Economia Bancaria - Topic 2 - Banking, Growth and Crises - 2023-2024 - PDF

Economia bancaria Topic 2 - Banking, Growth and Crises Tommaso Oliviero 2023-2024 LM Finanza - Dises GDP time series - USA A lot of information from just a single plot What do you see in this figure? Trends vs Cycles Trends are different across countries Countries e...

Economia bancaria Topic 2 - Banking, Growth and Crises Tommaso Oliviero 2023-2024 LM Finanza - Dises GDP time series - USA A lot of information from just a single plot What do you see in this figure? Trends vs Cycles Trends are different across countries Countries exhibit very different long-run growth rate even among developed countries Growth and Banking Understanding the determinants of those differences is important from (at least) three points of view: People living in those countries (GDP per capita is highly correlated to living standards) People living in other countries (if they are considering investing or doing business in a country) Policy makers (involved with economic policy of a country) Growth differences are so staggering that an immediate question is: why is it the case? Is it luck, policies or both? We will study the role of financial institutions (e.g, development of the banking sector) Cycles are also different among countries The economic cycle around the 2008/2009 financial crisis Notice that sometimes it is difficult to distinguish between trends and cycles: the case of Italy from 2007-2008 Business cycle and Banking Economists also worry about short run (business cycle) fluctuations The questions are: what is a recession? why some recessions are large and persistent? what are their determinants? We will study the recessionary effects of banking crises with a focus on the euro area in recent years Lecture outline 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The euro-area crisis Issue 1 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis Banking and growth: an old debate There has been, and there is still, an enormous debate in economics on the role of financial development for economic growth Robert Lucas (1995 nobel prize) in 1988 argued that finance is an overstressed determinant of economic growth Merton Miller (1990 nobel prize) in 1998 argued that the idea that financial markets contribute to economic growth is a proposition too obvious for serious discussion Do banks promote, follow or hamper economic growth? Simple question, many answers... we will see some Is there a positive correlation between economic growth and the level of financial development? If yes, what drives this relation? First, we will discuss this issue theoretically Second, we will study it empirically (the main problem, as often in this kind of works, is the assessment of the causality nexus): Countries with higher income consume more financial services Financial development fosters economic growth because better functioning financial systems limit market imperfections However the sign of the relation may also turn to be negative - we will see later under which circumstances How do banks promote growth? A simple theoretical framework I (Pagano M.,1993) Assume that the economy produces a single good that can be consumed or invested to accumulate capital The aggregate output in the economy depends linearly on the aggregate capital stock Yt = A · K t Capital stock is Kt+1 = Kt (1 − δ) + It where δ is the depreciation rate (exogenously given) In equilibrium It = φSt where φ indicates the capacity of the economic system to channel savings into investment How banks promote growth? A simple framework II Suppose St = sYt − > It = φsYt The output growth rate in t + 1 wrt t is Yt+1 − Yt gt+1 = Yt Substituting for the definition of Y, K and I Kt+1 It φsYt gt+1 = − 1 = (1 − δ) + − 1 = Yt − δ Kt Kt A hence gt+1 = Aφs − δ Theoretical prediction gt+1 = Aφs − δ Financial development can affect economic growth through three channels: 1. By funneling savings from savers to firms ⇒ φ ↑ 2. By improving the allocation of capital ⇒ A ↑ 3. By affecting the saving rate ⇒ s ↑ (1) φ - intermediation efficiency In the process of transforming saving into investment, financial intermediaries absorb resources: 1. A dollar saved by the economy generates less than one dollar worth of investment: the fraction φ 2. The remaining fraction 1 − φ goes to the bank as, for example, commissions or fees to the dealer or as reserve for regulation requirements If financial development reduces this leakage of resources raises φ and increases the growth rate g. (2) A - allocative efficiency A second key function of financial intermediation is the allocation of funds to those projects where the marginal product of capital is the highest in two ways: 1. Collecting information to evaluate alternative investment projects: screening and monitoring of firms, information production 2. Inducing individuals to invest in illiquid but more productive technologies by providing liquidity-risk sharing: If financial development increases the efficient allocation of resources, it raises A and ultimately the growth rate. (3) s - saving rate In this case the direction of the impact of financial development on the saving rate is ambigous: 1. Negative - Precautionary reasons Higher levels of financial development induce less savings for precautionary reasons. 