Paradox of Prudence Linkage between - South African rand Stability/FinStab_Research... · Paradox...

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Paradox of Prudence&

Linkage betweenFinancial & Price Stability

Markus Brunnermeier

Reserve Bank of South Africa Pretoria, South Africa, Oct 26th, 2017

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Overview

1. From Risk in Isolation to Systemic Risk• Volatility Paradox

• Direct Spillovers – domino effects

• Indirect Spillovers – amplifiers vs. absorbers

• Paradox of Prudence (becoming an amplifier)

2. From Separation Principles to Interlinkagesacross stability concepts• … and redistributive monetary policy

3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach

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The 2 Components of Systemic Risk

1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series

“Volatility Paradox” contemp. measures inappropriate

• Low VaR ⇒ low margins ⇒ high margins ⇒ high leverage ⇒ low risk-weights⇒ less capital ⇒ high leverage

• Shock leads to large adjustment• High VaR ⇒ …

Procyclicality• Countercyclical puffer… See paper

More subtle: better idiosyncratic risk sharing higher endogenous risk

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1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series• “Volatility Paradox” contemp. measures inappropriate

2. Spillovers/contagion – cross sectional• Direct contractual: domino effect – network

Network effects Bankruptcy of bank A

leads to default of B • 1st, 2nd, 3rd round effects• Random recovery rate

Data implications:• Position data• High frequency• High granularity

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1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series• “Volatility Paradox” contemp. measures inappropriate

2. Spillovers/contagion – cross sectional• Direct contractual: domino effect - network• Indirect: price effect (fire-sale externalities)

credit crunch, liquidity spirals

• Adverse GE response amplification, persistence7

Loss of

net worth

Shock to

capital

Precaution

+ tighter

margins

volatility

price

Fire

sales

nonlinearity

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Absorbers vs. amplifier

Shock absorber

Shock amplifier

Distributionexogenous endogenous

Direct Indirect

Contractual links “Virtual links”

Loss through bankruptcy/default

Similar exposurethan other levered players

Position data Response indicator- expectations/constraints

8Fat tail

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Absorbers vs. amplifier Response Indicator

Liquidity mismatch – not maturity mismatch

See Brunnermeier, Gorton & Krishnamurthy (2012)

A L

Micro-prudential Macro-prudential

Market Illiquidity exogenous depends on funding structure of other holders

Technological Illiquidity- Irreversibility

Market Illiquidity- Price Impact

Fund Illiquidity- Maturity- Haircut/margin sensitivity

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From Risk in Isolation to Spillover RiskFrom 𝑉𝑎𝑅 to Δ𝐶𝑜𝑉𝑎𝑅

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“Paradox of Prudence”

Fallacy of Composition in Risk Space

1. Keynes’ Paradox of Thrift

2. “Paradox of Prudence” Brunnermeier & Sannikov (Handbook chapter 2017)

• Each institution tries to reduce risk exposure (micro-prudent)

• Increases endogenous (systemic) risk (macro-imprudent) Liquidity spirals, fire-sales,…

Disinflationary spirals, …

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Overview







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Separation Principles Perspectives

Separation of task and accountability

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Interlinkages Perspectives

From YouTube video: “Money and Banking” by Markus.Economicus

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Interlinkages: MacroPru & MoPo

Liquidity spiral, fire sales

Disinflationary spiralEndogenous systemic risk

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Interlinkages: MacroPru & MoPo

In EME many MacroPru = MoPo measures

Inside money creation by private banks

Central bank balance sheet• Reserve holding due to liquidity regulation (LCR)

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A L

Ris

ky C

laim

A LR

isky

Cla

im

The “I Theory of Money” Technologies 𝑏

…

Net worth

Inside Money(deposits)

A L

Outside Money Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

Outside Money

Intermediaries• Can diversify within sector 𝑏

• Monitoring

• Create inside money

• Maturity/liquidity transformation

A L

𝐵1

Money

Ris

ky C

laim

Insi

de

equ

ity

A LA L

A LA L

𝐴1

Money

HH

Net

wo

rth

Technologies 𝑎

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Technologies 𝑏

A L

Ris

ky C

laim

A L

Shock impairs assets: 1st of 4 steps Technologies 𝑎

…

Net worth


A L

Outside Money Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

Losses

A L

𝐴1

Money

Ris

ky C

laim

Insi

de

equ

ity

𝐵1

A LA L

A LA L

𝐴1

Money

HH

Net

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Technologies 𝑏

Shrink balance sheet: 2nd of 4 steps

A

Technologies 𝑎


…

Net worth


A L

Pass through

Losses

Deleveraging Deleveraging

…

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

Outside Money

Switch

A L

Ris

ky C

laim

A LA L

𝐴1

Money

Ris

ky C

laim

Insi

de

equ

ity

𝐵1

A LA L

A LA L

𝐴1

Money

HH

Net

wo

rth

“Paradox of Prudence”

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Technologies 𝑏

Liquidity spiral: asset price drop: 3rd of 4 Technologies 𝑎

A L

Ris

ky C

laim

A LA L

𝐴1

Money

Ris

ky C

laim

Insi

de

equ

ity

𝐵1


Outside Money

…

Net worth


A L

Pass through

Ris

ky C

laim

Ris

ky C

laim

Ris

ky C

laim

Losses


A LA L

A LA L

𝐴1

Money

HH

Net

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Technologies 𝑎 Technologies 𝑏

Disinflationary spiral: 4th of 4 steps

A LA L

A LA L

𝐴1

Money

HH

Net

wo

rth

A L

Ris

ky C

laim

A LA L

𝐴1

Money

Ris

ky C

laim

Insi

de

equ

ity

𝐵1


Outside Money

…

Net worth


A L

Pass through

Ris

ky C

laim

Ris

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laim

Ris

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laim

Losses


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Redistributive MoPo: “I Theory of Money”

Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price • ⇒ “stealth recapitalization” - redistributive• ⇒ risk premia

Liquidity & Deflationary Spirals are mitigated

…

Net worth


A L

Reserves Pass through

𝑁𝑡

Long-term Bonds

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Adverse shock Liquidity & Deflationary Spirals

Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price • ⇒ “stealth recapitalization” - redistributive• ⇒ risk premia

Liquidity & Deflationary Spirals are mitigated

…

Net worth


A L


𝑁𝑡

Long-term Bonds

Ris

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Adverse shock Liquidity & Deflationary Spirals

Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price ⇒ “stealth recapitalization” - redistributive

⇒ Liquidity & Deflationary Spirals are mitigated

⇒ risk premia MoPo with risk premium focus

…

Net worth


A L


𝑁𝑡

Long-term Bonds

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Difference to New Keynesian View

Consumption Boost approach to “Bottleneck approach”

(New) KeynesianDemand Management

I Theory of MoneyRisk (premium) management

Stimulate aggregate consumptionSubstitution effect

Alleviate balance sheet constraintsIncome/wealth effect

Woodford Tobin (1982) BruSan

Price stickinessPerfect capital markets

Both Financial FrictionsIncomplete markets

Representative Agent Heterogeneous Agents

Cut 𝑖Reduces 𝑟 due to price stickinessConsumption 𝑐 rises

Cut 𝑖Changes bond pricesRedistributes from low MPC to high MPC consumers

- -

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Consumption Boost approach to “Bottleneck approach” (New) Keynesian

Demand ManagementI Theory of Money

Risk (premium) management









Cut 𝑖Changes asset pricesEx-post: Redistributesto balance sheet impaired sector

QE

- -

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Consumption Boost approach to “Bottleneck approach” (New) Keynesian

Demand ManagementI Theory of Money

Risk (premium) management









Cut 𝑖Changes asset pricesEx-post: Redistributesto balance sheet impaired sector

QE- US: QE1 & QE3: MBS- Japan 1990: corporate bonds

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Difference to Monetarist View

Target broad money supply measure

When private/inside money creation contractsreplace “missing” inside money with outside money

Ignores that • Private financial institutions “diversify” some risk away• If these institutions contract – more risk in the system• Money demand rises

Outside vs. Inside money Inside money allows banks to diversify idiosyncratic risk Outside money doesn’t

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Interaction between MoPo & MacroPru

Redistributive MoPo insures ⇒ Moral Hazard

MacroPru complements MoPo• Not substitutes

Good MacroPru enables more aggressive MoPo• More redistribution ex-post

• More risk-transfers/insurance ex-ante

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Overview







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Safe assets

“Good friend analogy” - like reserve assets

• Safe/available at any horizon - “when it counts”

• Precautionary buffer held in addition to more risky assets

Risk ⇒ demand for safe assets

“Safe asset tautology”• safe because it is “perceived to be safe”

• safe independent of fundamentals US Treasury downgrade

by S&P in 2011 ⇒ yield

German CDS spread ⇒ yield during Euro crisis

• Multiple equilibria

• Bubble

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Safe assets





Pool ofRisky assets

Safe asset

Deposits

Equity

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Safe assets





“Safe asset tautology”• safe because it is “perceived to be safe”

• safe independent of fundamentals US Treasury downgrade

by S&P in 2011 ⇒ yield

German CDS spread ⇒ yield during Euro crisis

• Multiple equilibria

• Bubble37

Pool ofRisky assets

Safe asset

Deposits

Equity

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Flight to Safety

Risk-on, Risk-off Flight to safe asset

If asymmetrically supplied by AE

Flight to safety cross-border capital flows

Who insures whom? (rich the poor?)• At times of global crisis issue new debt

- for AE: at inflated prices

- for EME: at depressed prices

• Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset

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Flight to Safety




Who insures whom? (rich the poor?)• At times of global crisis issue new debt

- for AE: at inflated prices

- for EME: at depressed prices

• Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset

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Flight to Safety




At times of global crisis, issuance of new debt• For US at inflated prices eases conditions

• For EME at depressed prices worsens conditions

Question: Who insures whom? (rich the poor OR poor the rich?)

• “Correct” insurance only if buffer is large (and debt long-term) enoughso that no new debt issuance needed & sale off safe asset 40

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Different Approaches to Counter Risks

Buffer Approach (public)

IMF Facilities Approach

Swapline Approach

Rechanneling Approach

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Buffer Approach

Buffers (public) more private imbalances

• Irrelevance theorem in BruSan2017 “International Monetary Theory: Mundell-Fleming Redux”

• International banks approach central bank as Lender of Last Resort in a Foreign Currency New additional rationale for Central Banks’

foreign reserve (safe asset) holding (in dollar)

Moral Hazard problem: banks hold fewer safe asset (in dollar) and rely on LOLR of CB

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Rechannel away from cross-border capital flows

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Rechannel away from cross-border flows

• With ESBies in Europe (SBBS = sovereign backed securities)

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sovereign bonds ESBies

Junior Bond

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Global Safe Asset (GSA) - without a Passport

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Rechannel flight to safety via GloSBBieS (Global SBBS)• Now, GSA junior bond

• Difference to ESBiesjunior bond also has to absorb currency risk

Both are internationalShift to a new equilibrium

Sovereign Bonds (+ currency swap)

GSA in $

Junior Bond in $

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Conclusion






3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach• Global Safe Asset - GloSBBS

Paradox of Prudence Linkage between - South African rand Stability/FinStab_Research... · Paradox...

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