Financial frictions, financial regulation and their impact ... · microprudential regulation, that promote financial stability. Macroprudential policy is one such tool. It fosters

47Penning- och valutaPolitik 2018:1

* WethankJohanAlmenberg,KerstinHallsten,JesperLindé,MarianneNessén,OlofSandstedtandKarlWalentinforusefulcomments.WewouldalsoliketothankIsaiahHullandKasperKragh-Sørensenforusefulliteraturesuggestions.

Financialfrictions,financialregulationandtheirimpactonthemacroeconomyDariaFinocchiaroandAnnaGrodecka*DariaFinocchiaroworksattheMonetaryPolicyDepartmentandAnnaGrodeckaworksattheFinancialStabilityDepartmentofSverigesRiksbank.

In the aftermath of the global financial crisis, increasing attention has been paid to the role played by financial factors in business cycle fluctuations. The crisis also led to the development of economic policies, beyond traditional microprudential regulation, that promote financial stability. Macroprudential policy is one such tool. It fosters a more resilient financial system by directly tackling systemic risk, that is the risk of a breakdown of the entire financial system with significant economic costs. Yet macroprudential policy is still in its ‘infancy’. In this article, we first emphasize the importance of financial markets for our understanding of the real economy and how they have traditionally been incorporated in macroeconomic models. Then we discuss the rationale for macroprudential regulation and present a cost-benefit framework to evaluate the merits of different macroprudential instruments; the benefits include a more resilient financial system and stable economy, and the costs involve forgone lending and lower economic activity. We conclude by summarizing some of the remaining challenges in the field.

1 Introduction

‘I have a simple explanation [for the first Modigliani-Miller proposition]. It’s after the ball game, and the pizza man comes up to Yogi Berra and he says, “Yogi, how do you want me to cut this pizza, into quarters?” Yogi says, “No, cut it into eight pieces, I’m feeling hungry tonight.” Now when I tell that story the usual reaction is, “And you mean to say that they gave you a [Nobel] prize for that?”’ MertonMiller

Themacroeconomicdisciplinehascomeunderstrongcriticismaftertheglobalfinancialcrisisof2007–2008,mostlyduetothenegligenceoffinancialfactorsinmainstreammacroeconomicmodels.1Themajorityofmodelsusedbypolicymakersandcentralbanksaroundtheworldbeforethecrisisdidnotexplicitlyallowforwell-articulatedfinancialmarkets:theyoftenassumedcompleteandefficientcapitalmarketswherefirms’ownershipandcapitalstructuresareirrelevant,andsoarefinancialinstitutions.2

Thisisthecase,forexample,inthewidelyusedNewKeynesianworkhorseDSGE3modelbySmetsandWouters(2007).Inthisstylizedmodel,households(andfirms)havefullaccess

1 SeethespecialissueoftheOxfordReviewEconomicPolicy‘RebuildingMacroeconomicTheory”.2 Undercompletemarkets,thereexistsamarketwithapriceforeveryassetforallpossiblestatesoftheworld.Agentscanbuy,eitherdirectlyorindirectly,anyasset,thatisthereexistcontractstoinsureagainstallpossibleeventualities(seeGulko,2008).Marketsarefurthermoreefficientifpricesfullyreflectallavailableinformation(Fama,1970).3 DynamicStochasticGeneralEquilibrium–aclassofmacroeconomicmodelswidelyusedincentralbanking,butalsoinacademiatoassesstheeffectsofdifferentpolicies.

Financial Frictions, F inancial regulation and their impact on the macroeconomy48

tofinancialmarketsandareperfectlyinsuredagainst,forexample,theriskoflosingtheirjobs.Itfollowsthatfinancialinstitutionsareredundantandacentralbank’smainroleistoadjustthepriceofcredit(seeVinesandWillis,2018).Inreality,financialmarketsarefarfromthisidealizedworldandthesemarketimperfections,thatisfinancialfrictions,arealsoimportantforaggregatefluctuations.Asamatteroffact,thedisconnectbetweenthefinancialandrealsidesoftheeconomyisatoddswiththedata.AsdocumentedinJermannandQuadrini(2012),financialflowswerehighlycyclicalevenduringthetranquiltimeoftheGreatModeration.4

Theempiricalrelevanceofmacro-financiallinkagesisnotanewdiscovery.5Economicclassics,suchasKeynes,WicksellorMinskywereawareofthecrucialroleofcreditintheeconomy.However,subsequentmacroeconomicresearchersshiftedtheirfocusawayfromtheimportanceoffinancialmarketsforeconomicdevelopments.Inthe1960s,therevolutionary‘irrelevancepropositions’ofModiglianiandMiller(M&Mhenceforth)identifiedthenecessaryconditionsthroughwhichfinancialfactorswouldprovetobeirrelevantfromatheoreticalperspective.Inanutshell,inasomewhatidealizedworldwithperfectlyfunctioningmarketsandabsentcorporatetaxes,agencyproblems,6informationfrictionsandbankruptcycosts,M&Mstatethatacompany’scapitalstructureisirrelevantforitsmarketvalue.Asaresult,debtandequityareonlytwodifferentwaysofslicingthesamepizza,thatisafirm’svalue.KashyapandZingales(2010)arguethatthetheorem,conceivedtoshowanextremebenchmark,hasovertheyearsbeen(mis)usedasaproofoftheunimportanceofcorporatefinanceforourunderstandingoftherealeconomy.

Inthe1990s,someearlymacroeconomicstudies(BernankeandGertler,1989,andKiyotakiandMoore,1997andCarlstromandFuerst,1997)highlightedtheimportanceofdeviationsfromtheM&Massumptionsandexplicitlyincorporatedfinancialfactorsintogeneralequilibriummodels.Buttogetherwithotherstudiesfocusingonbubbles,panicsandcontagion,theybelongedmoretotheperipheryoftheprofessionratherthantoitscore.Foraverylongtime,financialintermediariesweretreatedas‘aveil’(GertlerandKiyotaki,2010)inmainstreammacroeconomicmodels;7theincreasedeconomicstabilityintheprolongedperiodoftheGreatModerationpartlygavesupporttothenotionthatchangesinfinancialconditionsdidnotmatterformacroeconomicoutcomes.

Therecentcrisisbecameawake-upcallfortheprofessionanditprovidedtwomainlessons.

First,financialintermediationiscrucialforunderstandingbusinesscycledynamics.Whileinnormaltimesthefinancialsectorhelpsfirmsandhouseholdstosmoothincomefluctuations,itmayleadtotheiramplification(Brunnermeier,EisenbachandSannikov,2012)incrisistimes.Someeconomists(seeforexampleJordà,SchularickandTaylor,2013)arguethatfinancial-crisisrecessionsaremorecostlythannormalrecessionsintermsoflostoutput.Theimportanceoffinancialfactorsandinstitutionsforourunderstandingoftheeconomyisfurtherenhancedbytherecognitionthattheycouldalsohaveanimpactoneconomicgrowth(seeLevine,2005).