2. Positive - Interest rate spreads More developed financial systems require less spread. If interest rate on savings gets closer to productivity, it increases the saving rate of the economy The final impact of financial development on the saving ate s depends on the prevailing effect between the precautionary and the spread effect Issue 2 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis Financial development and growth: Growth Regression Establish the following statistical relation: gi = α + βFDi + i where between g is the average growth rate and FD is a measure of financial development of a country i 4 issues: 1. Determine the measurement of the indicators of economic growth and financial development FD 2. Determine the sign and the statistical significance of β 3. Determine if this relation can be interpreted as causal 4. Determine the channel of influence - φ or A or s? Financial development and growth: Goldsmith (1969) Estimate the growth equation: gi = α + βFDi + i gi is the average annual GDP growth of 35 countries over the period 1860 to 1963 - captures long-run trend FDi is equal to the average value of financial intermediary assets as a share of economic output (GDP) He found a positive and significant relation between the two variables - positive β Any criticisms? Goldsmith (1969): criticisms 1. The investigation involves only 35 countries - due to long period of investigation 2. It does not systematically control for other factors influencing economic growth 3. It does not examine whether financial development is associated with productivity growth and capital accumulation, which theory stresses. 4. The indicator of financial development, which measures the size of the financial intermediary sector, may not accurately gauge the functioning of the financial system. 5. The close association between financial system size and growth does not identify the direction of causality 6. The study did not shed light on whether financial markets, non-bank financial intermediaries, or the mixture of markets and intermediaries matter for economic growth - unclear channel of influence The growth regression by King and Levine (1993) Using a sample of 77 countries over the period 1960-1989: gi = α + βFDi + γXi + i β captures the effect of Financial Development (FD) on economic growth (g) The set of explanatory variables Xi include: income per capita, education, political stability, indicators of exchange rate, trade, fiscal, and monetary policy Measurement issues in KL The dependent variable g is measured in three (alternative ways): 1. per-capita GDP growth 2. per-capita capital stock growth 3. productivity growth The independent variable FD is measured in three (alternative ways): 1. DEPTH = Liquid liabilities / GDP - Liquid liabilities include currency plus interest-bearing liabilities of banks and non-bank financial intermediaries 2. BANK = Bank credit / (Bank credit + Central bank domestic assets) - Central domestic assets excludes foreign assets 3. PRIVY = Credit to the private sector / GDP KL (JME, 1993) results KL (JME, 1993) interpretation Interpretation of each β coefficient is like in a lin-lin multiple regression model: d(growthrate) d(FD) , keeping constant the other control variables if FD increases by 0.1, the average growth rate increases by 2.4×0.1=0.24 The sizes of the coefficients are economically large and statistically significant While addressing many of the weaknesses in earlier work, cross-country growth regressions do not eliminate all criticisms KL show that finance predicts growth, but they do not deal formally with the issue of causality It may simply be the case that financial markets develop in anticipation of future economic activity. Thus, finance may be a leading indicator rather than a fundamental cause Causality in economics Our estimation may represent a spurious correlation with no causality interpretation Sometimes correlations are interesting per se Most of the time, economists care about causal relation between variables Causality is important also for policy makers to guide policy choices What’s after King and Levine (1993) King and Levine (1993) show that finance predicts growth but they do not deal formally with the issue of causality They limit endogeneity concerns in the following way: gi = α + βFD1960 i + γXi + i Further developments in the literature The empirical literature has moved in two directions: 1. Identifying the causal impact of financial development in cross-country studies using quasi-natural experiments driven by historical events (e.g., Levine, Loayza, and Beck, 2000) 2. Identifying the channel(s) of influence of financial development with industry-level or within-country studies using granular data (e.g., Rajan and Zingales, 1998) Summary of results in Levine, Loayza, and Beck (2000) They confirm that countries with better functioning banks grow faster using countries’ legal origin as instrumental variable for FD Comparative legal scholars place countries into four major legal families, English, French, German, or Scandinavian, that descended from Roman law The adoption by one of the family happened