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Systemic Risks and Macroprudential Regulation in Banking

Final Report Summary - MACROBANK (Systemic Risks and Macroprudential Regulation in Banking)

The financial system of Europe and elsewhere in the world is still in crisis modus, as policy interventions are seemingly not sufficient to resolve an ongoing banking crisis. Policy makers in Europe and elsewhere repeatedly intervened with a range policy measures such as extremely low interest rates, liquidity provisions, quantitative easing, nationalisations, and other forms of subsidies. To date, the effectiveness of these policy measures, however, is to a large extent uncertain. It still is unclear how a banking sector can be protected against large losses and how policy makers can initiate a successful economic recovery.

MACROBANK developed an analytically tractable dynamic macroeconomic model in which entrepreneurs and banks may default. This model provides a theoretical basis for policy makers to identify structural causes for banking crises and to assess the effectiveness of possible crisis intervention policies. The key element of the model is that interest rates and loans are determined by repeated double-sided Bertrand competition between banks. Banks finance entrepreneurs who are subject to repeated macroeconomic productivity shocks. A sufficiently negative shock may cause the default of entrepreneurs. Losses of entrepreneurs stay on the balance sheet of banks and may therefore deplete bank capital, thereby reducing the available fund to finance production projects. A series of negative productivity shocks may lead to an insolvency of the banking system. The project showed how a tax-funded recapitalization of the banking system can resolve such a banking crisis and lead to an economic recovery. The analysis of the model reveals that the productivity of entrepreneurs is essential for the recovery of the economy. The effectiveness of intervention policies is analysed and tested with the help of computer simulations for which a software tool was developed. Key objectives of the analysis include the reduction of public debt and the extent to which intervention policies can restore debt to pre-crisis levels.

Using an alternative approach in which banks are modeled as portfolio managers, the project shows that the effectiveness of capital requirements in reducing the default risk of a financial intermediary crucially depends on the institution’s risk attitude. For any capital requirement, a sufficiently risk-neutral intermediary will increase her exposure default risk when facing a binding capital requirement. The project shows that a cap on the coefficient of variation of future net wealth restricts default risk without leading to inefficient allocations. The analysis suggests that it might be much more effective to curb the coefficient of variation of future wealth directly. The overall conclusion is that there is no capital adequacy rule that will fit all institutions when reducing default risk is the aim of financial regulation. Effective regulation needs to account for the risk-taking behaviour of intermediaries.

The project also undertook research into the analysis of the role of risk measures by replacing standard deviation of an intermediary’s final net worth by a newly developed downside-risk measure. As a risk mesaure, standard deviation as is problematic because financial regulation should be concerned with the risk of default rather than the risk of an extra high profit a financial intermediary might make. The project introduced a monotone downside risk measure. Based on this risk measure the behaviour of a portfolio managing intermediary who uses downside risk instead of standard deviation as risk was worked out. The corresponding portfolio decision problem was solved and a two-fund separation theorem established. The tenets of the classical capital asset pricing model could be generalized.

It is still too early to assess the impact of the research undertaken in terms of scientific and socio-economic impact. Perhaps fair to say that based on the projects’ results simple capital adequacy rules, which are uniformly imposed on the whole banking sector such as Basle III, may fail to enhance the stability of the banking system. Such rules do not account for the risk exposure of an individual bank. They may decrease rather than increase the stability of particular institutions and thus exacerbate the stability of financial system rather than strengthen it.