Second,inaworldwherefinancialinstitutionsarehighlyinterconnected,microprudentialmeasuresshouldbeaccompaniedbymacroprudentialones;onlythelattercanexplicitlytakeintoaccountthesystemicroleofsomefinancialactorsandtheresultingfeedbacksbetweenrealandfinancialsectorsintheeconomy.Microprudentialpolicies(forexamplecapitaladequacyrulesintheBaselaccords)havebeenadoptedbyfinancialregulatorsfordecadesand

4 TheGreatModerationdenotesatimeperiod,startingfromthemid-1980sandinterruptedbytheGlobalFinancialCrisis(2007–2008),characterizedbylowmacroeconomicvolatilityexperiencedinmanydevelopedeconomies.5 Macro-financiallinkagesarelinkagesbetweenfinancialconditionsandmacroeconomicdevelopments.SeeAppendixIofClaessensandKose(2017)forthesummaryofthehistoryofresearchonmacro-financiallinkages.6 Anagencyproblemdescribesthosesituations inwhichoneparty(theagent)actsonbehalfonanother(theprincipal), forexamplewhenamanager actsonbehalf of shareholders. In such situations, conflictsof interests could arise if the incentivesbetweentheagentandtheprincipalarenotaligned.7 Fordiscussionsofthis,seeCaballero(2010),GertlerandKiyotaki(2010),Quadrini(2011)andFernández-Villaverde(2012).


focusmainlyontherisksofindividualfinancialinstitutions.Assuch,theymightbeinsufficientformaintainingfinancialstability.Incontrast,macroprudentialpolicyattemptstofosterstrongerresilienceofthefinancialsystem(including,forexample,banks,firmsandhouseholds)andreducesystemicrisk,thatistheriskofabreakdownoftheentirefinancialsystemtriggeringseveredamagetotheeconomy.8Theexplicitgoalsofsuchpoliciesaretoreducethepro-cyclicalityofcreditflowsandaddresstheproblemof‘toobigtofail’institutions(thatisbankssystemicallyimportantduetotheirsizeandlevelofinterconnectedness).9Asaresult,differentmacroprudentialmeasureshavebothtimeseriesandcross-sectionalcomponents,thatistheymayaffectthecyclicalaspectsofsystemicriskanditsdevelopmentovertime,andtheymayaffectthedistributionofriskamongdifferentmarketparticipantsatagivenpointintime.Dynamicmacroeconomicmodelsoperatinginarepresentativeagentframework–whereallindividualsareassumedtobeidentical,arewell-suitedfortheassessmentofgeneralequilibriumeffectsofdifferentpoliciesandaddressingthetimedimensionofsystemicrisk.Asshowninthisreview,recentresearchhasalsomadeprogressintacklingthecross-sectionaldimensionofsystemicriskbyexplicitlytakingintoaccounttheheterogeneityoffinancialactorsintheeconomy(seeCorbaeandD’Erasmo,2014andBoissayandCollard,2016,discussedinthisreview).

Manymicro-andmacroprudentialpoliciesaimatloweringleverage,eitherofthebankingsystemorthatofprivateborrowers.Whileitisveryhardtoestablishwhattheappropriatelevelofleverageshouldbe,itcannotbedisputedthatsomeoftheexistingregulations(forexamplelimitedliabilityanddepositinsuranceforbanks,interesttaxdeductionsforcorporationsandhouseholds)encourageborrowingandintroduceawedgebetweenprivateandsocialcostsofdebt,aso-calledexternality.10Atoohighlyleveragedeconomymayleadtodebtoverhangproblems.11Indifficulttimes,highlyleveragedagentstendtodeleveragequickly,andthislikelyhasasignificantnegativeimpactonconsumptionandoutput.AsemphasizedbyTurner(2016),onceleverageishigh,itisdifficulttoreduceitwithoutadverseeconomiceffects.Duringtheglobalfinancialcrisisof2007–2008,manyexistingdebtcontractswereactuallynotrepaid,butshiftedaroundthesystem,fromtheprivatesectortothepublicsector,bothintheUSandinEurope.Pre-emptiveactionsaimingatcurbingthebuild-upofexcessiveleveragearethereforecrucial.

Inreality,policymakersfaceanimportanttrade-offbetweenthecostsofsystemicriskwhichmaterializeonlyincrisistimes,andthelevelofeconomicactivityintranquiltimes,whichislikelytobelowerunderstricterregulation.The‘Greenspandoctrine’wastheconsensusviewbeforetheglobalfinancialcrisis:preemptivefinancialregulationwasperceivedastoocostlyandtoobluntatool(seeJeanneandKorinek,2017)andtheappropriatepolicyinterventionwasbelievedtobe‘ex-post’,thatisatthetimeofthecrisis.Thecrisissignificantlychangedourviewsonthistrade-offbutalsofurtherstressedtheneedtoassessthecostsoffinancialregulationsaheadoftheintroductionofagivenmeasure.Thiscanonlybedoneiftheunderlyingmarketfailure–thespecificsourceofdeviationfromtheidealefficientmarketbenchmarkthatneedstobecorrected–iswellidentified.Thus,thedesignofanappropriatepolicytoolkitshouldideally:

8 Althoughthereisnoconsensusyetonthisissue,ourdefinitionofsystemicriskisinlinewiththeoneoftheEuropeanCentralBank:‘Systemicriskcanbestbedescribedastheriskthattheprovisionofnecessaryfinancialproductsandservicesbythefinancialsystemwillbeimpairedtoapointwhereeconomicgrowthandwelfaremaybemateriallyaffected’(ECB,2018).SeealsoBraconierandPalmqvist(2017)onthisissue.9 Adetaileddescriptionofmicro-andmacroprudentialpoliciesisprovidedinFreixas,LaevenandPeydró(2015).10 Ineconomics,anexternalitydenotesasituationwheretheactionsofonepartyimpactonanotherpartyandsuchinteractionisnottakenintoaccountbyagentsnorreflectedinmarketprices.Passivesmokingandtherelatedhealthcostsareatextbookexampleofnegativeexternality.Individualexcessiveindebtednessanditsimpacton(socially)expensivefinancialcrisesareanotherone.Assuch,anexternalityconstitutesamarketfailure,thatisadeviationfromtheidealmarket.11 SeeMyers(1977)andLamont(1995)forthediscussionofcorporatedebtoverhangandMianandSufi(2014)andMelzer(2017)forhouseholddebtoverhang.


i. Identifythesourceofmarketfailuretoaddress,

ii. Relyonanadequatecostandbenefitanalysis,

iii. Assesstheeffectivenessofdifferenttools.

Macromodelswithwell-articulatedfinancialsectorsarewellsuitedtoconductpolicyexperimentsbytakingintoaccountalltheaboveingeneralequilibriumset-ups.

Inwhatfollows,wefirstreviewthemostrecentattemptsintheliteraturetoincorporatefinancialfrictions,thatisdeviationsfromtheidealizedM&Mworldwithperfectlyfunctioningcapitalmarkets,inotherwisestandardtheoreticalmacromodels.Thenweevaluatethroughthelensofvariousmodelsboththecosts,thatisforgonelendingandeconomicactivity,andthebenefits,thatisamoreresilientfinancialsystemandstableeconomy,ofdifferentmacroprudentialtools.12

2 ModellingfinancialfrictionsInthemodelsreviewedinthisarticle,financialmarketsdeviatefromtheidealizedM&Mworldforvariousreasons.Sometimesitisassumedthatonlysomeassetscanbetradedincapitalmarkets.Inotherset-ups,somesortofagencyproblemusuallylimitsaccesstocreditmarkets.Thiscanhappenbecauselendersandborrowersareasymmetricallyinformed(informationalfrictions)oriflenderscannotforceborrowerstofulfiltheircontractualagreements(enforcementproblems,seeQuadrini,2011).

