Monetary policy, macroprudential policy, and financial stability

David Martinez-Miera, Rafael Repullo 27 March 2019

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When analysing the role of monetary and macroprudential policies in mitigating the build-up of risks in the financial sector, it is useful to recall the main contrasting views described in the survey paper by Smets (2014) (see also Adrian and Liang 2018). The first view, which he calls the modified Jackson Hole consensus, argues that “the monetary authority should keep its relatively narrow mandate of price stability and stabilising resource utilisation around a sustainable level, whereas macroprudential authorities should pursue financial stability, with each having their own instruments”. In Bernanke's (2011) words, “monetary policy is too blunt a tool to be routinely used to address possible financial imbalances; instead, monetary policy should remain focused on macroeconomic objectives, while more-targeted microprudential and macroprudential tools should be used to address developing risks to financial stability”.

The second view is the leaning against the wind policy, according to which “financial stability concerns should be part of the secondary objectives in the monetary policy strategy”. This view is best described by Stein (2013), who says that “supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns. If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behaviour”. He concludes that “monetary policy… has one important advantage relative to supervision and regulation – namely that it gets in all of the cracks”. 

In a recent paper (Martinez-Miera and Repullo 2019) we contribute to this debate by proposing a stylised general equilibrium model to assess the effects of monetary policy and macroprudential policy on the risk-taking incentives of financial intermediaries. The model builds on the setup in Martinez-Miera and Repullo (2017), in which competitive banks can reduce the probability of default of their loans by monitoring their borrowers at a cost. 

The model features four types of agents: entrepreneurs, investors, bankers, and consumers. There is large set of potential entrepreneurs that can be of two observable types: either safe or risky. They require external funding for their investment projects, which is provided by investors and banks. Banks are monitoring institutions set up by bankers to fund risky entrepreneurs. Investors are characterised by their aggregate initial wealth that is used to fund safe entrepreneurs and provide banks' debt. Bankers are characterised by their aggregate initial wealth that is used to provide banks' equity capital (and possibly also fund safe entrepreneurs). Finally, consumers are characterised by a downward-sloping demand for the output of safe and risky entrepreneurs. We assume free entry into the entrepreneurial and banking sectors. We also assume that investors and bankers are risk-neutral, and that all agents are price-takers. 

Monetary policy is modelled by introducing a central bank that can set the real safe interest rate via open market operations that change the funds that investors allocate to safe entrepreneurs and banks (note that we ignore nominal frictions and conduct our analysis in real terms). Macroprudential policy is modelled by introducing a regulator that can set a minimum capital requirement for banks, that is, a regulation that requires banks to have a minimum amount of equity capital per unit of loans. We highlight the different effects that these regulations have on the equilibrium structure of the economy, with special emphasis on their impact on the risk in the financial system. 

Financial sector equilibrium

To analyse the links between monetary policy, macroprudential policy, and financial stability, we focus on the role of competitive banks as intermediaries between risky entrepreneurs and (uninsured) investors. Entrepreneurs are penniless and, therefore, need funds for their investment projects. Banks can monitor entrepreneurs’ risky projects at a cost, which reduces their probability of default. We assume that monitoring is not contractible, so there is a moral hazard problem, which is the key informational friction in the model. In the presence of this moral hazard problem, (inside) capital provides ‘skin in the game’, serving as a commitment device to monitor borrowers and, by doing so, lower the banks’ cost of debt. 

We consider a one period economy in which the aggregate amount of bankers’ wealth as well as the aggregate amount of investors’ wealth is given at the beginning of the period. The equilibrium is characterised by a rate at which safe entrepreneurs borrow from investors (the safe rate), which defines the return that investors get from their wealth, a rate at which risky entrepreneurs borrow from banks, and a return that bankers get from their wealth. It is also characterised by the capital per unit of loans that banks choose to have (the inverse of banks’ leverage), the rate at which they borrow from investors (the banks’ cost of debt), and the monitoring intensity of the projects that they fund. Finally, the rates at which safe and risky entrepreneurs borrow from investors and banks, respectively, determine their investment, via the consumers' inverse loan demand functions. 

There are two possible types of equilibria. In the first, bank capital is scarce, in the sense that bankers get a higher return from their wealth than investors. In the second type, bank capital is abundant, and bankers get the same return from their wealth as investors. In a capital-scarce equilibrium all bankers' wealth is invested in bank capital, while in a capital-abundant equilibrium, part of it is also used to fund safe entrepreneurs. We focus our analysis on the capital-scarce equilibrium.

