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Bubbles, Crashes & the Financial Cycle
- 1. www.uni-bielefeld.de Bubbles, Crashes & the Financial Cycle Sander van der Hoog and Herbert Dawid Chair for Economic Theory and Computational Economics Bielefeld University 12th International Post-Keynesian Conference Kansas City, Sept. 2014
- 2. Introduction Eurace@Unibi Model Simulation Results Summary & Outlook Outline The Business & Financial Cycle Financial Instability Hypothesis Balance sheets Outline of topics I Agent-based Macroeconomics I Leverage cycle – Geanakoplos I Financial Instability Hypothesis – Minsky I Basel III and the procyclicality of capital adequacy requirements I Macro-prudential banking regulation Sander van der Hoog Bubbles, Crashes & the Financial Cycle
- 3. Introduction Eurace@Unibi Model Simulation Results Summary & Outlook Outline The Business & Financial Cycle Financial Instability Hypothesis Balance sheets The Business & Financial Cycle 1976-80 US real-estate boom 1980 DIMCA 2011: End of Regulation Q 1989: S&L Crisis 1980: Depository Institutions Deregulation and Monetary Control Act: Deregulation of Savings and Loans institutions 2011: Regulation Q: prohibition of interest-bearing demand deposit accounts Sander van der Hoog Bubbles, Crashes & the Financial Cycle
- 4. Introduction Eurace@Unibi Model Simulation Results Summary & Outlook Outline The Business & Financial Cycle Financial Instability Hypothesis Balance sheets Financial Instability Hypothesis I Equity/Asset-ratio: Measure for financial robustness I Fragility synchronized with business cycle? (Fragile booms, deleveraging recovery) Output and E/A ratio Sander van der Hoog Bubbles, Crashes & the Financial Cycle
- 5. Introduction Eurace@Unibi Model Simulation Results Summary & Outlook Outline The Business & Financial Cycle Financial Instability Hypothesis Balance sheets Empirical Motivations Features of macroeconomics with a financial cycle (Borio, 2012): I the financial boom should not just precede the bust but cause it ( `a la Minsky). I the presence of debt and capital stock overhangs (excess stocks, non-full utilization rates). Findings: I Recessions following a crisis after a fragile boom tend to have much larger declines in consumption, investment, output, and employment. (Shularick & Taylor, 2012) I Balance sheet recessions: Recessions driven by deleveraging lead to a prolonged slump. (Koo, 2011) Sander van der Hoog Bubbles, Crashes & the Financial Cycle
- 6. Introduction Eurace@Unibi Model Simulation Results Summary & Outlook Outline The Business & Financial Cycle Financial Instability Hypothesis Balance sheets Balance sheets Firm Assets Liabilities Liquidity + revenues – wage bill – taxes – dividends + interest deposits – interest on loans Loans from banks + new loans + new loans – bad debt Inventory + output – sales Capital stock Equity + investment + profits + bad debt Bank Assets Liabilities CB reserves (0:1%) Deposits – interest deposits +/– withdrawals + interest on loans + new loans – taxes – dividends +/– CB reserves Loans to firms CB debt (+0:15%) + new loans +/– CB reserves – bad debt +/– interest Equity + profits – bad debt Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 7. Agent Role Activity Activity Role Agent Capital Goods Market igood supply vintage menu posted prices igood demand vintage choices Investor Producer credit supply rank credit risk credit demand rank interest Credit Market (credit rationing) E u r a c e @ U n i b i Household InvGoodFirm Bank asset demand savings decision Financial Market (index bond) ECB Monetary policy Gov Employer Policy maker Investor ConsGoodFirm Consumer Cons. Goods Market (local malls) cgood demand consumption choice Producer cgood supply posted prices labor supply reservation wage Employee labor demand wage schedule Labor Market (search matching) Creditor Debtor
- 8. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Monetary Policy Banking Regulation Capital Adequacy Requirement Reserve Requirement Literature: The Credit Channel of Monetary Policy Transmission 1. The broad borrowers’ balance sheet channel: (Bernanke Blinder 1988) I Credit demand side I Focusses on external finance premium: probability of default External finance premium: inversely related to borrower’s net worth. I Changes in the value of assets on the balance sheet of a firm affect the firm’s ability to borrow. 2. The narrow bank lending channel: (Bernanke Gertler 1995) I Supply of bank loans determined by financial health of banks. I Changes in the value of assets on the balance sheet of a bank affects the bank’s ability to lend. Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 9. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Monetary Policy Banking Regulation Capital Adequacy Requirement Reserve Requirement Capital Adequacy Requirement 1. Firm’s default probability t = maxf3 104; 1 eDf PDf t =Ef t g; = 0:1 2. Interest rate offered by bank b to firm i r bf t = rECB 1 + B PDf t + bt ; bt U[0; 1] bt rECB = 0:01 B = 3: penalty rate for high-risk firm, uniform across banks : bank’s ideosyncratic operating costs Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 10. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Monetary Policy Banking Regulation Capital Adequacy Requirement Reserve Requirement Capital Adequacy Requirement 1. Risk-exposure of credit request (Expected Loss at Default): xf t = PDf t Lft (1) 2. Constraint: Capital Adequacy Requirement (CAR) X f xf t Xb t Eb t ; 0 (2) 3. Risk-exposure ”budget” of the bank: Vb t Eb t Xb t (3) 4. Loan granted: `ft = 8 : Lft if xf t Vb t No rationing Lft = Vb t =PDf t if 0 Vb t xf t Partial rationing 0 if Vb t 0 Full rationing (4) Possibility of credit rationing: f : Vb t PDf t `ft = 0g ! Lft = Vb t =PDf t Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 11. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Monetary Policy Banking Regulation Capital Adequacy Requirement Reserve Requirement Reserve Requirement I Constraint: Reserve Requirement t
- 12. Depb t (5) Mb I Excess liquidity ”budget” of the bank: Wb t Mb t
- 13. Depb t (6) I Loan granted: `bf t = 8 : Lft if Wb t Lft No rationing Lft = Wb t if 0 Wb t Lft Partial rationing 0 if Wb t 0 Full rationing (7) Possibility of credit rationing: f : Wb t Lft = 0g ! = Wb t =Lft I Illiquid banks stop lending to all firms (bank lending channel) I Risky firms cannot get loans (borrower’s balance sheet channel) Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 14. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Amplitude of recessions Firm activity Bank activity Network dynamics Parameter sensitivity analysis 0 200 400 600 800 1000 2000 3000 4000 5000 Months Eurostat_output alfa_20_gamma 1.0 2.0 4.0 8.0 16.0 32.0 -sensitivity: Cap. Adq. Req. I Default: = 32 (3%) I Lower: amplitude of recessions increases 0 200 400 600 800 1000 2000 3000 4000 5000 Months Eurostat_output beta_20_gamma_10_alfa 0.01 0.02 0.05 0.10 0.20 0.50
- 15. -sensitivity: Reserve Req. I Default:
- 16. = 0:05 (5%) I Higher: amplitude of recessions decreases Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 17. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Amplitude of recessions Firm activity Bank activity Network dynamics Parameter sensitivity analysis l l l l l l l l l l l l l l l l l l l l l l ll l l l l l l l l ll l l l l l l l l l l l l l l l l l l l l l l l l l ll l l l l l l l l l l l l l ll l l l l l l l −8000 −6000 −4000 −2000 Parameters batch_full_amplitude_recession 1.0 2.0 4.0 8.0 16.0 32.0 -sensitivity: Cap. Adq. Req. I Default: = 32 (3%) I Lower: amplitude of recessions increases l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l ll −7000 −6000 −5000 −4000 −3000 −2000 −1000 Parameters batch_full_amplitude_recession 0.01 0.02 0.05 0.10 0.20 0.50
- 18. -sensitivity: Reserve Req. I Default:
- 19. = 0:05 (5%) I Higher: amplitude of recessions decreases Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 20. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Amplitude of recessions Firm activity Bank activity Network dynamics Firm activity Number of illiquid firms No constraint 0 100 200 300 400 500 0 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Capital constraint ( = 2) 0 100 200 300 400 500 0 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Liquidity constraint (
- 21. = 0:50) 0 100 200 300 400 500 0 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 22. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Amplitude of recessions Firm activity Bank activity Network dynamics Bank activity Number of active banks (unconstrained + constrained by equity/liquidity constraint) No constraint 0 100 200 300 400 500 0 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity Capital constraint ( = 2) 0 100 200 300 400 500 0 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity Liquidity constraint (
- 23. = 0:5) 0 100 200 300 400 500 0 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 24. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Amplitude of recessions Firm activity Bank activity Network dynamics Network dynamics Shown: lending relationships between banks - firms Initial state: Each firm (80) has a single loan with one random bank (20) t = 0 t = 500 t = 900 t = 1000 Figure : Black: banks, Blue: firms. = 18:5; = 10;