for historical reasons linked to conquest or imperialism (e.g., the French law adopted in countries under directly or indirectly the Napoleon empire) Differences in legal origin affects Financial Development through to differences in the legal rules covering secured creditors, the efficiency of contract enforcement, and the quality of accounting standards Summary of results in Rajan and Zingales (1998) It shows that industries that are more dependent from external finance benefit disproportionately more from financial development than industries that are less dependent from external finance External financial dependence at industry level is measured by the fraction of capital expenditures financed with external funds for U.S. firms in each industry Financial development disproportionately boosts the growth of value added of industries that are naturally heavier users of external finance More on the mechanism... better functioning financial systems ease the external financing constraints that impede firms to invest and innovate - allocative efficiency mechanism A within-country study with quasi-natural experiment A flourishing economic literature rely on historical events as one of the main determinants of current economic development Pascali (2016) finds that differences in local banking development related an historical event during the Italian Renaissance are related to higher financial development nowadays This work establishes a causal effect of local banking development on GDP-per capita of Italian regions; the effect goes through an increase in firms’ productivity The history of Italian banks Jews arrived in Rome during the Roman Empire owing to a mass deportation following the Roman Empire’s victories After temporary expulsions from Rome, and, the Jewish residents spread from Rome to the rest of Italy For centuries, their religion and the discriminatory actions by Catholics prevented them from acquiring economic and social prominence in Italy At the end of the fourteenth century, a sudden change in Catholic doctrine prohibited Catholics (laity - as clergy were already prohibited) from lending for a profit, but still allowed the Jews to do so The history of Italian banks II Italian cities that hosted a Jewish community developed complex credit markets, for two reasons: 1. Jewish communities became specialized in the money-lending business because they were still allowed to lend and because of sufficient availability of capital 2. New charitable loan banks have been created to drive the Jews out of the local financial market, the so-called Monti di Pietá. These institutions were sponsored by wealthy Christians and local charitable initiatives and extended credit on a nonprofit basis The Monti di Pietá were created in cities in which the Jewish minority was most influential While the Jewish money-lending industry disappeared over the centuries, the Monti have survived to the present day and gave rise to a significant portion of contemporary Italian banks (e.g., San Paolo, Banco di Roma and Monte dei Paschi originate from the Monte di Pietá) Results in Pascali (2016) Pascali (2016) reconstructs the approximate size of the Jewish population in 1500 and use the Jewish demography as an exogenous source of variation Jewish demography in 1500 explains a larger frequency of having a Monti di Pietá in a city, and larger Credit/GDP and bank branch density nowadays in Italian municipalities The causal impact of branch density due to the presence of Jewish in 1500 is large and significant: results indicate that if a bank fell from the sky in a city characterised by the average branch density and 100,000 residents, local GDP per capita would be expected to increase by 2.8% At least 11% of the North-South gap in per capita GDP is attributable to lower current credit availability, which is due to the expulsion of Jews Issue 3 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis Non-linear effect of financial development Is "too much" finance a potential issue? Arcand, Berkes and Panizza (2015) study the following non-linear version of the growth regression: gi = α + β1 FDi + β2 FD2i + γXi + i Use a large sample of countries in the period 1970-2010 Too much or too little bank-finance? 41 Figure 1. Marginal Effect Using Cross-Country Data. This figure plots the marginal effect of credit to the private sector on growth obtained from the regression of Table 1, column 6. 10 5 0 dGR/dPC −5 −10 −15 −20 0 0.5 1 1.5 2 2.5 Credit to Private Sector/GDP source: Arcand et al. (2015) d(g) Marginal effect: d(FD) = β1 + 2β2 FD The relationship between finance and growth is negative when financial depth reaches a value between 0.8 and 1 What is the reason for the "too much finance" effect? Positive but decreasing returns of financial depth which, at some point, become smaller than the cost of instability (for instance through financial crises) The evidence in Arcand et al. (2015) is robust to the exclusion of years of financial crises... there is something more than the "instability effect" The dark side of banks An excessively bank-based financial structure is prone to three problems: 1. The hold-up problem: banks become specialized producers of soft information about borrowers’ credit quality. This creates overtime a bilateral monopoly and increases the re-financing probability of distressed borrowers 2. Politically powerful banks: the concentration of banks, that arise because of large fixed costs, may allow them to lobby for private interests or lax regulation 3. Volatile credit supply: bank credit supply can be a volatile source of financing and may provide amplification effects The issue of over-banking Some countries display banking systems that are large relative to the size of their economies, whether measured by income or household wealth Europe is home to the world’s largest banking system. The total assets of banks in the EU amounted to 42tn euro (334% of EU GDP) in 2013 The expansion has been very rapid over the past decades Why is over-banking a concern? Two reasons: 1. Large banking systems may be associated with excessive risk taking by banks which ultimately leads to financial crises 2. As banks become very large, they may become too large to save by domestic taxpayers, thereby increasing the likelihood of sovereign debt crises Issue 4 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis Bank bias in Europe Langfield and Pagano (2016) document the rise of the banking sector in Europe in the last decades relative to equity and private bond markets This expansion is associated with more systemic risk and lower economic growth, particularly during housing market crises Banks amplify negative shocks via credit supply due to financial accelerator mechanism(s) Historical behavior of Europe, USA and Japan - LP (2016) From 1880 until the 1960s, bank assets to GDP fluctuated around 70% in both the Unites States and major western European countries In the late 1980s, bank assets amounted to about 180% of GDP in Japan and major western European countries Only since 1990 has Europe’s banking system grown so much larger than its international peers A zoom on Europe - LP (2016) Some EU countries (Italy and Germany) experienced more modest increases.Elsewhere, banking sector grew very substantially relative to GDP (ratio more than doubled in few years) Non-EU countries - LP (2016) We observe rapid increases after 2000 in other developed countries but at non-comparable magnitude Financial structure - LP (2016) Europe displayed already a bank-based financial sector before 2000. The recent dynamic of bank assets over GDP amplified the difference wrt Japan and USA Costs and benefits of a bank-based structure Information processing role of banks 1. Benefit: improve access to finance 2. Cost: strategic use of information monopoly (hold-up) Business Innovation 1. Benefit: protecting confidential information regarding clients’ plans 2. Cost: no high-risk/high-return projects are financed Reaction to adverse shocks 1. Benefit: relationship lending provides insurance against temporary (negative) shocks to firms 2. Cost: bank lending is highly pro-cyclical and credit market disruptions amplify negative shocks (financial accelerator effect) Financial accelerator The idea that economic disruptions may be generated or amplified by deteriorating credit-market conditions goes under the name of financial accelerator framework developed by the work of Ben Bernanke (nobel prize 2022) Two necessary conditions: 1. Financial markets are imperfect (information asymmetry between lenders and borrowers) 2. The relationship between borrowers and savers is mediated by financial intermediaries that operate at some cost - the cost of credit intermediation When the cost of intermediation rises, banks may react either by charging higher interest rates to clients or by cutting credit to clients who would have been granted it in normal times When credit stops flowing to borrowers or it becomes too expensive, both private investments and asset prices collapse When banks matter Suppose that there is asymmetric information between lender and borrowers and, as a result, the firm can obtain only a collateralized loan The value of a loan cannot exceed the value of assets: (1 + r)L ≤ mqK where m is the fraction of collateralizable assets and qK reflects the value of collateralizeable assets (asset volume K multiplied by its price q) The firm maximization problem is subject an additional collateral constraint: L ≤ mqK 1+r When banks matter II If the constraint binds (1 + r)L = mqK there is an additional cost to the interest rates for an additional unit of credit - marginal cost of capital is greater than the interest rate This spread is the external finance premium due to the cost of intermediation Shocks to the collateral value or level (qK), shocks to the financial intermediation technology (m), or a monetary policy shock that affects the interest rate (r) may all have real impacts on the borrowers’ activity Financial accelerator at work The literature has usually distinguished two main channels of transmission through a financial accelerator mechanism: 1. The balance sheet channel (shocks to qK) 2. The bank lending channel (shocks to m) A key assumption for the financial accelerator theory to hold in practice is the presence of financial frictions that prevent the switch from intermediated to direct lending (e.g., from bank credit to bonds) Financial accelerator at work II When a negative shock occurs to the value of assets used as collateral in the bank-firm relations (e.g. real estate prices)... 