Animportantdistinctionintheexistingliteratureiswhetherriskisexogenous,thatisnotinfluencedbyeconomicagents’decisions,orendogenous.Systemicriskfallsintothesecondcategoryanditisoneoftheprimaryreasonsforregulatingfinancialinstitutions.Inanutshell,under-capitalizationofthefinancialsystemleadstorisksnotbeinginternalizedbyfinancialmarketparticipants,whichcanseverelyamplifythesubsequenteconomicdownturnorevencausearecession.Understandingtheunderlyingsourceofmarketfailureiscrucialwhendesigninganefficientinstrumentorcombinationoftoolstoaddressit.13 De Nicolò,FavaraandRatnovski(2012)classifytheseexternalitiesintothreemaincategories:14

i. Strategic complementarities – interactionsbetweenbanksinducingthemtotakeexcessiverisk(FarhiandTirole,2011),thatisbanksmightfinditoptimaltocorrelatetheirportfolioswitheachother’sbecausetheyanticipatethatinacrisiseventtheywillbebailed-outbythegovernment;

ii. Pecuniary externalities,thatisover-indebtednessamonghouseholds,corporationsorbanksmightinducefiresalesduringadownturn.Theresultingnegativeimpactoffallingpricesontheirbalancesheetscanamplifytheslump(Lorenzoni,2008andBianchi,2011);theseeffectsonpricesarenotprivatelyinternalized,therebyinducingagentstotakeontoomuchdebt.

iii. Externalitiesrelatedto interconnectedness,thatisonedistressedbankcouldjeopardizethestabilityofotherfinancialinstitutions(AllenandGale,2000).

Recently,FarhiandWerning(2016)putforthadifferentsourceofexternality,ademandexternality,whichprovidesajustificationformacroprudentialpoliciesinenvironmentswhereoutputisdemand-driven.Financialdecisionsofeconomicagentsinfluencethewealthdistributionintheeconomy,which,throughdifferentmarginalpropensitiestoconsumeamongagents,affectstheaggregatedemandinthepresenceofnominalrigidities.

12 Althoughmonetarypolicycouldalsoimpactonfinancialstability,inthisarticleweleaveadiscussionoftheinteractionsbetweenmonetaryandmacroprudentialpoliciesout.SeeInternationalMonetaryFund[IMF](2005)onthisissue.13 Inreality,over-indebtednessorexcessiverisktakingcanalsobetheresultofbehavioralfactors.Although,thereisavastliteratureexplicitlytakingintoaccountthosefactors,inthisarticlewefocusonstudieswhichdonotconsiderdeviationsfromrationality.14 AlthoughDeNicolò,FavaraandRatnovski(2012)mainlyfocusonexternalitiesaffectingfinancialinstitutions,herewebroadentheirdefinitionsalsotootherfinancialmarketsparticipants,forexampleborrowinghouseholdsandfirms.


Householdsusuallydonottakeintoaccounttheimpactoftheirfinancialdecisionsonthewealthdistributionandaggregatecapacityoftheeconomy.Macroprudentialpoliciesthatinternalizethisimpactcouldpotentiallyimprovethewelfareoftheeconomy.Asanillustration,onecouldimagineasuddencreditcrunchinaworldwithborrowersandsaverswheremonetarypolicyisconstrainedbythezerolowerbound.Byrestrictingborrowingbeforethecrisis,aregulatorcouldimprovethespendingcapacityofborrowersduringthecrash,therebystabilizingtheeconomy.Thesestabilizationbenefitsarenottakenintoaccountbyprivateagents,thusjustifyingtheregulatoryintervention.

Fortheeaseofexposition,inwhatfollowswedistinguishwhetherthefinancialfrictionimpairsthesupplyordemandofcredit.

2.1 Credit-demandfrictionsEarlyattemptsintheliteraturetoincorporatedeviationsfromtheM&Mirrelevancepropositionintomacromodelsfocusonthedemandsideofcredit.Inthosestudies,macrofinanciallinkagesarisebecausefirmsand/orhouseholdsarefinanciallyconstrained,thatiscapitalmarketsarenotperfectlyfunctioning.Specifically,limitedaccesstocreditmarketscreatesalinkbetweenfirms’andhouseholds’balancesheetconditionsandtherealeconomy.Suchalinkcanactbothasanamplificationtoolandasasourceofbusinesscyclefluctuations,asfurtherexplainedbelow.Inthisrespect,studyingfinancialfrictionshelpstoaddresstwoofthecentralissuesinmacroeconomics:i)understandinghowevenmoderatechangesineconomicfundamentalscanhavelargemacroeconomicconsequencesii)explainingtheoriginsofbusinesscycles.

Financialfrictionscanamplifytheimpactofeconomicdisturbancesviatheirimpactonhouseholds’andfirms’balancesheets.ThisisthecaseintheseminalworkofKiyotakiandMoore(1997)andBernanke,GertlerandGilchrist(1999).Inthefirstpaper,lenderscannotforceborrowerstorepaytheirdebtunlessitiscollateralized.Hence,intheirwork,capitalisbothafactorofproductionandithascollateralvalue,andbothaspectsarereflectedinitsprice.Inabust,dueforexampletodisruptionsoriginatingintheproductionsectoroftheeconomy,so-calledsupplyshocks,movementsinthepriceofcapitalfurtherimpairborrowers’collateralcapacity,therebyaggravatingtheeffectsoftheinitialshock.Therefore,theinteractionbetweencreditlimitsandassetpricesamplifiesandspreadstheeffectsoftheinitialnegativeshocktoothersectors.InBernanke,GertlerandGilchrist(1999),thereareinformationasymmetriesbetweenborrowersandlendersandmonitoringiscostly.Thisagencyproblemcreatesaninterestratespreadbetweeninternalandexternalfundingproportionaltoborrowers’networth.Inadownturn,themarketvalueoffirms’networthdeteriorates.Asaresult,agencycostsincreasecountercyclically,therebyfurtherreducingfirms’borrowingability.Thislastchanneltriggersacontractionininvestmentsandafurtherdeepeningofthecrisis.Thisistheso-called‘financialaccelerator’.Iacoviello(2005)buildsonKiyotakiandMoore(1997)inamodelwherehousinghasadualroleasaconsumptiongoodaswellasacollateralizableasset.Inthatframework,housingpricedipscanconsiderablydepressaggregatedemand.

Furthermore,financialfrictionscanalsobeasourceofbusinesscyclesratherthanamereamplificationtool,asshowninJermannandQuadrini(2012).Alsointheirset-up,firmscoulddefaultontheirdebtsandthislimitstheirabilitytoborrow.Moreover,debtispreferredtoequitybecauseinterestrateexpendituresaretaxdeductible.Crucially,itisfurtherassumedthatfirmscannoteasilychangetheircapitalstructure,thatisthecompositionofdebtandequity.Asaresult,asuddendeteriorationoffirms’financingconditions,aso-callednegativefinancialshock,willforcethemtocutemploymentanddepressaggregatedemand.AccordingtotheestimatesinChristianoMottoandRostagno(2003),a‘liquidityshock’inducedhouseholdstoaccumulatecurrencyattheexpensesofdepositsduringtheGreatDepression.Intheirset-up,financialfactorsareimportantfortherealeconomybecauseafinancialacceleratoràlaBernanke,GertlerandGilchrist(1999)isatwork.


2.2CreditsupplyfrictionsMorerecently,bankshavebeenexplicitlyincorporatedintomacromodelsinordertoexploretheimpactofcreditsupplyimperfectionsonfinancialintermediationandtherealsideontheeconomy.Inthisstrandofliterature,financial intermediaries’balancesheetconditionsmatterforbusinesscyclesfluctuations.

Inreality,banksfulfilmultiplefunctions.Theycontributetotheefficiencyofthepaymentsystem,channelfundsbetweensaversandinvestors,provideliquidity(demanddeposits)andengageinmaturitytransformation,loanmonitoringandriskmanagement(seeFriexas,LaevenandPeydró,2015).Intheexistingtheoreticalliterature,financialintermediariescanprovideoneormoreoftheabovementionedservices.However,thewell-functioningofthefinancialsystemcanbedisruptedbytheexcessiverisk-taking(ofbankers)orbypoorfinancialregulations.