- 25. = 0:10: Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 26. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Summary Capital Adequacy Requirement () 1. More limits on excessive risk-taking 2. Amplitude recessions increases 3. More banks fail 4. More firms go illiquid I constraint does not discriminate I constraint self-reinforcing 5. Steep, sudden deleveraging 6. Concentration in banking sector Reserve Requirement (
- 27. ) 1. More limits on liquidity supply 2. Amplitude recessions decreases 3. Banks stay alive 4. Large firms go illiquid I large firms largest credit demand I liq. constraint helps small firms 5. Gradual deleveraging in waves 6. Bank equity can recover Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 28. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Outlook I Macroprudential regulation I Systemic risk I Bank-firm networks I Empirically-grounded bank behavior I Credit quotas I Credit rationing of SMEs Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 29. Thank you for your attention! Model documentation: www.wiwi.uni-bielefeld.de/vpl1/research/eurace-unibi.html Papers: I H Dawid, S Gemkow, P Harting, S van der Hoog M Neugart (2014): Agent-Based Macroeconomic Modeling and Policy Analysis: The Eurace@Unibi Model. In: S-H Chen, M Kaboudan (Eds), Handbook on Computational Economics and Finance. Oxford University Press. I H Dawid, S Gemkow, P Harting, S van der Hoog M Neugart (2012): The Eurace@Unibi Model: An Agent-Based Macroeconomic Model for Economic Policy Analysis. Working Paper University Bielefeld. I H Dawid, S Gemkow, P Harting, S van der Hoog M Neugart (2011): Eurace@Unibi Model v1.0 User Manual. Working Paper Bielefeld University. I H Dawid P Harting (2012): Capturing Firm Behavior in Agent-Based Models of Industry Evolution and Macroeconomic Dynamics, in: G. B¨ unstorf (Ed), Applied Evolutionary Economics, Behavior and Organizations. Edward Elgar, pp. 103-130. I H Dawid M Neugart (2011): Agent-based Models for Economic Policy Design, Eastern Economic Journal 37, 44-50.
- 31. Scenario: Capital Adequacy Requirement Output 0 100 200 300 400 500 1500 2000 2500 3000 Months Eurostat_output alfa 2.0 8.0 Bank activity 0 100 200 300 400 500 0 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity Firm activity 0 100 200 300 400 500 0 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L 0 100 200 300 400 500 0 5000 10000 15000 20000 Months Bank_equity alfa 2.0 8.0 Bank equity 0 100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Months F_EARatio alfa 2.0 8.0 Firm fragility 0 100 200 300 400 500 0.040 0.045 0.050 0.055 0.060 0.065 0.070 Months Firm_mean_interest alfa 2.0 8.0 Mean interest
- 32. Scenario: Minimum Reserve Requirement Output 0 100 200 300 400 500 2000 2200 2400 2600 2800 Months Eurostat_output min_cash_reserve_ratio 0.10 0.50 Bank activity 0 100 200 300 400 500 0 5 10 15 20 Months Bank_active_multi Bank_active_none Bank_active_exposure Bank_active_liquidity Firm activity 0 100 200 300 400 500 0 5 10 15 20 Months Firm_insolvency_SL Firm_insolvency_S Firm_insolvency_L Firm_illiquidity_S Firm_illiquidity_L 0 100 200 300 400 500 5000 10000 15000 20000 Months Bank_equity min_cash_reserve_ratio 0.10 0.50 Bank equity 0 100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Months F_EARatio min_cash_reserve_ratio 0.10 0.50 Firm fragility 0 100 200 300 400 500 0.045 0.050 0.055 0.060 0.065 0.070 Months Firm_mean_interest min_cash_reserve_ratio 0.10 0.50 Mean interest
- 33. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Scenarios: Firm Fragility Firm E/A-ratio Capital constraint 0 100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Months F_EARatio alfa 2.0 8.0 Liquidity constraint 0 100 200 300 400 500 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Months F_EARatio min_cash_reserve_ratio 0.10 0.50 Liquidity constraint 0 100 200 300 400 500 0.045 0.050 0.055 0.060 0.065 0.070 Months Firm_mean_interest min_cash_reserve_ratio 0.10 0.50 Sander van der Hoog Bubbles, Crashes the Financial Cycle
- 34. Introduction Eurace@Unibi Model Simulation Results Summary Outlook Literature I Hyman P. Minsky (1982): The Financial Instability Hypothesis: Capitalistic Processes and the Behavior of the Economy I Hyman P. Minsky (1986, 2008): Stabilizing an Unstable Economy I Delli Gatti, Desiderio, Gaffeo, Cirillo Gallegati, 2010: Macroeconomics from the Bottom-Up I Dosi, Fagiolo, Napoletano Roventini, 2012: Income distribution, credit and fiscal policies in an agent-based keynesian model. LEM Papers Series 2012/03, I Ashraf, Gershman Howitt, 2011: Banks, Market Organization, and Macroeconomic Performance: An Agent-Based Computational Analysis I Schularick Taylor, 2012: Credit booms gone bust: Monetary policy, leverage cycles, and financial crises, American Economic Review 102 (2), 1029-61. I Claessens, Kose Terrones, 2011: How do business and financial cycles interact? Sander van der Hoog Bubbles, Crashes the Financial Cycle