1. Banks react to a decrease in the value of firms’ collateral after a recession by cutting the amount of granted credit 2. The subsequent collapse of investment further depresses economic activity and collateral values 3. Banks’ own equity value decreases, so that credit supply must be reduced in order to keep their leverage ratio unchanged or even de-leveraging The opposite (positive) loop may occur in presence of asset price increases Tested hypotheses Bank-based financial structures may feature higher risk and lower economic growth than market-based structures (the final effect depends on the dominance of costs vs benefits) The aggregate economy is more volatile in bank-based structures especially during times of large drops in asset prices (financial accelerator effect) Financial structure and growth Estimate the following model: crisis/boom git = α + β1 Sit−1 + β2 Sit−1 xPit−1 + γXit−1 + Fi + Tt + it where g is the average growth rate of real GDP per capita (5-year average) S is the bank-market ratio (ratio of total bank assets to stock and private bond market capitalization, averaged over five years) Pcrisis/boom identify boom/bust in the housing/stock market (average annual rate of at least +/-5% over 5 years) X is a set of control variables A positive/negative estimated β1 indicates that relatively larger market based financing countries display higher/lower economic growth in normal times The analysis in LP (2016) regards the period 1988-2011 Financial structure and growth - Results in LP (2016) An increase in the bank-market ratio is associated with lower GDP growth in the subsequent five-year period This effect is larger when interacted with housing market crises (no interaction with stock market crises) Issue 5 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis From IS-LM to CC-LM The IS-LM framework is augmented with the following features: 1. Firms can finance their activities with direct (e.g., bonds) and indirect markets (e.g., credit) 2. Direct and indirect financing are not perfect substitutes 3. The banking sector offers deposit contracts to depositors and credit contracts to firms Aggregate demand is the sum of consumption and investment (closed economy, no public sector) The financial markets has three markets: money (M), bonds (B), loans (L) Firms The financial structure of firms is such that: 1. a fraction φ of firms is financed with bonds at the interest rb 2. a fraction 1 − φ of firms is financed with credit at the interest rl The investment function can be written: I = φ(I0 − I1 rb ) + (1 − φ)(I0 − I2 rl ) Households Households savings sY is given by the sum of bonds and deposits: S = D + Bh Bh = b0 + b1 rb - demand for bonds is increasing in their returns D = d0 − d1 rb + d2 Y - demand for deposit is increasing in income and decreasing in bonds’ returns Banks Banks raise deposits D and keep a fraction of it roD as liquid reserves The fraction (1 − ro)D is used to issue loans L The bank balance sheet is: L + roD = D L is supplied inelastically : L = D(1 − ro) Equilibrium conditions Assuming that all demand for money is absorbed by deposits (M = D), the total amount of deposits is given by: MB M= ro = D = d0 − d1 rb + d2 Y The market for loans clears (demand=supply): L = (1 − φ)(I0 − I2 rp ) The market for goods clears (demand=supply): Y = C + I The market for bonds clears: Bh = φ(I0 − I1 rb ) The IS-LM equilibrium Y = C0 + cY + φ(I0 − I1 rb ) + (1 − φ)(I0 − I2 rp ) If φ = 1 - no market for loans - we are back to the old IS: 0 −I1 rb Y = C0 +I1−c d0 d1 LM: Y = MB rod2 − d2 + r d2 b If monetary policy is expansionary, the LM moves and Y increases The IS-LM graphically The CC-LM equilibrium Y = C0 + cY + φ(I0 − I1 rb ) + (1 − φ)(I0 − I2 rp ) If φ < 1 the IS is augmented with an additional factor and is C0 +I0 −φ(I1 rb )+(1−φ)MB 1−ro called the CC: Y = 1−c ro where MB 1−ro ro = L = (1 − φ)(I0 − I2 rl ) The CC is more rigid than the IS (less sensitive to rb ) but it is directly affected by monetary shocks (the intercept) If monetary policy is expansionary, the LM moves right and Y increases, but also the CC moves to the right The CC-LM graphically Takeaways from the CC-LM In presence of a fraction of firms which is dependent from loans, the credit channel has an amplification effect for a given monetary policy shock Monetary policy shocks are empirically related to large changes in investments, although investments are not sensitive to changes in bond returns The accelerator mechanism strictly depends on the structure of the economy: it depends on the fraction of firms that are bank dependent (e.g., the fraction of SMEs) The financial accelerator effect of monetary policy When a negative monetary shock occurs, credit supply to borrowers with tighter credit conditions reduces (CC-LM basic effect) A tightening of monetary policy that reduces the net worth of borrowers or impacts on banks’ ability to finance their activities should imply a reduction in credit to borrowers that is larger for less creditworthy borrowers Net worth of banks may be also negatively affected by increasing policy rates, and