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The risk of deflation
(2009)
This paper was prepared for the meeting on Financial Regulation and Macroeconomic Stability: Key issues for the G20, organised by the CEPR and the Reinventing Bretton Woods Committee, London, 31 January 2009. Introduction: The onset of financial instability in August 2007, which quickly spread across the world, raises a number of questions for policy makers. First, what are the roots of the crisis? Many factors have been emphasized in the debate, including the opacity of complex financial products; the excessive confidence in ratings; weak risk management by financial institutions; massive reliance on wholesale funding; and the presumption that markets would always be liquid. Furthermore, poorly understood incentive effects – arising from the originate-to-distribute-model, remuneration policies and the period of low interest rates – are also widely seen as having played a role. Second, how can a repetition of the crisis can be avoided? Much attention is being focused on regulation and supervision of financial intermediaries. The G-20, at its summit in November 2008, noted that measures need to be taken in five areas: (i) financial market transparency and disclosure by firms need to be strengthened; (ii) regulation needs to be enhanced to ensure that all financial markets, products and participants are regulated or subject to oversight, as appropriate; (iii) the integrity of financial markets should be improved by bolstering investor and consumer protection, avoiding conflicts of interest, and by promoting information sharing; (iv) international cooperation among regulators must be enhanced; and (v) international financial institutions must be reformed to reflect changing economic weights in the world economy better in order to increase the legitimacy and effectiveness of these institutions. Third, how can the consequences for economic activity be minimized? Many of the adverse developments in financial markets – in particular the collapse of term interbank markets – reflect deeply entrenched perceptions of counterparty risk. Prompt and far-reaching action to support the financial system, in particular the infusion of equity capital in financial institutions to reduce counter-party risk and get credit to flow again, is essential in order to restore market functioning. A particular risk at present is that the rapid decline in inflation in many countries in recent months will turn into deflation with highly adverse real economic developments. This background paper considers how large the risk of deflation may be and discusses what policy can do to reduce it. It is organized as follows. Section 2 defines deflation and discusses downward nominal wage rigidities and the zero lower bound on interest rates. While these factors are frequently seen as two reasons why deflation can be associated with very poor economic outcomes, they should not be overemphasized. Section 3 looks at the current situation. Inflation expectations and forecasts in the subset of economies we look at (the euro area, the UK and the US) are positive, indicating that deflation is not expected. This does not imply that the current concerns of deflation are unwarranted, only that the public expects the central bank to be successful in avoiding deflation. The section also looks at the evolution of headline and “core” inflation, focusing on data from the US and the euro area. Section 4 reviews how monetary and fiscal policy can be conducted to ensure that deflation is avoided. Section 5 briefly discusses special issues arising in emerging market economies. Finally, Section 6 offers some conclusions. An Appendix discusses deflation episodes in the period 1882-1939.
This paper examines the sustainability of the currency board arrangements in Argentina and Hong Kong. We employ a Markov switching model with two regimes to infer the exchange rate pressure due to economic fundamentals and market expectations. The empirical results suggest that economic fundamentals and expectations are key determinants of a currency board’s sustainability. We also show that the government’s credibility played a more important role in Argentina than in Hong Kong. The trade surplus, real exchange rate and inflation rate were more important drivers of the sustainability of the Hong Kong currency board.
Over the last four decades the literature on bond rating changes and its effects on security prices increased significantly with almost all studies not controlling for the respective reason for those. We therefore investigate the impact of rating events on the stock and the credit default swap (CDS) market incorporating rating reviews and rating changes together with the reason mentioned by the rating agency. Our results for the general effects are in line with prior findings but conditioning on the respective reason shows that the markets’ anticipation of rating actions is largely driven by events due to changes in firms’ operating performance. Furthermore, we provide empirical evidence for the hypothesis in prior literature that a surprise downgrade does not necessarily have to be bad news for stockholders when wealth is transferred from bondholders, but negative rating actions are always bad news for bondholders. The results additionally reveal increasing rating announcement effects by declining credit quality of firms for both rating reviews and changes. JEL Classification: D82, G14, G20. Keywords: Credit Default Swaps, Credit Ratings, Credit Rating Reasons, Event Study.
