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Research 3 • HoF-Newsletter • Quarter 2/2010

WHERE FINANCE MEETS MACRO

A recent research program by Ester Faia responds to these questions by building up a benchmark for macro models which include different aspects of the banking sector. This Ignazio Angeloni Ester Faia Goethe University

Adviser to the Executive Board of the ECB and a BRUEGEL Visiting Fellow

program involves three main lines of research. The first of these is a work co-authored with Ignazio Angeloni (ECB and BRUEGEL), titled “A Tale of Two Policies: Prudential Regulation and Monetary Policy with Fragile Banks”, which studies the optimal combination of monetary and macro-prudential policies. In this paper, Angeloni and Faia

T

he crisis of 2007-2009 has shown that

markets and monetary policy. What

introduce optimizing banks, modeled along

banking and financial market struc-

implications do expansionary monetary

the lines of Diamond and Rajan (JoF 2000 or

tures can at times interact with macro-

policies have for the risk taking behavior

JPE 2001), into a macro (dynamic stochastic

economic conditions and monetary poli-

of banks? What role do secondary mar-

general equilibrium) model. This framework is

cies in ways that generate financial

kets play in terms of igniting and foster-

then used to study the role of banks in the

disruptions and systemic instability.

ing systemic risk? What is the optimal

transmission of shocks, the effects of monetary

Existing macro models are not well-

combination vis-à-vis macro-prudential

policy when banks are exposed to runs, and

equipped to capture these phenomena.

regulation and monetary policy? And

the interplay between monetary policy and

The next generation of macro models,

what are the consequences of financial

Basel-like capital ratios. Banks in the model

however, should be capable of expressing

globalization for the stability of financial

choose the optimal capital structure in order to

the interaction between finance and

markets? These, among others, are the

maximize the expected return for outside

macroeconomics, and of incorporating

questions that remain to be answered fol-

investors, namely uninformed investors and

the risks stemming from the interplay

lowing the financial crisis.

bank capitalists. In equilibrium, bank leverage

between the banking sector, financial 8

depends positively on the uncertainty of proj-

HOF-Newsletter_07

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Research 3 • HoF-Newsletter • Quarter 2/2010

ects and on the bank's "relationship lender"

crisis has highlighted the limits of the "origi-

knows that the loan is non-performing. The

ronment in which foreign lending finances

skills, and negatively on short-term interest

nate-to-distribute" banking model, but its

possibility of transferring credit not only

expenditure on housing. The authors find that

rates. A monetary restriction reduces leverage,

nexus with the macroeconomy and monetary

reduces the impact of liquidity shocks on bank

monetary policy should target the exchange

while a productivity or asset price boom

policy remains unexplored. In a paper titled

balance sheets, but also the bank incentive for

rate rather than the domestic inflation rate in

increases it. The transmission of all shocks

“Credit Risk Transfer and the Macro-

monitoring. As a result, secondary markets

order to contain persistent global imbalances.

points in the direction of a risk-taking chan-

economy”, Ester Faia builds a macro

free up bank capital and exacerbate the impact

nel: low interest rates, as induced by lax mon-

(dynamic stochastic general equilibrium)

of productivity and other macroeconomic

etary policies or productivity booms, encour-

model with banks, and examines its properties

shocks on output and inflation. By offering the

age banks to take on too much risk, thereby

with and without active secondary markets for

possibility of capital recycling and by reducing

leading to the phenomena of exuberance and

ABS. In this model, it is assumed that banks

bank monitoring, secondary credit markets in

Diamond, D. W., Rajan, R. G. (2000)

over-reaction. In this environment, pro-cycli-

are subject to liquidity shocks which may

general equilibrium allow banks to take on

“A Theory of Bank Capital”,

cal capital ratios are destabilizing; monetary

induce them to sell loan claims on unfinished

more risk. This research has been awarded the

Journal of Finance, Vol. 55(6), pp. 2431–2465.

policy can only partly offset this effect. The

projects in secondary markets. Both the origi-

prestigious Lamfalussy award.

optimal (utility maximizing) policy combina-

nation and the selling activity are subject to

tion includes mildly anti-cyclical capital ratios

moral hazard problems. Firms, after having

The last line of research refers to a paper

“Liquidity Risk, Liquidity Creation and Financial

and a monetary policy response to asset prices

obtained loans from the bank, might choose to

which explores the consequences of financial

Fragility: A Theory of Banking”,

or leverage.

exert a low effort and thus undermine the suc-

globalization for an optimal policy: part of a

Journal of Political Economy, Vol. 109 (2), pp. 287–327.

REFERENCES

Diamond, D. W., Rajan, R. G. (2001)

cess of a project unless properly monitored.

bigger research project sponsored by an FP7

The results of the aforementioned paper are of

Through monitoring, banks acquire private

grant from the European Community,

great policy relevance. In fact, they were

information about firms' projects. This leads to

whose team leaders are Michel Juilliard, Ester

Holmström, B., Tirole, J. (1997)

recently presented to the Executive Board of

a second moral hazard problem between

Faia,

“Financial Intermediation, Loanable Funds and the

the European Central Bank in a policy seminar.

depositors ("uninformed investors") and

Pearlman, Marco Ratto and Volker Wieland.

Real Sector”,

banks; one which becomes even more severe

More specifically, the paper is co-authored by

Quarterly Journal of Economics, Vol. 112,

A second line of research pursued by Ester

when the bank has the possibility of selling

Ester Faia and Eleni Iliopulos and titled

pp. 663–691.

Faia is the role of the secondary market for

loans on the secondary market. The bank is

“Financial Globalization, Financial Fric-

asset-backed securities (ABS) in the transmis-

inclined to offer the loan on the secondary

tions and Monetary Policy”. It studies the

The full articles are available at:

sion of shocks in macro models. The financial

market in the case of a liquidity shock or if it

optimal setting of monetary policy in an envi-

http://www.wiwi.uni-frankfurt.de/profs/faia/

Paul

Levine,

Albert

Marcet,

Joe

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