We show that in equilibrium banks will choose a positive amount of capital and a positive level of monitoring. Moreover, the monitoring intensity will be increasing in the intermediation margin. Since the probability of default of the loans to risky entrepreneurs is linked to their monitoring by banks, it follows that whatever happens to banks' intermediation margin is key to determining its effects on financial stability. 

After characterising the equilibrium of the model, we show that an (exogenous) increase in investors' wealth results in higher investment of safe and risky entrepreneurs, lower returns of debt and equity, lower intermediation margins, and higher leverage and risk-taking by banks. We also show that an (exogenous) increase in bankers' wealth results in higher investment of safe and risky entrepreneurs, lower returns of debt and equity, higher intermediation margins, and lower leverage and risk-taking by banks. Hence, we conclude that not only the aggregate amount of funding but also the relative amounts of investors and bankers' wealth are key determinants of financial stability, as they generate opposite effects on banks' risk-taking incentives. This allows us to conclude that shocks to the aggregate amounts of investors’ and bankers’ wealth are key drivers of financial stability.

Risk-taking effects of monetary and macroprudential policies

Monetary policy is modelled by introducing a new agent, the central bank, which can engineer a change in the safe interest rate. A way in which this can be done in our model setup is by assuming that (i) there is a government with an amount of outstanding safe debt, and (ii) the central bank can increase or decrease the amount of government debt held by investors. This means that the initial wealth of investors is divided between a part invested in funding safe entrepreneurs and banks, and another part invested in government debt. From the perspective of individual investors, the division is immaterial since they get the same return, but it matters from an aggregate perspective because an open market sale of government debt reduces the funds allocated by investors to private investments, and hence changes the equilibrium of the model. 

Macroprudential policy is modelled by introducing a new agent, the macroprudential regulator, who can set minimum capital requirements for banks. We assume that parameter values are such that the capital requirement is binding, and analyse the effect on the equilibrium of the model of increasing the requirement. 

We show that tighter monetary policy increases the return of debt and equity, reduces investment for both safe and risky entrepreneurs, increases the intermediation margin, and hence reduces risk-taking by banks. We also show that higher capital requirements increase the return of equity, decrease the return of debt, shift investment from risky to safe firms, increase the intermediation margin and hence reduce risk-taking by banks. It is important to highlight that although the effect of both policies on risk-taking goes in the same direction, higher capital requirements have a positive effect that is not present with tighter monetary policy, namely, they shift investment toward safe firms, reducing the safe rate and consequently the cost of bank debt, which leads to a further increase in the intermediation margin. For this reason, we conclude that macroprudential policy appears to be more effective than monetary policy for reducing risk-taking by banks. 

We also consider how these two policies interact, showing that, in contrast to our previous result, in the presence of binding capital requirements a tightening of monetary policy increases risk-taking by banks. The reason for this somewhat surprising result is as follows. With binding capital requirements, investment of risky entrepreneurs, and hence the rate at which they borrow from banks, is determined by the capital requirement. Under these conditions, the higher cost of bank debt due to the tightening of monetary policy is not translated into higher loan rates, so the intermediation margin goes down, increasing banks' risk-taking. 

Welfare analysis

It is important to note that although both monetary and macroprudential policies can be effective in ameliorating banks' risk-taking incentives, this may be costly in terms of social welfare as they also affect equilibrium investment. Hence, to complete the discussion we undertake a welfare analysis, which requires to derive the objective function of the social planner. Social welfare comprises the return of investors’ wealth, the return of bankers’ wealth, the consumers’ surplus from entrepreneurial output, and the profits or losses of the central bank from open market operations, in the case of active monetary policy, which are assumed to be transferred to or from investors in a lump sum manner. 

Armed with this social welfare function we first show that the laissez-faire equilibrium of the model is constrained inefficient – that is, a social planner subject to the same moral hazard problem as the banks could improve upon the equilibrium allocation. The reason is that perfect competition among banks leads to intermediation margins and monitoring intensities that are too low. By marginally moving investment from risky to safe firms, the social planner widens intermediation margins and increases bank monitoring, which leads to higher social welfare.

We next analyse the optimal stand-alone monetary policy, the optimal stand-alone macroprudential policy, and the optimal combination of the two policies. Our numerical results show that the optimal combination of both policies is closer in terms of both financial stability and social welfare to the optimal stand-alone macroprudential policy, which are in turn higher than those that can be obtained with the optimal stand-alone monetary policy. The increase in welfare delivered by the combination of both policies is achieved by a further increase of capital requirements that is accompanied by a tightening of monetary policy, which dampens the fall in the safe rate. 