The objective of this paper is to test the hypothesis that in particular financially constrained firms lease a higher share of their assets to mitigate problems of asymmetric information. The assumptions are tested under a GMM framework which simultaneously controls for endogeneity problems and firms’ fixed effects. We find that the share of total annual lease expenses attributable to either finance or operating leases is considerably higher for financially strained as well as for small and fast-growing firms – those likely to face higher agency-cost premiums on marginal financing. Furthermore, our results confirm the substitution of leasing and debt financing for lessee firms. However, we find no evidence that firms use leasing as an instrument to reduce their tax burdens. Keywords: Leasing; financial constraints; capital structure; asymmetric information.
This paper addresses the question whether close borrower-lender relationships, so called hausbank-relationships, facilitate the funding and beneficial development of SME. To this end, we derive a model which relates a firm's growth rate to its need for external funds and subsequently compute the firms that exceed their predicted growth rate. We then use this measure to identify specific characteristics that are associated with long- and short-term financing of firm growth, in particular the influence of relationship lending. We find that close ties with savings banks predict firms' access to external finance to fund growth. Moreover, the long-term liabilities of firms with hausbank-relationships almost double those with multiple relationships while the overall leverage is about the same. In turn, we find an strong empirical relationship between the provision of long-term funds and firm growth. Keywords: small business lending, credit access, public banks JEL Classifications: G21, D21
The objective of this paper is to test the hypothesis that in particular financially constrained firms lease a higher share of their assets to mitigate problems of asymmetric information. The assumptions are tested under a GMM framework which simultaneously controls for endogeneity problems and firms' fixed effects. We find that the share of total annual lease expenses attributable to either finance or operating leases is considerably higher for smaller firms with higher average interest rates and high-growth firms - those likely to face higher agency-cost premiums on marginal financing. Furthermore, our results confirm the substitution of leasing and debt financing for lessee firms. However, we find no evidence that firms use leasing as an instrument to reduce their tax burdens. Keywords: Leasing, financial constraints, asymmetric information, GMM JEL Classifications: D23, D92, C23
This paper investigates the impact of IT standardization on bank performance based on a panel of 457 German savings banks over the period from 1996 to 2006. We measure IT standardization as the fraction of IT expenses for centralized services over banks' total IT expenses. Bank efficiency, in turn, is measured by traditional accounting performance indicators as well as by cost and profit efficiencies that are estimated by a stochastic frontier approach. Our results suggest that IT standardization is conducive to cost efficiency. The relation is positive and robust for small and medium-sized banks but vanishes for very large banks. Furthermore, our study confirms the often cited computer paradox by showing that total IT expenditures negatively impact cost efficiency and have no influence on bank profits. To the best of our knowledge, this paper is first to empirically explore whether IT standardization enhances efficiency by employing genuine data of banks' IT expenditures. JEL Classification: C23, G21 Keywords: IT standardization, cost and profit efficiency, savings banks
Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modeling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically-estimated and widely-cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one-sixth as large.
The budget constraint requires that, eventually, consumption must adjust fully to any permanent shock to income. Intuition suggests that, knowing this, optimizing agents will fully adjust their spending immediately upon experiencing a permanent shock. However, this paper shows that if consumers are impatient and are subject to transitory as well as permanent shocks, the optimal marginal propensity to consume out of permanent shocks (the MPCP) is strictly less than 1, because buffer stock savers have a target wealth-to-permanent-income ratio; a positive shock to permanent income moves the ratio below its target, temporarily boosting saving. Keywords: Risk, Uncertainty, Consumption, Precautionary Saving, Buffer Stock Saving, Permanent Income Hypothesis.
We model the motives for residents of a country to hold foreign assets, including the precautionary motive that has been omitted from much previous literature as intractable. Our model captures many of the principal insights from the existing specialized literature on the precautionary motive, deriving a convenient formula for the economy’s target value of assets. The target is the level of assets that balances impatience, prudence, risk, intertemporal substitution, and the rate of return. We use the model to shed light on two topical questions: The “upstream” flows of capital from developing countries to advanced countries, and the long-run impact of resorbing global financial imbalances
We present a tractable model of the effects of nonfinancial risk on intertemporal choice. Our purpose is to provide a simple framework that can be adopted in fields like representative-agent macroeconomics, corporate finance, or political economy, where most modelers have chosen not to incorporate serious nonfinancial risk because available methods were too complex to yield transparent insights. Our model produces an intuitive analytical formula for target assets, and we show how to analyze transition dynamics using a familiar Ramsey-style phase diagram. Despite its starkness, our model captures most of the key implications of nonfinancial risk for intertemporal choice.