supply may react Financial accelerator effect: both the balance sheet channel or the lending channel may be triggered by monetary policy shocks in presence of binding financial frictions Issue 6 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The Euro-area crisis Macroeconomic consequences of (micro) financial imperfections The Great Financial Crisis suggests us that financial markets are not a veil - against the real business cycle view Real business cycle models have been developed mainly disregarding the role of financial intermediation The Great Depression (1929) had something to teach The credit view developed starting from the contributions of Mishkin (1978) and Bernanke (1983) Financial intermediaries may have a role for macroeconomic fluctuations or temporary deviations from long-run trend Deciphering 2007-2009 Great Financial Crisis (GFC) Macroeconomic considerations: 1. We analyze the premises to the US financial crisis 2. We summarize the main facts that characterize the financial collapse Microeconomic issues regarding the banking system Chronology of the GFC The US financial crisis: Premises I Macroeconomic premise I: inflows of foreign capital from late 90s Crises hit the emerging markets in late 1990s: East Asian economies collapsed, Russia defaulted, and Argentina, Brazil and Turkey faced severe stress deterioration in financial institutions balance sheets From net absorbers of financial capital from the rest of the world some of these countries - notably China - became net exporters of financial capital There was a large world demand for safe assets - the US offered these supposedly safe assets The US became the main absorber of international capital flows - pressure for declining interest rates The US financial crisis: Premises II Macroeconomic premise II: low policy rates The decline in interest rates was not counter-reacted by the monetary authority: the Greenspan’s expansionary policy Between January 2001 and June 2003, decreasing monetary policy rates, dropped from 6% to 1% encouraging households’ indebtness Low interest rates favored loan demand - especially mortgages Household leverage increased sharply: US households became net absorbers of financial funds Housing price bubble: large boom followed by a large burst The US financial crisis: Premises III The role of financial innovation: 1. The traditional banking model was replaced by the originate to distribute banking model 2. The creation of new structured securities (CDOs) was used to by intermediaries to hedge the mortgage credit risk American politicians looked with favor at a larger homeownership and at mortgage equity withdrawal sustaining house price increases Government-Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac, were the first issuers of mortgage-backed securities (MBS) Regulatory and market failures (e.g., rating agencies) Credit view at work in the run-up of the crisis Two feedback mechanisms amplified the perverse effect of low interest rates: The balance sheet channel at work: very low interest rates reduced the cost of debt and increased the demand for houses. Therefore, real estate prices increased allowing households to get more credit, thanks to the rise of collateral values, which, in turn, inflated house prices even more The lending channel at work: rising real estate prices reduce the risk of the financial assets originated via the securitization of mortgages, in turn allowing financial intermediaries to raise additional funds to be invested in acquiring more assets Financial innovation in the US banking market The traditional banking model, in which the banks hold loans until they are repaid, was replaced by the "originate to distribute" banking model in which loans are pooled, trenched and resold via securitization The creation of "new" structured securities (CDOs) was used to by intermediaries for hedging the mortgage credit risk Banks did not hold CDOs directly in their balance sheet The use of CDOs by a bank involved the creation of a separate corporate entity called a special investment vehicle (SIV) Securitization and SIVs SIVs are separate corporate entities that issue very short term debt contract and buys a collection of long term assets such as corporate bonds and loans and/or mortgages The SIV created the diversified portfolio of these loans/bonds/mortgages and slides this portfolio into tranches The issuing banks were sponsoring the SIVs through contractual credit lines to guarantee their reputation (off balance sheet) Market failures related to the securitization Banks were basically transferring the credit risk to other entities Regulatory arbitrage: unlike "classical" mortgages, capital requirements were lower (or zero) for off-balance-sheet activities that included the sponsor of SIVs - this increased the leverage capacity of banks and the supply of loans at very low price Moreover rating agencies were providing overly optimistic forecasts about CDOs, favoring their distribution, and underpricing the risk - error or fraud? The combination of these two failures resulted in the housing bubble: cheap credit plus low credit standards plus increase in aggregate leverage The fragility of the banking system Diversification of risk