Conclusion

Summing up, we construct a model that allows us to analyse the effect on financial stability of tightening monetary policy, modelled by raising the safe interest rate via open market sales of government debt by a central bank, and tightening macroprudential policy, modelled by raising capital requirements for banks. We show that both policies are effective in improving banks' monitoring incentives, through an increase in the intermediation margin. However, there is one significant difference – tighter capital requirements shift investment toward safe firms, decreasing safe rates, whereas tighter monetary policy reduces investment for both safe and risky firms, increasing safe rates, so the effect on the margin is smaller. Consequently, macroprudential policy appears to be a more effective instrument for reducing risk-taking by banks. Moreover, we also show that in the presence of binding capital requirements a tightening of monetary policy increases risk-taking by banks. This result highlights the importance of analysing the interaction of both policies. 

We complete our discussion by providing a welfare analysis of the model, showing that the laissez-faire equilibrium allocation is constrained inefficient, because competition among banks leads to intermediation margins and monitoring intensities that are too low. Hence, there is a role for government intervention. In particular, we show that tightening monetary and macroprudential policies, on their own, increase welfare. Moreover, we also show that their optimal combination is closer in terms of both financial stability and social welfare to the optimal stand-alone macroprudential policy than to the optimal stand-alone monetary policy. In this sense, the results of our paper provide support for the view that macroprudential policy should be the primary tool for addressing risks to financial stability. 

It should be noted that our model of monetary policy abstracts from nominal frictions and simply assumes that the central bank can raise the real interest rate via open market sales of government debt that reduce the funds that investors allocate to private investments. This assumption allows for a clearer understanding of the mechanisms whereby monetary policy may contribute to financial stability. But at the end of the day, one would like to have a more realistic model of monetary policy.

It should also be noted that our conclusion in favour of using macroprudential tools as the primary instrument to enhance financial stability should be qualified in situations in which, as we analysed in Martinez-Miera and Repullo (2018), the presence of a shadow banking system may reduce the effectiveness of these tools. 

References

Adrian, T, and N Liang (2018), “Monetary Policy, Financial Conditions, and Financial Stability,” International Journal of Central Banking, 14, 73-131. 

Bernanke, B (2011), “The Effects of the Great Recession on Central Bank Doctrine and Practice,” Remarks at the 56th Economic Conference, Federal Reserve Bank of Boston. 

Martinez-Miera, D, and R Repullo (2017), “Search for Yield,” Econometrica, 85, 351-378.

Martinez-Miera, D, and R Repullo (2018), “Markets, Banks and Shadow Banks,” CEPR Discussion Paper no. 13248. 

Martinez-Miera, D, and R. Repullo (2019), “Monetary Policy, Macroprudential Policy, and Financial Stability,” CEPR Discussion Paper no. 13530. 

Smets, F (2014), “Financial Stability and Monetary Policy: How Closely Interlinked?,” International Journal of Central Banking, 10, 263-300.

Stein, J (2013), “Overheating in Credit Markets: Origins, Measurement, and Policy Responses,” Remarks at Research Symposium, Federal Reserve Bank of St. Louis.

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Topics:  Financial markets Monetary policy

Tags:  monetary policy, Macroprudential policy, financial stability, global crisis, Central Banks, investment

Associate Professor of Finance in the Business Department, Carlos III University

Professor of Economics and Director, CEMFI; CEPR Research Fellow

Events

  • 17 - 18 August 2019 / Peking University, Beijing / Chinese University of Hong Kong – Tsinghua University Joint Research Center for Chinese Economy, the Institute for Emerging Market Studies at Hong Kong University of Science and Technology, the Guanghua School of Management at Peking University, the Stanford Center on Global Poverty and Development at Stanford University, the School of Economics and Management at Tsinghua University, BREAD, NBER and CEPR
  • 19 - 20 August 2019 / Vienna, Palais Coburg / WU Research Institute for Capital Markets (ISK)
  • 29 - 30 August 2019 / Galatina, Italy /
  • 4 - 5 September 2019 / Roma Eventi, Congress Center, Pontificia Università Gregoriana Piazza della Pilotta, 4, Rome, Italy / European Center of Sustainable Development , CIT University
  • 9 - 14 September 2019 / Guildford, Surrey, UK / The University of Surrey

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