Instabile Finanzmärkte
(2009)
Die Vorstellung selbst-stabilisierender, zum Gleichgewicht tendierender Finanzmärkte, lange Zeit als Selbstverständlichkeit angesehen, ist durch die aktuelle Banken- und Kreditkrise in Frage gestellt. Trotz ausgefeilten Risikomanagements der Banken und einer an Basel II orientierten Aufsicht ist es in den Jahren 2007-2009 zu einem Zusammenbruch des Interbankenmarktes und weiter Teile der Anleihemärkte gekommen. Die hierdurch erzwungenen massiven Staatsinterventionen zur Bankenrettung sind ohne Beispiel in der modernen Wirtschaftsgeschichte. In diesem Essay suchen wir nach Ansatzpunkten einer Erklärung für die Instabilität der Finanzmärkte. Als zentrale Krisenursache sehen wir Schwächen der Informationsarchitektur, deren Aufgabe darin besteht, glaubwürdige Information für Investoren bereitzustellen. Drei Determinanten der Instabilität werden herausgestellt, erstens die Nutzung von Schuldtiteln verbunden mit hohen Verschuldungsgraden, zweitens die Handelbarkeit von Titeln verbunden mit erhöhter Risikoübernahme, sowie drittens die zunehmende Komplexität von Finanzprodukten und Finanznetzwerken verbunden mit einer Homogenisierung der Aktiva- und Risikostrukturen von Finanzinstituten. Alle drei Faktoren verstärken die Anfälligkeit des Finanzsystems und zugleich die Bedeutung der Informationsarchitektur. Hieraus lassen sich Anforderungen an eine sinnvolle Reform der Regulierung ableiten. Neben den Anreizproblemen, die Gegenstand einer weiteren Arbeit sind (Franke/Krahnen 2009), diskutieren wir hier vier Kernthemen: glaubwürdige Informationen, makroprudentielle Aufsicht, robuste Eigenkapitalstandards und eine notwendige Risikobegrenzung auf Derivatemärkten
American households have received a triple dose of bad news since the beginning of the current recession: The greatest collapse in asset values since the Great Depression, a sharp tightening in credit availability, and a large increase in unemployment risk. We present measures of the size of these shocks and discuss what a benchmark theory says about their immediate and ultimate consequences. We then provide a forecast based on a simple empirical model that captures the effects of wealth shocks and unemployment fears. Our short-term forecast calls for somewhat weaker spending, and somewhat higher saving rates, than the Consensus survey of macroeconomic forecasters. Over the longer term, our best guess is that the personal saving rate will eventually approach the levels that preceded period of financial liberalization that began in the late 1970s. Classification: C61, D11, E24
This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments. JEL Classification: G21, G28 Keywords: credit risk, risk transfer, systematic risk
This dissertation consists of three chapters. The first two chapters investigate the real effects of inflation and the third chapter the role of child care for fertility and female female labor supply. Chapter 1 introduces a generalized panel threshold model to analyze the relation between inflation and economic growth for a sample of developing countries. It is demonstrated that allowing for regime intercepts can be crucial for obtaining unbiased estimates of both, inflation thresholds and its marginal effects on growth in the various regimes. The empirical results confirm that the omitted variable bias of standard panel threshold models can be statistically and economically significant. Chapter 2, which is joined work with Dieter Nautz, investigates the impact of inflation on relative price variability (RPV) as a further important channel of the real effects of inflation. With a view to the recent debate on the Fed's implicit lower and upper bounds of its inflation objective, the econometric model introduced in Chapter 1 is used to explore the inflation-RPV linkage in U.S. cities. Chapter 3 investigates the relationship between fertility, female labor supply and child care in the context of a life cycle model for Germany. A particular emphasis is placed on the differences between West and East Germany. Counterfactual policy experiments mimicking recent policy reforms on maternal leave and the provision of subsidized child care are conducted with a structurally estimated version of the model.