theoretically ensured by securitization was illusory: the credit risk was in the end held by the sponsor banks or other intermediaries - more and more risky households were entering the housing market Moreover the funding strategy of SIVs (borrowing short-term) was exposing the financial markets to increasing funding liquidity risk Both increasing credit risk and liquidity risk represented the seeds of the financial collapse The beginning of the end Between June 2004 and June 2006, the US policy rate increased from 1% to 5.25%, jeopardising the sustainability of mortgage debts Around mid-2007 insolvencies on subprime lending increased possibly due to a decrease in the expectations of house price growth In spring 2007, the insolvency rate on the subprime mortgages exceeded 16%, thus speeding up the property price drop A deterioration of the prices of mortgage related product (CDOs) started: concerns about the value of structured products and the erosion of confidence in rating started to widespread The loss in value of CDOs and the increasing uncertainty made money market participants reluctant roll-over the short-term debt of intermediaries operating in the shadow banking: interbank market freeze Chronology of the GFC The financial crisis went through the following five stages: 1. August 2007 - mid March 2008: distress episodes related to the collapse of the short-term liquidity market - rescue plans for Northern Rock (UK) and Bear Stearns (USA) 2. mid-March 2008 - mid-September 2008: liquidity problems turned into solvency problems - nationalization of Fannie Mae and Freddie Mac; the failure of Lehman Brothers 3. mid-September 2008 - end-October 2008: the collapse of the international financial markets and the reaction of central banks by cutting rates 4. end-October 2008 - mid-March 2009: the world recession and the government reactions (fiscal policy) 5. mid-March 2009 - onwards: the first signs of recovery thanks also to unconventional monetary policy actions Credit view at work in the recession The balance sheet channel at work: 1. The drop in asset prices (e.g., housing) made leveraged investors credit constrained 2. To return on their debt, investors had to fire sale their assets; these sales depress the price further, inducing more selling and a drop in collateral value - negative spiral Financial stability risks are usually linked to real estate lending booms which are typically followed by deeper recessions and slower recoveries Conclusions on the US financial crisis It is undoubtedly true that the recent recession has been made "great" by the contemporaneous banking crisis The amplification mechanisms from financial markets to the real economy contributed to the deepness and length of the recession Is the US experience a more "generalizable" event? The Great Financial crisis in the world The 2007-2008 US financial crisis was not an isolate episode Many countries in the world had a financial crisis in the same years Caprio et al. (2014) analyze the impact of different financial determinants on the probability of having a banking crisis in the period 2007-2008 by estimating the following model: Prob(Crisisc = 1/X) = Φ(α + β1 · NetInterestMarginc + β2 · CreditDepositc + β3 · Concentrationc + β4 · Restrictionc + β5 · PrivateMonitoringc ) Definition of variables I Crisis: a dummy equal to one if the country is classified as either borderline crisis or systemic crisis and zero otherwise Net Interest Margin: the country bank’s net interest revenue, as a share of its interest-bearing assets, to proxy the banking system orientation towards traditional activity Credit Deposit: the country’s loan/deposit ratio. While a high ratio indicates high intermediation efficiency, a ratio significantly above one suggests reliance on possibly unstable non-deposit funding Definition of variables II Concentration: the share of the country’s three largest banks in all country’s banks assets. While big banks could reduce risk via enhanced asset diversification, they could raise risk if managers and shareholders anticipate too-big-to-fail policies by regulators Restriction: the value of the Overall Restrictions index, measuring the extent of regulatory restrictions on bank activities in securities markets, insurance, real-estate, and owning shares in non-financial firms Private Monitoring: a value of the index measuring the degree to which regulations empower, facilitate, and encourage the private sector to monitor banks Results The results show that there are many similarities between the 2007-2008 US experience and the rest of the world. Indeed... Interpretation of the results I Net Interest Margin is negative and statistically significant. This indicates that countries with a higher level of net interest margin had a lower probability to be in crisis in 2008. A higher net interest income is associated with less securitization. Indeed, a higher level of net interest margin represents a strong incentive for banks to undertake traditional activities, such as loans, instead of riskier non-traditional activities such as securities trading Credit Deposit is positive and statistically significant, meaning that countries with a higher credit/deposit ratio had a higher