Showing papers by "Alistair Milne published in 2014"

The Net Worth Trap: Investment and Output Dynamics in the Presence of Financing Constraints

Abstract: We study the impact of financing constraints on investment and output dynamics, in a continuous time setting with output a linear function of capital. Decline of net worth reduces investment and, if firms can rent capital to unconstrained outside investors, can create a 'net worth trap' with both investment and output falling below normal levels for long time periods. We provide a detailed account of our model solution and discuss both the economic intuition underpinning our results and the implications for macroeconomic modeling. Keywords: cash flow management, corporate prudential risk, financial accelerator, financial distress, induced risk aversion, liquidity constraints, liquidity risk, macroeconomic propagation, multiperiod financial management, non-linear macroeconomic modelling, Tobin's q, precautionary savings

In Good Times and in Bad: Bank Capital Ratios and Lending Rates

Abstract: This paper investigates the relationship between bank capital ratios and lending rates using data from 1998 to 2012 for 13 large banks accounting for 75% of total UK lending. We document a substantial change in the coefficient of the Tier 1 capital ratio in reduced-form regressions for secured household lending rates; the coefficient changes from positive pre-crisis to negative in crisis. Significant changes are also detected in the relationship for unsecured household and corporate lending. Such instability is difficult to reconcile with many well-established theories of financial intermediation but is consistent with the relatively recent theories of bank portfolio decisions emphasising cyclical variation in bank leverage and risk-appetite.

Leverage Constraints and Real Interest Rates

Abstract: This paper investigates the macroeconomic dynamics of consumption and real interest rates when there are constraints on debt finance, used both for insurance against income shocks and transferability of resources over time. We amend a standard continuous‐time deterministic model, with patient and impatient household sectors, introducing sector level income shocks. Shocks that push the impatient sector towards its leverage limit increase precautionary saving and result in a substantial but transient decline of the real interest rate relative to the deterministic benchmark. We discuss the resulting dynamics of consumption, leverage and interest rates, and implications for macroeconomic modelling and policy.

Bank competition, fire-sales and financial stability

Abstract: This paper applies a simple liquidity modelling framework and shows that forced asset sales (‘fire-sale’) provide an alternative theoretical support to the traditional view that bank competition can lead to financial instability. This arises from the fact that in a multi-bank economy, a bank can take advantage of other banks in fire-sale by choosing a riskier funding structure, and the incentive to do so increases as the number of banks in the economy increases. We also discuss the effectiveness of some possible policies to restrain the incentives for excessive risk-taking.

Counterparty Risk Management and the Global Legal Entity Identifier (LEI)

Abstract: The global legal entity identifier (LEI) system is a recently launched standard for unique, universal and unambiguous identification of financial market participants endorsed by the leadership of the G20 and supported by the Financial Stability Board and financial regulators in all the major jurisdictions. This paper uses a variety of sources of information to assess (i) the business impact of the LEI, and associated reporting and clearing requirements, on OTC derivatives markets business; (ii) and the application of LEI and associated relationship data (eg ownership) to managing and monitoring OTC counterparty and systemic financial risk. It finds that these regulatory measures have had unintended costs (prompting withdrawal of firms from OTC derivatives markets; imposing unnecessarily large though largely transitional costs of compliance); and while the LEI will yield substantial industry benefits a considerable amount of work remains yet to be done if it is to be useful for the measurement and management of counterparty and systemic risk.

Lessons from the Medical Industry for Big Data in Finance: Ontologies and Financial Stress Diagnostics

Abstract: We examine the lessons from the experience of the SNOMED CT ontology in medicine for the monitoring of systemic financial risk. Using big data to create financial stress diagnostics that are informative about the causes of systemic risk, requires ontological understanding of financial data at the granular level. The history of SNOMED indicates that developing such an understanding is a long term project, requiring co-operation of many participants and a well developed structure of governance.

A Theoretical Comparison of Banking Structures

Abstract: The objective of this paper is to compare, based on a theoretical framework, the value created in different banking structures. We construct a simple model to characterise a banking group that consists two different subsidiary banks. The model distinguishes safe utility subsidiary bank from riskier casino subsidiary bank. Under these model specifications, three types of banking structures: (1) total separation, (2) ring fencing, and (3) universal banking are studied. Our proposed model shows that total separation is always a suboptimal banking structure to both the banking group and the economy as a whole, while the comparison between ring fencing or universal banking depends on the expected returns to the subsidiary banks.

Macroeconomic and Macroprudential Policy Making

Abstract: This short and preliminary paper considers the relationship between fiscal, monetary and prudential policy instruments. It argues that the currently employed instruments (government borrowing, expansion of central bank balance sheets) do not address the underlying reason for slow global growth, the high levels of leverage in the (public and private) non-financial sector. It suggests that addressing this problem requires ‘monetary expansion by gift’ (also known as helicopter money). It further argues that this should be treated from an accounting perspective so that it does not result in any deterioration in central bank net worth and employment of this instrument should be independent of day-to-day political control and therefore conducted by an independent central bank as one of the basic monetary policy instruments. It also argues that macroprudential policies will then be needed to restrain unsustainable credit expansions and are operationally are best though as a branch of large exposure regulation, focusing on the exposure of institutions to systemic risks such as commercial property prices or maturity mismatch.

The net worth trap: investment and output dynamics in the presence of financing constraints

Abstract: We study the impact of financing constraints on investment and output dynamics, in a continuous time setting with output a linear function of capital. Decline of net worth reduces investment and, if firms can rent capital to unconstrained outside investors, can create a 'net worth trap' with both investment and output falling below normal levels for long time periods. We provide a detailed account of our model solution and discuss both the economic intuition underpinning our results and the implications for macroeconomic modeling. Keywords: cash flow management, corporate prudential risk, financial accelerator, financial distress, induced risk aversion, liquidity constraints, liquidity risk, macroeconomic propagation, multiperiod financial management, non-linear macroeconomic modelling, Tobin's q, precautionary savings