InGertlerandKaradi(2011),bankschannelfundsfromsaverstoinvestorsandareinvolvedinmaturitytransformation,thatistheyholdlong-termassetsfinancedbyshort-termdeposits.Amoral hazard 15 probleminthefundingmarketscreatesaspreadbetweenlendinganddepositrates.Specifically,asbankerscanchoosetodivertavailablefunds,theirliabilitiesareconstrainedbytheirequitycapital.Asaresult,movementsinfinancialintermediaries’balancesheetswillspreadtotherestoftheeconomyandamplifybusinesscycles.AsimilartransmissionmechanismisatworkinGertlerandKiyotaki(2010),wheredifferentfinancialintermediariesinteractintheinterbankmarketandaresubjecttoshocksthatcanleadtobank-runs.Inbothmodels,thedemandsideofcreditworksinafrictionlessmanner,thatisfirms’borrowingisnotrestrainedbycollateralconstraints.

Moralhazardproblemscouldbemulti-layered.Theycan,forexample,arisebetweendepositorsandbanks,butalsobetweenentrepreneursandfinancialintermediaries.MehandMoran(2010)buildonthedoublemoralhazardframeworkofHolmstromandTirole(1997).Intheirset-up,bankscanmoreefficientlychannelresourcesbetweeninvestorsandentrepreneursbymonitoringthequalityofdifferentinvestmentprojects.Atthesametime,toinducebankstoproperlymonitorandnotinvestinatooriskyloanportfolio,investorsrequirebankstoinvesttheirowncapital,thatistohavesomeskininthegame.Itfollowsthatbankcapitalpositionsinfluencethebusinesscyclethoughabankchanneltransmissionmechanism,thatistheeffectsofsupply-sidedisturbancesareamplifiedandpropagatetotherealsideoftheeconomy.

Borrowers’andfinancialintermediaries’balancesheetconditionsinteractwitheachother.InIacoviello(2015)andMendicinoetal.(2016),boththedemandandsupplysideofcreditareimpaired.InIacoviello(2015),householdandentrepreneurs’borrowingiscollateralizedbyrealestate,asinIacoviello(2005).Banksintermediatefundsbetweensaversandborrowersandaresubjecttoacapitaladequacyconstraint,thatistheirabilitytoraisefundsinthedepositmarketisconstrainedbytheamountofequitycapital.InMendicinoetal.(2016),thebankingsidefeaturestwokeydistortions.First,banksoperateunderlimitedliabilityanddepositsarepartiallyinsuredbythegovernment.Second,uninsuredbankdebtispricedaccordingtotheexpectedeconomy-widebankfailurerisk,therebycreatinganincentiveforbankstorelaxtheirlendingstandards.Onthedemandsideofcredit,bothhouseholdsandentrepreneurscandefaultontheircreditandthecostofexternalfundingistiedtotheirbalancesheetconditions,asinBernanke,GertlerandGilchrist(1999).

Finally,thedegreeofcompetitioninthebankingsectorcanalsoplayaroleformacroeconomicstability.InGeralietal.(2010),banksissuecollateralizedloanstobothhouseholdsandfirms,obtainfundingviadeposits,andaccumulatecapitaloutofretainedearnings.Financialintermediariesoperateinamarketwithimperfectcompetitionandcanadjustratesonlyinfrequently.Thismarketset-upcreatesinterestspreadswhichdependon

15 Moralhazarddescribesthosesituationsinwhichacontractcreatesaconflictofinterestsbetweenthepartiesinvolved.Forexample,aninsurancecontractcouldprompttheinsuredtotakeonmoreriskbecausesheisprotected.


thebanks’capital-to-assetsratioandthedegreeofinterestrate‘stickiness’.Households’,firms’andbanks’balancesheetconditionsmatterforhowdisturbancespropagateintheeconomy.Similarly,AndresandArce(2012),developaframeworkwhereinvestors’creditcapacityistiedtothevalueoftheirrealestateholdings.Lendingmarginsareoptimallysetbybanksinamarketwithimperfectcompetitionandhaveasignificanteffectonaggregatevariables.Theirfindingsshowthatinthelongrun,strongerbankingcompetitionincreasesoutputbyreallocatingtheavailablecollateraltowardsinvestors.Atthesametime,competitionincreasestheshort-runresponseofoutput,creditandhousingpricestodisturbances.

3 Macroprudentialtools:acostsandbenefitsanalysis

Thissectionevaluatestheeconomicimpactofseveralmacroprudentialmeasuresthroughthelensofdifferenttheoreticalmacroeconomicmodels.16Followingthestructureofsection2,westartbydiscussingmacroprudentialmeasuresthatmostlyaffectcreditdemand,althoughsomeofthesemeasureshaveimplicationsforcreditsupply,too.Wethenendthissectionbydiscussingbankcapitalregulationthatdirectlyaffectscreditsupply.

Manyofthereviewedpapersaddresstheproblemofexcessivehouseholdindebtednessthat,alongwithlowcapitalratiosofbanks,increasestheoverallleverageofthesystem.17 Asexplainedintheprevioussections,toohighleveragecanconsiderablyincreasemacroeconomicvolatility,therebymotivatingtheneedforregulations.Table1summarizesthemainquantitativefindingsofthediscussedpapers.Somepapersmentionedinthissectionprovidemainlyqualitativeinsightsandassuch,theyarenotconsideredinTable1.

Table 1. Quantitative findings of discussed papers.

Paper Findings

LTV regulation

Gelain,LansingandMendicino(2013)

LoweringLTVfrom0.7to0.5lowershousepricevolatilityby4percentandlowershouse-holddebtvolatilityby27percentunderrationalexpectations.Underadaptiveexpectations,itlowershousepricevolatilityby2percentandhouseholddebtvolatilityby18percent.Thevolatilityofconsumption,outputorinflationisnotaffected.

RubioandCarrasco-Gallego(2014)

IncreasingastaticLTVratioupto0.55iswelfareenhancingforborrowersandsavers.AboveLTVof0.55,increasingLTVfurtherdecreasesthewelfareofborrowersandincreasesthewelfareofsavers,leadingtoanoveralldecreaseinwelfare.AcountercyclicalLTVratioreactingtocreditgrowthincreasesthetotalwelfare.

MendicinoandPunzi(2014)

Coupledwithaninterestraterulereactingtocreditgrowth,acountercyclicalLTVrulereac-tingtohousepricesalmostdoubleswelfare,decreasingthevolatilityintheeconomy.

ChenandColumba(2016)

LoweringLTVfrom85to80percentleadstoashort-runreductioninconsumptionandoutput.Inthelong-run,debt-to-incomegoesdownby10percent,outputby0.5percentandhousepricesby0.2percent.StricterLTVrulesimprovewelfare,butonlymarginallysobelowthe60%limit.

Finocchiaro,Jonsson,NilssonandStrid(2016)

Areductionoftheloan-to-incomeratioby10percentinequilibriumrequiresloweringLTVfrom75to69.5percent(by7.22percent).Onaggregate,housingandgoodsconsumptiondonotchange.GDPgoesdownby0.4percent.

AlpandaandZubairy(2017)

StricterLTVregulationisaneffectivetool(second-best)inreducingthehouseholddebt-to-GDPratioattheexpenseofloweroutputandaggregateconsumptionintheshortrun.HigherlevelsofLTVinducemorevolatilityandarewelfare-detrimentalforpatienthouse-holds,whiletheyarepreferredbyimpatienthouseholds.TheoptimalregulatoryLTVratioisataround0.66.

16 SeeGuibourgandLagerwall(2015)foramoregeneraldiscussionofhowmacroprudentialmeasuresaffecttheeconomy.17 SeeEmanuelsson,MelanderandMolin(2015)foradiscussionofriskslinkedtoelevatedhouseholdindebtednessandSverigesRiksbank(2015)foradiscussionofpossiblemeasurestomanagefinancialrisksinthehouseholdsector.


