Financial Contracting and the Specialization of Assets - Norges Bank

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Financial Contracting and the Specialization of Assets - Norges Bank Powered By Docstoc
					Property Prices and Bank Risk Taking

Giovanni Dell’Ariccia (IMF and CEPR)

Norges Bank Macroprudential Regulation Workshop, Oslo, November 29-30, 2012

 The views expressed in this paper are those of the authors and do not
 necessarily represent those of the IMF, its Executive Board, or Management.
Before the crisis …A policy gap
p Monetary policy to focus on inflation and output gap

p Asset prices a concern only through their impact on GDP
  and inflation (exceptions RBA, Riksbank, some EMs)

p Benign neglect approach to boom/busts:

   n Bubbles difficult to identify

   n Costs of clean up limited and policy effective

   n  Better clean up than prevent

p Bank risk taking important, but job of regulators
Before the crisis … A policy gap
p Regulatory policy focused on individual institutions

p Limited attention to credit aggregates or asset price

p Ill equipped to deal with booms:

   n Correlated risk taking

   n Fire sales and other externalities

   n Few regulators had necessary tools (exceptions:
Before the crisis … A theory gap
p Macro literature:
   n Financial intermediation seen as macro neutral

   n Asset prices (including property prices) did matter. They could
     accentuate the cycle through financial accelerator

   n But macro models largely ignored their impact on bank risk taking.
     In equilibrium, no bank defaults

p Banking literature
   n Focused on excessive risk taking by intermediaries operating
     under limited liability and asymmetric information

   n There are defaults/crises in equilibrium

   n But there is little attention to macro and monetary policy
Before crisis … Macro looked OK
But house prices were rising rapidly
Then the crisis came …

p Standard policies rapidly hit their limits

p Limited effectiveness of less traditional policies

p Large fiscal and output costs

p Multiple banking crises; especially in countries
  with their own real estate booms

House boom/busts and great recession
A closer look at real-estate booms
and bank risk taking behavior
p Most large banking crises preceded by some form
  of property price boom
  n   Scandinavia 1990s
  n   Asia 1997
  n   Japan 1990
  n   More recently: US, Spain, Ireland, Iceland, Latvia,…

p Property cycles can have macro consequences,
  even without open banking crises
  n Borrower debt overhang

p But things are worse when credit booms (and lax
  standards) are involved
Real-estate cycles and bank behavior

p Credit constraints – Leverage cycles

p Adverse selection and strategic interaction

p Bubbles

p Govt. guarantees - Risk externalities
Financial Accelerators – Leverage Cycles
p Collateralized credit as solution to agency problems
  (Kiyotaki/Moore, 1997)

p Cycle emerges: asset prices  credit aggregates 
  investment/demand  asset prices

p Effect magnified if logic applied to intermediaries
  (Kiyotaki/Gertler, 2009, Iacoviello, 2011)

p Further widening if leverage is cyclical (Adrian/Shin,
  2009/Geanakoplos 2010)

p Regulation may also contribute (Herring/Wachter, 1999)

p But most models do not deal with risk taking
 Magnified macro fluctuations
        Duration of recession           Time to return to trend
             (quarters)                       (quarters)

Source: Claessens/Kose/Terrones, 2008
Adverse selection and strategic effects
p Rising house prices reduce incentives to screen
  n Even bad borrowers can refinance/sell property

p  Winner curse reduced in good times:
  n   My competitors screen less
  n   More untested applicant borrowers
  n    Better distribution of applicants
  n    Less incentives to screen

p “Conservative” lending punished
  n Investor pressure on managers (compensation schemes)
  n Borrowers shop for lax standards
Easy mortgages during U.S. boom

Source: Dell’Ariccia, Igan, and Laeven 2009
p Normal times: prices reflect fundamentals

p Bubble: speculative motive allows for deviation
  from fundamentals (Allen/Carletti, 2011)

p Banks may fund speculators:
  n Govt. guarantees
  n Risk shifting (limited liability)
  n Can’t separate speculators from “legitimate” consumers

p Increasing recourse to instruments with
  correlated risks
  n U.S.: teaser-rate/interest-only loans
  n East Europe: FX denominated loans
 Interest-only loans and boom

Source: Barlevy and Fisher (2011)
Credit and housing booms in East Europe
FX lending and credit boom
Strategic complementarities
p Government guarantees
   n Do not want to die alone (Farhi/Tirole, 2012)
   n Greenspan put
   n FX in Eastern Europe

p Risk taking externalities
   n Poor incentives structure if systemic banks take
     excessive risk
   n Correlated risk taking
   n Self fulfilling equilibria

p Ex-post …
   n Macro bailouts did occur
A new policy consensus?
p If benign neglect is dead, then what?
   n   Asset price booms difficult to spot
   n   But other policy decisions also taken under uncertainty
   n   Booms involving leveraged agents more dangerous
   n    Real estate case

p Objectives?
   n Prevent unsustainable booms altogether
   n Alter lender/borrower behavior
   n Increase resilience to busts

p No silver bullet
   n Broader measures: hard to circumvent but more costly
   n Targeted tools: limited costs but challenged by loopholes
Monetary policy
p Natural place to start
   n Credit highly correlated with monetary aggregates

   n Increase cost of borrowing, decrease loan demand, lower
     collateral values

   n Risk-taking channel

p Potential issues
   n Conflict of objectives

   n Impact on balance sheets

   n Capital inflows (especially in SOEs)

   n Switch to riskier lending (FX, IO loans)
Evidence of risk shifting

 Source: Landier et al. 2011
Fiscal policy
p Prudent stance can:
  n Reduce overheating
  n Buffer for bailout/stimulus during a potential bust
  n Reduce incentives for leverage (deductibility, FAT)

p Time lags make it an impractical tool
  n Some measures hard to use countercyclically
  n “Tax planning”, circumvention, calibration

p Little evidence of effectiveness in stopping
  booms… …but fiscal room critical in busts
Macro-Prudential Tools
p Most ‘experiments’ in emerging markets,
  particularly Asia

p Common tools:
  n Maximum LTV/DTI limits
  n Differentiated risk weights on high-LTV loans
  n Dynamic provisioning

p Discretion rather than rule-based

p Mixed evidence on effectiveness
Hong Kong: Limited Effectiveness of
LTV Limits
Korea: Effective LTV Limits, but
Difficult Calibration?
p Benign neglect might be dead, so …

p Emerging consensus that leveraged bubbles (real
  estate in particular) are dangerous

p What to do. Still many open questions:
   n Monetary policy remains blunt instrument
   n Fiscal impractical. Perhaps helpful on liability structures
   n Macroprudential tools promising …

p But it will take time:
   n Develop new macro models
   n Design/calibrate macroprudential tools
   n Build institutions to control them
Limited liability and speculators

    Unlevered              Levered
    consumer               speculator
                H-P(1+r)                H-P(1+r)
       q                    q

     1-q                   1-q
                L-P(1+r)                L-P(1+r)

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