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Asset prices, financial and monetary stability: exploring the nexus
TL;DR: In this paper, the authors argue that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalance.
Abstract: This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.
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TL;DR: This paper studied the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870-2008, utilizing the data to study rare events associated with financial crisis episodes.
Abstract: The crisis of 2008-09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870-2008, utilizing the data to study rare events associated with financial crisis episodes. We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks' balance sheets. We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large. Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are
2,021 citations
Cites background from "Asset prices, financial and monetar..."
...…money and credit aggregates provided valuable information for policymakers aiming for financial and economic stability.11 11 Some argued that excessive credit created “imbalances” and a risk of financial instability (e.g., Borio and Lowe 2002, 2003; Borio and White 2003; White 2006; Goodhart 2007)....
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...Particularly relevant works are those by Borio and Lowe (2002, 2003), who like us focus on cumulative effects and place a high weight on the lagged credit growth signal....
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TL;DR: In this paper, the authors discuss the implications of monetary policy and prudential supervision on financial intermediaries and suggest market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.
Abstract: Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk. 1 The author is the Economic Counselor and Director of Research of the International Monetary Fund. This paper reflects the author’s views and not necessarily those of the International Monetary Fund, its management, or its Board. I thank Laura Kodres for extremely useful conversations and suggestions, Sergei Antoshin for valuable research assistance, and Douglas Diamond, Jonathan Fiechter, Laura Kodres, Donald Kohn, Hyun Shin, Jeremy Stein, and Hung Tran for valuable comments on a previous draft.
1,199 citations
TL;DR: In this paper, the authors identify the effects of monetary policy on credit risk-taking with an exhaustive credit register of loan applications and contracts, and find that a lower overnight interest rate induces lowly capitalized banks to grant more loan applications to ex ante risky firms and to commit larger loan volumes with fewer collateral requirements to these firms, yet with a higher ex post likelihood of default.
Abstract: We identify the effects of monetary policy on credit risk-taking with an exhaustive credit register of loan applications and contracts. We separate the changes in the composition of the supply of credit from the concurrent changes in the volume of supply and quality, and the volume of demand. We employ a two-stage model that analyzes the granting of loan applications in the first stage and loan outcomes for the applications granted in the second stage, and that controls for both observed and unobserved, time-varying, firm and bank heterogeneity through time*firm and time*bank fixed effects. We find that a lower overnight interest rate induces lowly capitalized banks to grant more loan applications to ex ante risky firms and to commit larger loan volumes with fewer collateral requirements to these firms, yet with a higher ex post likelihood of default. A lower long-term interest rate and other relevant macroeconomic variables have no such effects.
965 citations
TL;DR: In this article, the authors argue that insufficient attention has so far been paid to the link between monetary policy and the perception and pricing of risk by economic agents, what might be termed the "risk-taking channel" of monetary policy.
862 citations
TL;DR: In this article, the authors discuss the implications of monetary policy and prudential supervision on financial sector-induced turmoil and suggest market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.
Abstract: Developments in the financial sector have led to an expansion in its ability to spread risks. The increase in the risk bearing capacity of economies, as well as in actual risk taking, has led to a range of financial transactions that hitherto were not possible, and has created much greater access to finance for firms and households. On net, this has made the world much better off. Concurrently, however, we have also seen the emergence of a whole range of intermediaries, whose size and appetite for risk may expand over the cycle. Not only can these intermediaries accentuate real fluctuations, they can also leave themselves exposed to certain small probability risks that their own collective behaviour makes more likely. As a result, under some conditions, economies may be more exposed to financial-sector-induced turmoil than in the past. The paper discusses the implications for monetary policy and prudential supervision. In particular, it suggests market-friendly policies that would reduce the incentive of intermediary managers to take excessive risk.
763 citations
Cites background from "Asset prices, financial and monetar..."
...Perhaps oversimplifying the well-argued ideas of Borio (2003), Borio and Lowe (2002), and Crockett (2001, 2002, 2003), in this new environment, credit expansions are less likely to be accompanied by goods price inflation....
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