Grodecka(2017) WhenborrowersareconstrainedbytheLTVconstraintonly,loweringLTVby5percentfrom85percentreducesequilibriumdebttoGDPby8percent,housepricesby2percentandoutputby−0.2percent.Intheshortrun,theeffectsarestronger.TakingintoaccountarealisticdistributionofborrowersacrossdifferentconstraintsinSweden,where60percentofborrowersareconstrainedbyLTV,loweringLTVlowersequi-libriumdebttoGDPby3.09percent,housepricesby3.17percentandincreasesoutputby0.09percentinthelongrun.

LTI/DSTI regulation

Gelain,LansingandMendicino(2013)

Iflendersuseanadditiveborrowingconstraint,putting75percentofweightonlaborincomeand25percentweightonthehousingcollateralvalue,thevolatilityofhousepricesincreasesby3percentandthevolatilityofhouseholddebtgoesdownby44percentunderrationalexpectations,whileitreducesthevolatilityofhousepricesby5percentandofhouseholddebtby49percentinthemodelwithhybridexpectations.Thevolatilityofconsumptionandoutputremainunchanged.


Areductionoftheloan-to-incomeratioby10percentinequilibriumrequiresloweringLTIfrom251to226percent(by25percentagepoints).Theaggregateconsumptiongoesdownby0.1percentandGDPby0.4.

Grodecka(2017) WhenborrowersareconstrainedbytheDSTIconstraintonly,loweringDSTIfrom25percentby5percentreducesequilibriumdebttoGDPby7percentandoutputby−0.4percent,withoutanegativeeffectonhouseprices.Intheshortrun,negativeoutputandhousepriceeffectsarereducedcomparedtoasimilarLTVexperiment.TakingintoaccountarealisticdistributionofborrowersacrossdifferentconstraintsinSweden,loweringDSTIlowersequilibriumdebttoGDPby3.09percent,housepricesby0.21percentandoutputby0.07percentinthelongrun.

Amortization regulation

Chambers,GarrigaandSchlagenhauf(2009b)

Mortgageproductswithflexibleamortizationschemescanincreasehomeownershipupto6p.p.,mostlyamongyoungandpoorpeople.Theiravailabilityalsoincreasesaveragehousesizeandresidentialinvestment.

ForlatiandLambertini(2012)

Inamodelwithtwo-periodmortgageloans,lowearlyamortizationleadstohigherleverage,outputandhousingpricesinequilibrium.Thedynamicresponsestoshocksareamplifiedinthatcase.


Increasingtheamortizationpacefrom50to45yearslowersoutputintheshortandinthelongrun.Long-runoutputisloweredby0.4percent,housepricesby0.5percentanddebt-to-incomeratiobyaround10percent.Welfareimpactofstricteramortizationregulationisnon-linear.


Areductionoftheloan-to-incomeratioby10percentinequilibriumrequiresacceleratingtheamortizationfrom50yearsto44.9years.TheaggregateconsumptiondoesnotchangeandGDPgoesdownby0.3.

Svensson(2016) Inamodelinwhichunconstrainedborrowersfollowtheiroptimalfuturemortgagepath,imposinga2percentamortizationrequirementovera10yearhorizonleadstoanincreaseininitialandaveragedebtfrom7.6to20percent,dependingontheinterestratespreadbetweenthesavingsandmortgagerateandtherefinancingpossibilitiesofborrowers.

Hull(2017) Stricteramortizationruleshavelittleimpactonreducingdebt-to-incomeratiosbecauseoptimizinghouseholdsrefinancetoremainontheirpreferredoptimizationpath.

Grodecka(2017) TakingintoaccountarealisticdistributionofborrowersacrossdifferentconstraintsinSweden,increasingtheamortizationpaceby5percentlowersdebttoGDPby4.2percent,outputby0.09percentandincreaseshousepricesby0.13percent.Intheshortrun,housepricesmayfallunderstricteramortizationrules.

Tax deductibility of mortgage interest rates

Gervais(2002) Abolishinginterestratetaxdeductionsorintroducingtaxationofimputedrentsforhomeownersiswelfareenhancingforallincomequintiles.Theabolitionoftaxdeductibilityofmortgageinterestpaymentsleadstoahomeownershipratethatis4.2percentagepointslower,lowerincometaxes(by2.2percentundertheassumptionofconstantgovernmentrevenues)andalmostunchangedoutput.Ifimputedrentsweretaxedatthesamelevelasbusinesscapitalincome,thehomeownershipratewouldbelowerby4.2percentagepoints,housingcapitalwoulddeclineby8.56percentandbusinesscapitalwouldriseby6.64percent.Incometaxratedecreasesby14percent.


Chambers,GarrigaandSchlagenhauf(2009a)

Abolishinginterestratetaxdeductibilityincreasesthehomeownershiprateby0.7p.p.,leadstoareductioninincometaxes(underaconstantgovernmentrevenue)andincreaseswelfareby1percent.Whenimputedrentsfromowningareequalizedwithtaxesonincomefromrentalunits,resourcesareredistributedfromhousingtobusinesscapital.Averageandmarginaltaxratesarereduced,increasingtheincomeandhomeownershiprate(by3p.p.).Welfareincreasesby3.3−3.7percent.

ChoandFrancis(2011)

Removingmortgageinterestdeductibilitydecreaseshomeownershipby0.07p.p.andincreaseswelfareby0.16percent.Applyingtheincometaxratetousuallyuntaxedimputedrents,leadstoafallinhomeownershipby34.73p.p.andwelfareincreasesofalmost10percent.Taxincentiveshavelittleimpactonwealthinequality.

Floetotto,KirkerandStroebel(2016)

Abolishinginterestratetaxdeductionslowershousepricesbyupto3percentintheshortrunandby1percentinthelongrun.Homeownershipratedropsby14.76p.p.(from72.27percent),and17.8percentofagentsareworseoffinthenewsteadystate.Taxingimputedrentsleadstoadropinhomeownershiprateby32.29percentagepoints,ashort-rundecreaseinhousingpricesby11percentanda4percentdecreaseinthelongrun.52.4percentofagentsareworse-offinthenewsteadystate.Transitionwelfarecostsarehigherthansteadystatewelfarecosts.


Loweringtaxdeductibilityofmortgageratesdecreaseswelfare.Loweringtaxdeductibilityfrom30to35percentdecreasesthedebt-to-incomeratiointhelongrunby2.2percent.Ifadditionalgovernmentrevenueisredistributedtohouseholds,thepolicychangecanhavenoeffectonoutput.


Alltheexperimentsrefertoapolicychangeloweringdebt-to-incomeby10percent.Ifgovernmenttransferstheadditionalrevenuetoborrowersandsaversinproportionoftheirsalary,taxdeductibilityhastobeloweredfrom30percentto2.8percent,leadingtoanincreaseofgoodsconsumptionby0.2percentandaGDPlowerby0.3percent.Ifthegovernmenttransfersadditionalrevenuesonlytoborrowers,taxreliefhastobeloweredto−6percent.Aggregateconsumptiongoesdownby0.1percentandGDPby0.6percent.Theadditionalrevenuecanbeusedtoboostpublicconsumption.Inthatcase,thegovern-menthastolowerthetaxdeductibilityto6.2percent.AggregateconsumptiongoesdownbutGDPincreasesby0.3percent.


Areductionofinterestratedeductibilityfrom100to70percentlowersthesteadystateoutputby0.22percentandborrowers’welfareby0.59percent,whilesaversgain0.22percentofwelfareandrenters0.33percent.Introducingataxonimputedrentof7.7percentleadstoafallinthesteadystateofoutputby0.26percent,welfarelossesforsavers(−0.17percent)andborrowers(−0.3percent)andwelfaregainsforrenters(+0.33percent).