Das House of Finance hat im Sommer 2008 sein Gebäude bezogen. Unter seinem Dach führt das House of Finance drei Abteilungen aus den Fachbereichen Rechtswissenschaft und Wirtschaftswissenschaften der Goethe-Universität sowie sechs rechtlich selbstständige Institute – darunter auch das E-Finance Lab - zusammen. Neben den traditionellen Aufgaben in der Forschung und Lehre verfolgt das House of Finance das Vorhaben, die Ergebnisse der Forschung für die Praxis und auch für den Finanzplatz Deutschland nutzbar zu machen. Als ein Element dieses Wissenstransfers veröffentlicht das House of Finance die „Newsletter“. Der „Newsletter“ gibt Auskunft über - drei aktuelle Forschungsergebnisse, - die Entwicklungen in der Executive Education, - die neuesten Veröffentlichungen der im House of Finance ansässigen Wissenschaftler, - den Veranstaltungskalender. Der Newsletter umfasst jeweils 16 Seiten und erscheint vierteljährlich in englischer Sprache.
This paper analyzes the risk properties of typical asset-backed securities (ABS), like CDOs or MBS, relying on a model with both macroeconomic and idiosyncratic components. The examined properties include expected loss, loss given default, and macro factor dependencies. Using a two-dimensional loss decomposition as a new metric, the risk properties of individual ABS tranches can directly be compared to those of corporate bonds, within and across rating classes. By applying Monte Carlo Simulation, we find that the risk properties of ABS differ significantly and systematically from those of straight bonds with the same rating. In particular, loss given default, the sensitivities to macroeconomic risk, and model risk differ greatly between instruments. Our findings have implications for understanding the credit crisis and for policy making. On an economic level, our analysis suggests a new explanation for the observed rating inflation in structured finance markets during the pre-crisis period 2004-2007. On a policy level, our findings call for a termination of the 'one-size-fits-all' approach to the rating methodology for fixed income instruments, requiring an own rating methodology for structured finance instruments. JEL Classification: G21, G28
Algorithmic trading engines versus human traders – do they behave different in securities markets?
(2009)
After exchanges and alternative trading venues have introduced electronic execution mechanisms worldwide, the focus of the securities trading industry shifted to the use of fully electronic trading engines by banks, brokers and their institutional customers. These Algorithmic Trading engines enable order submissions without human intervention based on quantitative models applying historical and real-time market data. Although there is a widespread discussion on the pros and cons of Algorithmic Trading and on its impact on market volatility and market quality, little is known on how algorithms actually place their orders in the market and whether and in which respect this differs form other order submissions. Based on a dataset that – for the first time – includes a specific flag to enable the identification of orders submitted by Algorithmic Trading engines, the paper investigates the extent of Algorithmic Trading activity and specifically their order placement strategies in comparison to human traders in the Xetra trading system. It is shown that Algorithmic Trading has become a relevant part of overall market activity and that Algorithmic Trading engines fundamentally differ from human traders in their order submission, modification and deletion behavior as they exploit real-time market data and latest market movements.
The recent financial crisis has led to a vigorous debate about the pros and cons of fair-value accounting (FVA). This debate presents a major challenge for FVA going forward and standard setters’ push to extend FVA into other areas. In this article, we highlight four important issues as an attempt to make sense of the debate. First, much of the controversy results from confusion about what is new and different about FVA. Second, while there are legitimate concerns about marking to market (or pure FVA) in times of financial crisis, it is less clear that these problems apply to FVA as stipulated by the accounting standards, be it IFRS or U.S. GAAP. Third, historical cost accounting (HCA) is unlikely to be the remedy. There are a number of concerns about HCA as well and these problems could be larger than those with FVA. Fourth, although it is difficult to fault the FVA standards per se, implementation issues are a potential concern, especially with respect to litigation. Finally, we identify several avenues for future research. JEL Classification: G14, G15, G30, K22, M41, M42