probability to be in crisis in 2008. A ratio significantly above one suggests reliance on possibly unstable non-deposit funding. While some of these alternative sources may be as stable as customer deposits, i.e. retail bonds funding, many other can prove highly volatile, such as in the case of interbank or money market loans. This evidence suggests that in most countries the alternative funding sources were of the volatile type in the financial crisis Interpretation of the results II Concentration is negative and statistically significant, indicating that countries with a higher level of concentration in the banking sector had a lower probability to be in crisis in 2008, a finding consistent with the absence of crisis, for example, in Australia or Canada. A more concentrated banking system implies that the bank’s charter value is higher and, as a consequence, the incentives for bank owners and managers to take excessive risk are lower Restriction is negative and statistically significant. This suggests that more restrictions on bank activities lowered the probability for the country to be in crisis in 2008. In other words, the regulatory-induced specialization in the banking sector enhances financial stability Private monitoring is negative and statistically significant, meaning that countries with a higher level of private monitoring had a lower probability to be in crisis in 2008 Issue 7 1. The impact of financial development on long-run economic growth 2. Main conclusions from cross-country and within-country analyses 3. The non-linear effect of financial development 4. Empirical differences in financial development: an international perspective 5. The credit channel of monetary policy 6. The Great Financial Crisis 7. The euro-area crisis The euro-area crisis The flight-to-safety in sovereign debt markets The economic consequences of sovereign debt crisis and the diabolic loop between banks and public debt The flight-to-safety When interest rates spike in some regions or asset classes, they declines in some other regions or asset classes These relative price movements reflect a flight-to-safety of international capitals In Europe, during the sovereign debt crisis, capital flew from southern European countries to Germany: the yield of German government bonds has been at its lowest historical levels The flight to safety: graphical exploration source: Brunnermeier and Reis (2019) Core: France and Germany; Periphery: Greece, Ireland, Italy, Portugal and Spain) These assets were perceived the same risk until 2010 Between 2010 and 2012, while one line spikes, the other declines What happens in July 2012? The diabolic loop between banks and public debt Banks hold a lot of national debt for different reasons: 1. Financial regulation requires banks to hold safe assets - sovereign are considered by regulators riskless, even in crisis period 2. The monetary authority conducts market operations by buying sovereign bonds or accepting them as collateral 3. Usually banks buy sovereign on the primary markets and then re-sell to private investors 4. The governments can pressure on banks to buy sovereign when risk is large in exchange of implicit guarantees (moral suasion hypothesis) The effect of this concentration of national bonds held by banks, and government guarantees to banks is the foundation of the diabolic loop The diabolic loop source: Brunnermeier and Reis (2019) An increase in the interest rate of new bonds implies that older bonds are worth less This generates losses for banks and increases liability and equity risk of banks with a final effect on banks’ supply of credit and ultimately investments (financial accelerator) and tax revenues The effect is amplified in case of expected bailout of banks by government: the potential increase in public spending, reinforce concerns about the sustainability of public debt which depresses bond prices further (negative spiral) The diabolic loop at work source: Brunnermeier and Reis (2019) On September 2008 the Irish gvt issued broad state guarantee to the banks, enhancing the diabolic loop In Greece the CDS spread move hand-in-hand in the period 2008-2011 as Greek banks were largely and increasingly exposed to Greek sovereign Similar correlation for Italy Readings I Arcand, J. L., Berkes, E., and Panizza, U. 2015. Too much finance? Journal of Economic Growth, vol. 20 - Sections 1, 2, 3 Brunnermeier M. and Reis R. 2019. A crash course on the euro crisis, NBER working paper 26229 - Sections 1, 6, 7 Ferri G. and Vincenzo D’Apice. 2021. Financial Accelerator Framework. A Modern Guide to Financial Shocks (chapter 1), Elgar Modern Guides Langfield S., and Pagano M. 2016. Bank Bias in Europe: Effects on Systemic Risk and Growth. Economic Policy, Vol. 31 - Sections 1, 2, 3, 5 Readings II Levine R. 2005. Finance and growth: Theory and evidence. Chapter 15 of Handbook of the economic growth - Sections 1, 2 , 3.1, 3.2 Oliviero T. and G.W. Puopolo. 2021. Financial Accelerator Framework. A Modern Guide to Financial Shocks (chapter 3), Elgar Modern Guides Pascali, L. 2016. Banks and Development: Jewish Communities in the Italian Renaissance and Current Economic Performance. The Review of Economics and Statistics, vol. 98 - Sections 1, 2