Abolishingtaxdeductibilityofmortgageinterestratesiswelfareenhancing.Loweringthetaxdeductibilityofmortgageratesisthemosteffectivemeasureintermsofthereductionofhouseholdindebtednessperunitoflostoutput.

SommerandSullivan(2017)

Eliminatinginterestratedeductibilityincreaseshomeownershipfrom65to70percentandlowershousepricesby4.2percent.Mortgagedebtgoesdownby31percent.Welfareishigherby0.757percent.Inthetransitiontothenewsteadystate,58.4percentofagentsarebetter-offwithoutmortgagetaxdeductions.

Capital regulation

Gertler,KiyotakandQueralto(2012)

Introducingasubsidy(0.0061)perunitofoutsideequityfinancedwithataxontotalassets,whichtogetherhasaflavorofcountercyclicalcapitalrequirementforoutsideequity,leadstoincreaseinwelfareby0.285percent.

AngeloniandFaia(2013)

Regulatorycapitalratioslowerbankrisk,definedasbankrunprobability.Mildlycountercyclicalcapitalratiosdampenthebusinesscycle.

CorbaeandD’Erasmo(2014)

Increasingtherisk-weightedcapitalrequirementfrom4to6percentleadstoanincreaseininterestratesby50basispoints,and9percentdeclineinlendingandintermediatedoutput.Depositinsurancedecreasesby59percentduetoadecreaseinbankexits.


CovasandDriscoll(2014)

Introducingaliquidityrequirementlowersequilibriumloansupplyby3percent,whileincreasingbankholdingsofsafesecuritiesby6percent.Outputdeclinesby0.3percentandconsumptionby0.1.Whenrisk-basedcapitalrequirementsareincreasedfrom6to12percent,banksecuritiesholdingsincreaseby9percent.Loansupplydecreasesby1percent,outputandconsump-tionby0.1percent.

Clercetal.(2015) Thereisanoptimalrisk-basedcapitalratio:10.5percentforbusinessloansand5.25per-centformortgages.Highbankleverageamplifiesthebusinesscycles.Theeffectofcountercyclicalcapitalratiosisambiguous:mayamplifyordampenthebusi-nesscycle,dependingonthelevelofcapitalratio.


Increasingriskweightsonhouseholds’mortgagesfrom25%to30%lowershouseholddebtintheshortrunby0.5percentandaggregateconsumptionby0.05.Inthelong-run,thedebtlevelisalmostunchanged.Inthesteadystate,theDTIratioincreasesby0.5percent,aggregateconsumptionfallsby2percentandoutputby2.4percent.Increasingriskweightsonmortgagesiswelfareimproving,withdiminishingmarginaleffectaboveariskweightof40percent.

Begenau(2016) Thereisanoptimalrisk-basedcapitalratio:14percentforU.S.calibration.Higherriskratiosmayleadtomore,notlesslending,duetohouseholds’demandforliquidbanks’assetsanditsimpactonbankfundingcosts.Lowerbankleveragereducesoutputvolatility.

BegenauandLandvoigt(2017)

Thereisanoptimalcapitalratio:15%.Increaseincapitalrequirementsleadstoariseintheshadowbanking.Theaggregatebankingsystembecomessaferunderhighervaluesofcapitalratios.

BoissayandCollard(2016)

Theneedforregulationarisesduetoanagencyproblemonthemarketofinterbankloans.Introducingcapitalandliquidityrequirementsiswelfareenhancing.TheoptimalpolicymixforU.S.calibrationentailsaleverageratioof17.35%,aliquidityratioof12.5%andarisk-weightedcapitalrequirementof19.83%.

Davydiuk(2017) OptimalRamseypolicyrequiresacyclicalcapitalratio,mostlyintherangeof4to6percent.Itcanraiseabove6percentinperiodsofabnormaleconomicgrowth.

3.1 Loan-to-valueregulationLoan-to-value(LTV)regulationisaverypopularmacroprudentialtool,widelyappliedinadvancedandemergingeconomies(seeAkinciandOlmstead-Rumsey,2018).Themajorityoftheoreticalmacroeconomicstudiesevaluatingtheeffectivenessofloan-to-valueregulationfocusonthetime-dimensionofsystemicriskandoperateinanenvironmentwithlimitedheterogeneity.Inthisclassofmodels,agentsareusuallyclassifiedintworepresentativegroups:borrowersorsavers,and,assuch,thecross-sectionalaspectsofborrowinglimitsareoftenleftoutfromtheanalysis.Moreover,theexistingstudiesmostlyconcentrateonLTVregulationinthecontextofmortgageborrowing.Fromamicroprudentialperspective,LTVconstraintstypicallystemfrommoralhazardproblemsbetweenborrowersandlendersandaredesignedtosecurethelenders’payoffinthecaseoftheborrowers’default.Atthesametime,anLTVconstraintlinksdebttoassetpricesandcreatescollateralexternalitiestherebyimpactingonsystemicrisk,somethingthatcanbeaddressedbymacroprudentialinterventions.

LTVregulationcanaddressexternalitiesarisingbothonthesupplysideandonthedemandsideofcredit.Fromtheperspectiveoflenders,LTVlimitsimposequantityrestrictionsontheirassetallocation.Thismitigatesexternalitiesconnectedtostrategic interactionsthatcouldinducebankstoreducetheirlendingstandardsandtakelargeriskexposures.Fromtheperspectiveofborrowers,LTVconstraintsaddresstwomainexternalities:ademand externalityandpecuniary externalities.Householdstakingondebtdonottakeintoaccounthowtheirbehaviorimpactswealthdistributionintheeconomy,thedevelopmentofhousingprices,generaldebtlevel,andmorebroadly,output.Once


anegativeshockhitstheeconomy,foreclosurestendtoleadtofurtherhousepricefalls,generatingnegativefeedbackloops(seeFrame,2010).

Asidefromthecollateralfunction,LTVregulationcanbeseenasprotectionofhomeownersfinancingtheirhouseswithmortgages,giventhatitensuresaminimumequitystakeinthehome.Thisstakeactsasacushionagainstnegativehomeequity.AsMianandSufi(2014)explain,homeownershaveajuniorclaimonhomeandtakethefirstlosseswhenhousepricesstarttodecline,whicherodestheirequity.Moreover,ahousepricecollapsemayleadtodebtoverhangofhomeownerswhostarttoreducetheirconsumptiontomaintainthedebtservice,whichcreatesabignegativedemandeffectontheeconomysincetheirmarginalpropensitytoconsumeisusuallyhigherthanfortherestofthepopulation.Assuch,imposingLTVrequirements,asidefromsecuringlenders’payoffinthecaseofborrowers’default,protectsborrowersaswell,and,correctingforthedemandexternality,hasfar-reachingmacroeconomicimplications,beyondthedistributionoflossesbetweenthelendersandborrowers.HighLTV,meaninglowborrowers’equityinthehouse,mayalsolowerborrowers’incentivestohonortheirdebtobligations,thatisitmayincreasetheprobabilityofdefaultwhenhousepricesstarttofall,whichwillinturnnegativelyaffectbanks.Thusbyloweringtheleverageoftheeconomy,LTVlimitsstabilizebusinessfluctuations.However,toostrictLTVrequirementsmaybealsonegativefortheoutput18 or evenwelfare-detrimental,asdiscussedinthissection.

MostoftheexistingtheoreticalliteraturetacklingthisissuebuildsonIacoviello(2005).SincestricterLTVlimitsreduceborrowers’leverage,acommonfindinginthisstrandofliteratureisthatstricterLTVregulationiseffectiveinreducingmacroeconomicvolatility(Gelain,LansingandMendicino,2013;RubioandCarrasco-Gallego,2014andMendicinoandPunzi,2014)andhouseholdindebtedness(ChenandColumba,2016,Finocchiaroetal.,2016,AlpandaandZubairy,2017andGrodecka,2017).Thesebenefitscomeatthecostofloweroutput,aggregateconsumptionand,insomecases,borrowers’welfare(seeTable1fortheestimates).

