Better prepared against financial crises
The ongoing financial crisis has left economists and financial analysts struggling to identify its root causes and explain its complexities. In this vein, the EU-funded FINMAP (Financial distortions and macroeconomic performance: Expectations, constraints and interaction of agents) project proposed new analytical tools, models and methodologies to help monetary policy address ongoing challenges in the sector. These tools and approaches can help regulators and finance authorities analyse the dynamics of financial markets within the real economy, along with the impacts of regulatory reforms and effectiveness of monetary policy. In more detail, the project team studied the integration of binding credit constraints and liquidity freezes in macroeconomic models. It documented speculative bubbles and proposed early warning indicators that could avert financial meltdown. The team also investigated the behaviour of agents under risk and uncertainty and how monetary policy impacts agents’ expectations in preventing negative outcomes. Particular focus was placed on modelling financial institutions and their interactions, along with their links to financial authorities and monetary policy. Using approaches that central banks rely on, FINMAP investigated models and methodologies belonging to three key categories. It first looked at the limitations of stochastic dynamic general equilibrium (DSGE) models that have been used for policy analysis and macroeconomic forecasting. Considering alternatives to the limited DSGE models, the team developed agent-based models for specific segments of the financial sector and a banking sector model that addresses its interaction with the real sphere. These models were then used to conduct counterfactual policy analyses. Another area researched involved new network models that help the financial sector probe systemic risk due to high connectivity within the financial sector. These models also underline chains of contagious defaults and macroprudential policy to improve resilience. Lastly, the project researched expectations in financial markets, along with challenges in links between private and public information. This investigation was designed to support financial authorities in improving their communication strategy and assessing the results of rating agencies and other institutions that release sensitive signals conflicting with private information. The tools, models and new communication approach will no doubt enhance resilience in the face of financial upheavals in the future.
Keywords
Financial crisis, FINMAP, financial distortions, macroeconomic performance, banking