focus mainly on risk and use dated tools such as value at risk (VaR). There exists a vast literature on risk management tools for estimating credit risk. I cite only the Schönbucher’s (2003) book — the quantitative credit derivative researcher’s bible—for this area of research, even if more recent or advanced studies exist, because I am more interested in applications to financial stability.

One of the few articles adapting such techniques to financial stability is that of Jarrow (2007). Jarrow’s (2007) criticism of Basel II is that systemic risks are misrepresented mainly because of the limitations of the risk management tools used. The author describes in detail the differences between the way a credit derivative model views the risk of default and the way Basel II views the

100CHAPTER 4. ASSET PRICE INVOLVEMENT IN MACRO-PRUDENTIAL POLICY

bank risk of defaults. He demonstrates that current credit modeling tools are more appropriate to refining the minimum capital requirement in conjunction with the methods used by Basel II. I also use simple derivative risk management tools to help define banking system leverage.

4.1.4 Review of Regulations

The implementation of macroprudential policy is relatively new and requires a brief review from the regulatory perspective. Most regulatory bodies can summarize macroprudential pol- icy as counteracting the procyclical tendencies of the financial industry. The Group of Thirty’s Working Group on Macroprudential Policy (2010) note the following, from a regulator’s per- spective:

Macroprudential policy has not been a major focus of national governments. The Turner Review explains that the Bank of England’s focus on monetary policy through an inflation target and the Financial Services Authority’s (FSA’s) focus on individual institutions rather than on system-wide risk led to a situation in which macropru- dential concerns “fell between two stools” in the United Kingdom. (Working Group on Macroprudential Policy 2010, p. 21)

This report identifies four macroprudential instruments for policy implementation: • Leverage

• Liquidity • Credit extension

• Supervision of market infrastructure and business conduct

One recommended, Group of Thirty’s, policy tool is the adoption of a maximum aggregate gross leverage to guard against underestimating risk, thus limiting the risk of aggregated posi- tions and the feedback from fire sales. I provide a theoretical model and numerical implementa- tion for the maximum aggregate gross leverage.

The Bank for International Settlements’ Committee on the Global Financial System (2010) also examines macroprudential instruments and frameworks and lists the following macroprudential instruments:

4.1. INTRODUCTION 101 • Leverage

• Liquidity, or market risk • Interconnectedness

Within these categories, note that up to now most policy implementations were carried out mainly based on judgment—for example, the very widely publicized stress test—instead of a rule-based system. A rule-based system would be more transparent and predictable for the firms concerned, which could help them preemptively adapt to these rules. It is also possible that the existing tools are not well defined, and I hope this work will contribute to the literature by defining them.

Finally, Saporta (2009), of the Bank of England, overviews macroprudential issues and cate- gorizes them as follows:

• Incentive problems, such as being too big to fail or incomplete contracts

• Information friction, such as network externalities, risk illusion, and adverse selection • Coordination problems, such as peer benchmarking, fire sales, and credit crunch external-

ities

In this paper the Bank of England propose one way of dealing with these risks, it is to impose a systematic capital surcharge, specifically using option pricing to calibrate it to weather crises Merton (1974). This is one of the few cases where modern risk management techniques are used to find the level of capital needed for the banking system.

Saporta (2009) also shows that, within a financial system, institutions are categorized by their degree of leverage and business, and not by the kind of assets they own. This is a consistent categorization, since some firms, such as mortgage houses, own mainly real estate mortgages, but the Saporta approach does not capture firms such as large investment banks, which own different kinds of assets.

This thesis shows that the types of loan collateral assets on the balance sheet of a financial firm have systemic significance.

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4.1.5 Securitization

The securitization business is not central to this work, but it is clearly pertinent here, since this thesis investigates the significance of bank loan collateral assets. The financial press has widely blamed collateralized debt obligations (CDOs) for the 2007 crisis, and this work hopes to shed some light on this issue. First, some specific features of securitization must be described.

Securitization has allowed market participants to resell on-balance-sheet debt and to take tar- geted credit exposure for risk management. Securitization has also been used to circumvent cap- ital requirements in two ways. First, securitization allows debt to be passed on to someone else. This is a good way to deal with the capital–asset ratio, the only issue being that the end holder of the credit risk does not always understand it, which is quite often the case. Risk manager have used securitized instruments to circumvent regulation. For example, since regulators’ risk management measures are blind to long tails, transferring risk to the long tail makes it disappear.

The popularity of securitization in the United States and in Europe can be estimated from the following two figures. The European graph show all outstanding securitization, while the US graph shows only asset-backed securities. The sources are Bloomberg, Dealogic, Fitch Ratings, Moody’s, prospectus filings, Standard & Poor’s (S&P), Thomson Reuters, and the Securities In- dustry and Financial Markets Association.

4.1. INTRODUCTION 103

Figure 4.1: European Securitization Outstanding (USD millions)

Figure 4.2: US Asset-Backed Securities Outstanding (USD billions)

On the one hand, collateralized loan obligations and loans behave similarly, from a lender’s perspective (Benmelech, Dlugosz & Ivashina 2009). The main risk for this kind of instruments is due to two externalities because of the way these instruments were priced during 1990–2008,

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with risk shifting and an inability to price in the risk of fire sales.

Risk shifting arises from the fact that securitization can fool the current regulatory system’s measures of risk, that is, the value at risk. Value at risk looks at the first percentile of risk but assumes a normal distribution and is therefore blind to a long tail. For example, the risk on subprime debt can damage the first percentile risk of a bank, so the bank sells this risk and buys a AAA CDO tranche of subprime investments. The new CDO does not impact the first percentile of risk because its risk is high but with a much lower probability. Overall, the sub- stitution of a subprime investment with a subprime AAA CDO tranche only shifts the risk on the right side of the distribution, making it invisible to value at risk management.

The other main weakness of most credit derivative models, including that used by the credit rating agencies, is that a firm’s probability of default is taken in isolation from the rest of the economy. Default is a first-order effect of company risk; it does not appropriately take into account the risk of the entire economy to be stressed. For most banks, the credit risk model assumes that recovery is a fixed number—40% to be exact, which was invalidated after the crisis. Only in late 2008 did most investment banks move to stochastic recovery.2 _{Amraoui & Hitier}

(2008) describe the first and now most commonly used stochastic recovery model, as well as the fact that the previous model cannot be calibrated with the current level of credit spread. Brunnermeier & Sannikov (2010) model the fact that financial specialists were basically under-