LTVrequirementscanbeexplicitlydesignedtoaddresstheprocyclicalityofcreditflowsissue.RubioandCarrasco-Gallego(2014)examinewelfareimplicationsofdifferentstaticLTVlevels,alongwiththeeffectsofintroducingamacroprudentialTaylor-typerulethatreactstocreditgrowth.TheyfindthatacountercyclicalLTVrulethatrespondstochangesincreditiswelfare-enhancing.Inasimilarsetup,MendicinoandPunzi(2014)studywelfareimplicationsofcountercyclicalLTVrulesinatwo-countrymodelwheremonetarypolicymayrespondtohouseholdindebtednessorhouseprices.TheLTVpolicymaximizingsocialwelfaredependsontheassumedbehaviorofmonetarypolicymakers.LargestwelfaregainscomparedtostaticpoliciesareobtainedwhenLTVreactscountercyclicallytohouseprices,whileinterestratereactstocreditgrowth.

3.2 Loan-to-income/Debt-service-to-incomeregulationLoan-to-income(LTI)anddebt-service-to-income(DSTI)regulationsimposealimitonborrowingordebtserviceinrelationtodisposableincome,therebydirectlytargetingriskyborrowerswhomightalsoraisemacropudentialconcernsinthepresenceofpecuniaryanddemand externalities.19Onthesideofthelender,similarlytoLTVregulation,theselimitsaddressthestrategic interaction externality,preventinglendersfromloweringtheircreditstandards.Notably,DSTIlimits,bydirectlylinkinginterestrateexpensestodebt,enhancethetransmissionmechanismfrominterestratesintocreditgrowth,housepricesandaggregatedemand.LTIandDSTIlimitscancoexistandtheycomplementbothLTVcapsandcapital

18 Hereandinwhatfollows,wereferto‘outputcosts’intermsofGDPlevels;thepapersreviewedinthisarticlearesilentonthepotentialeffectsofdifferentpoliciesongrowthrates.19 SeeAlfelt,LagerwallandÖlcer(2015)fortheanalysisofLTIasapolicymeasure,withthefocusonSweden.


adequacyrequirements.Someofthereviewedpapersspecificallyaddresstheinteractionsbetweendifferentregulations(seeGreenwald,2016andGrodecka,2017).

LoweringLTIandDSTIlimitsreduceshouseholdindebtedness(Finocchiaro,etal.2016,Grodecka,2017)andlowersthevolatilityofhousepricesandcreditintheeconomy(Gelain,LansingandMendicino,2013).ThismayhowevercomeatthecostoflowerGDP.

WhiletheliteratureconsideringLTVrequirementsforborrowinghouseholdsisfairlyextensive,theoreticalmodelsincorporatingLTIorDSTIconstraintsaremuchrarer,despitetheirimportantroleinthelendingprocessinmanycountries(seeAkinciandOlmstead-Rumsey,2018).Someofthemacroeconomicpapersconsiderconstraintsappliedtoborrowersinseparatemodels,withoutstudyingtheircoexistenceandinteraction.AnexampleisFinocchiaroetal.(2016)whostudytheeffectsofmacroprudentialpoliciesseparatelyinamodelwhereborrowersaresubjecttoLTIconstraintsandinamodelwhereborrowersaresubjecttoLTVconstraints.TheyfindthatstricterLTIlimitsareeffectiveinloweringdebttoGDPatthecostofloweroutputandconsumption.

Moreresearchisneededontheinteractionofdifferentborrowingconstraintsthatareappliedtoborrowersbylenders.20AnearlyexampleofconsideringLTVandLTIlimitsinonegeneralequilibriummodelisthepaperbyGelain,LansingandMendicino(2013)whostudytheimpactofborrowingconstraintsonthevolatilityobservedintheeconomy.21 Inoneoftheirexperiments,theyaugmenttheirtypicalLTVborrowingconstraintwithaloan-to-incomepart,concludingthatsucharuleiseffectiveindecreasingthevolatilityofdebtintheeconomy.Tworecentpapersmoreexplicitlyaccountforthecoexistenceofdifferentborrowingconstraints(Greenwald,2016,Grodecka,2017),augmentingatypicalIacoviello(2005)stylecollateralconstraintwithapayment-to-income/debt-service-to-incomeconstraint.22Theyconcludethattheeffectivenessofloan-to-valueregulationasamacroprudentialtoolinsuchaframeworkislowered,becausenotallborrowersintheeconomyarealwaysboundbythisconstraint.DSTIlimitsseemtohaveabiggerimpactontheeconomyinthissetup.

3.3AmortizationregulationAmortizationrulesspecifytherepaymentofdebtprincipalinthecaseofalong-termdebtcontract.Assuch,theydirectlyaffectthespeedofdeleveraging.Theamortizationpaceimpactstheevolutionoftheloan-to-valueofagivencontract,andhence,itcanhandlesituationswherehouseholdsoverborrowinthepresenceof,forexample,pecuniary or demand externalitiesorbehavioralfactors.Amortizationregulationcanalsointroducelimitationsforlending,influencingbanks’assetsandtheircomposition,correctingthereforeforexternalitiesarisingduetostrategic interactions.

Traditionalmortgageamortizationschemesrequireagradualrepaymentoftheprincipleovertimeandtheseannuitymortgagesarethemostcommonformofamortizationarrangementsworldwide(foraninternationalcomparisonofmortgagetermsseethereportbyLea,2010).However,somecountriesallowformoreflexibleschemesunderwhichamortizationpaymentsvaryovertimeandmaybefrontloadedorbackloaded.IntheU.S.,beforethecrisisof2007–2008,someloancontractsevenallowednegativeamortization;insuchcontracts,themonthlydebtservicedidnotcoverinterestpayments,causingthe

20 Modelsintheoverlapping-generationsframeworkoftentakeintoaccountacoexistenceoftwoborrowinglimits.However,theirinteractionisrarelyafocusoftheanalysis.Moreover,someofthemoperateinapartialequilibriumcontext,excludingtheanalysisofgeneralequilibriumeffects.21 Theadditiveborrowingconstraint inGelain,LansingandMendicino(2013),putting75percentofweightonlabour incomeand25percentweightonthehousingcollateralvalue,turnsouttohavenoimpactonthevolatilityofconsumptionoroutput.Thedecreaseinthevolatilityofhouseholddebtisdrivenbythefactthatincludingtheincomeintheborrowingconstraintinducescountercyclicalityoftheloan-to-valueratioandstabilizesthedebt.22 WhileGreenwald(2016)focusesonaconstraint-switchingeffectduetowhichborrowersswitchbetweenbeingboundbyaDSTIorLTVconstraint,Grodecka(2017)studiestheinteractionoftwoconstraintsinamodelwithoccasionallybindingconstraints,includingsituationswhenborrowersareconstrainedbybothLTVandDSTIregulationatthesametime,orbyneitherofthem.


principaltoincrease.InSweden,butalsoforexampleDenmark,U.K.orAustralia,interest-onlymortgagecontractshavealsobeen/arepopular,inwhich,foracertainperiod,onlytheinterestonloansispaid.Theseamortizationschemes,inpractice,backloadtheprincipalpayment,whichmeansthatborrowers’homeequityisnotincreasingovertime.Thismayreducetheincentivesoftheborrowertohonorhisdebtobligation,asdiscussedintheLTVsection.Chambers,GarrigaandSchlagenhauf(2009b)showthatflexibleamortizationschemesenablebettermatchingofthelife-cycleprofilesofborrowers,potentiallyincreasingthepoolofborrowersandthushomeownership,mostlyamongyoungandpoorpeople.23

WhileLTVrulesmostlyapplyattheoriginationoftheloan,traditionalamortizationschemesensurethat,overthedurationoftheloancontract,theLTVofexistinghomeownersgoesdown.Thus,similarlytostricterLTVorLTIratios,stricteramortizationrulesreducetheleverageofthesystemand,accordingly,businesscyclefluctuations(ForlatiandLambertini,2012;ChenandColumba,2016,Finocchiaroetal.,2016andGrodecka,2017).Atthesametime,theymaynotcoincidewithsomeborrowers’optimalrepaymentpath,whichcaninducetheborrowerstotrytocircumventtheforcedamortization(Svensson,2016andHull,2017).24Thecostofstricteramortizationrulesmayalsoincludeloweroutput(ChenandColumba,2016;Finocchiaroetal.,2016andGrodecka,2017).BesidestheirinfluenceontheaverageLTVintheeconomy,amortizationrulesalsohaveadirectimpactonthebindingnessofDSTIconstraints,asstricteramortizationrulesincreasetheperiodicaldebtservice,whichmaybetoadisadvantageforcertaintypesofhouseholds.

3.4Housing-relatedtaxpolicymeasuresHousing-relatedtaxpolicymeasuresusuallyaimatpromotinghomeownership.However,asaby-product,throughthepreferentialtaxtreatmentofhomeowners,theyalsoincentivizehouseholdleverageandhenceinteractwithothermacroprudentialtoolsthataimataddressingoverborrowing.Amongallthemeasuresconsideredinthisarticle,theconclusionsofresearchontax-relatedmeasuresarethemostdisparate.Existingstudiesusuallyfocusontheimpactofthesepoliciesonhomeownershipratesandwelfare.Inwhatfollows,wefocusontheresearchthattacklestheissueofmortgageinterestratetaxdeductibilityandthetaxationofimputedrents.Inmostcountries,thereisnotaxdeductiononmortgageinterestpaymentsandimputedrentsarenottaxed(seeOECD,2017andAndrews,CalderaandJohansson,2011).However,mortgageinteresttaxdeductionsarerelativelymorepopularthantaxingimputedrentsandsomecountriesallowforthefulldeductionofinterestpaymentsfromtaxableincome.

Howwouldtheabolitionofinterestratedeductibilityimpactonhomeownershipandwelfare?AccordingtoGervais(2002),ChoandFrancis(2011)andFloetotto,KirkerandStroebel(2016),operatinginanoverlappinggenerationsframework(OLG),25suchapolicywouldreducethehomeownershiprate,butincreasewelfareintheeconomy.Taxdeductionslowertherevenueofthegovernmentwhichcouldbespentonloweringforexamplelabortaxesintheeconomy.Thus,itisnotobviouswhicheffectstheabolitionoftaxdeductionswouldhave.Infinitehorizonmodelsmostlyfocusonthecostsideofstrictertaxpolicies:ChenandColumba(2016)andFinocchiaroetal.(2016)showthatthesteadystateimpactofabolishinginterestratedeductionsdependsonhowthegovernmentdecidestospendtheadditionaltaxrevenue.ChenandColumba(2016)concludethatloweringmortgageinterest

23 However,thisflexibilitydoesnothaveobviousimplicationsforthevolatilityofborrowers’consumption,whoseeffectdependsonthelevelofinflationineconomy.24 Svensson(2016)showsthatunconstrainedhouseholdscanreacttoanamortizationrequirementbyincreasing,notdecreasingtheirdebt:theywillinitiallyborrowmorethanplanned,investthesuperfluousamountinasavingsaccountandusethewithdrawalsfromthisaccounttosatisfytheregulation.Onarelatednote,Hull(2017)showsthatintroducingstricteramortizationrequirementsinasetupwhereborrowershaveaccesstoconsumerloanslowerstheaggregatedebt-to-incomeratioonlyslightly.Thisisduetothefactthat,evenifanamortizationpathissuggestedbytheregulation,peoplecanstillrefinanceandusetheobtainedfundstonullifypreviousperiods’amortizationinordertofollowtheiroptimalamortizationpath.25 Inoverlappinggenerationmodels,agentsindifferentphasesoftheirlife,thatisyoungandold,interactwitheachother.


ratetaxdeductibilityreduceswelfare,AlpandaandZubairy(2016)andAlpandaandZubairy(2017)confirmthisconclusion,butonlyfortheborrowersintheeconomy.Anothersetofstudies,findsoppositeeffectsofhouse-relatedtaxincentivesonthehomeownershiprateinOLGset-ups.Chambers(2009a)findthateliminatingtheinterestratetaxdeductionleadstoasmall,butpositiveeffectonthehomeownershiprate.26ThewelfareeffectsfromabolishingtaxdeductibilityinChambers,GarrigaandSchlagenhauf(2009a)arepositive.SommerandSullivan(2017)secondtheseresults.

Theimpactofintroducingtaxationonimputedrents27ismostlyqualitativelysimilartotheeffectsoflowerinteresttaxdeductibility.Gervais(2002),andChoandFrancis(2011)concludethatintroducingtaxationofimputedrentshasstrongernegativeeffectsonhomeownershipratesthanabolishinginterestratetaxdeductibility.Floetotto,KirkerandStroebel(2016)confirmtheresultsforhomeownership,butincontrasttotheotherstudies,findthatintroducingataxonimputedrentsturnsouttobewelfaredetrimental.Chambers,GarrigaandSchlagenhauf(2009a)concludethatintroducingimputedrentstaxationcanincreasethehomeownershiprateandiswelfareimproving.AlpandaandZubairy(2016)showthatitismostlyrentersthatbenefitfromtaxingimputedrents,whilehomeownerssufferfromthispolicy.

Apartfromhomeownershipandwelfare,housing-relatedtaxationalsoinfluencesbusinessdecisionsoffirms.Ifhomeownershipispromoted,moreresourcesareallocatedtotheconstructionsector.Gervais(2002)andChambers,GarrigaandSchlagenhauf(2009a)findthatwhenthesetaxincentivesarelowered,resourcesareredistributedfromhousingtobusinesscapital.

Throughtheirimpactonhouseholdleverage,housing-relatedtaxescanalsoimpactthedebtlevelintheeconomy.Lowerlevelsofinterestratetaxdeductibilityareeffectiveinreducinghouseholddebt(ChenandColumba,2016,Finocchiaro,etal.,2016,AlpandaandZubairy,2017).Lowerhouseholdleveragemaycomeatacostofloweroutputintheeconomy,butthismostlydependsonhowthegovernmentspendstheadditionalrevenue,asdiscussedintheearlierpartofthissubsection.

Tosum-up,theconclusionsfromtheliteratureonhousing-relatedtaxpolicymeasuresvarygreatlyanddependtoalargeextentontheassumptionsregardinghouseholds’heterogeneity,OLGversusrepresentativeagents’frameworks,anddifferentaspectsoftherental market.

3.5CapitalregulationCapitalregulationdirectlyaffectsthesupplyofcreditintheeconomyanditiswidelyusedworldwide(seeKara,2016).Mostofthemacroeconomicmodelsstudyingcapitalregulationfocusonthetime-dimensionofsystemicriskandtheprocyclicalityofbanklending.Banksarehighlyleveraged,hencebothchangesontheassetsideoftheirbalancesheets(loandefaults,fallingpricesofcollateral)andontheliabilityside(rolloverproblems,bankrunsbydepositors)caneasilyleadtoadisruptioninbankactivitiesandbankdistressorevenbankruptcies.Theprocyclicalityoffinancialflowsisheightenedinthepresenceofexternalitiesdefinedinsection2.Whenbankshavecorrelatedportfolios(duetostrategic interactions),theywilllikelywanttoliquidatetheirportfoliosatthesametime,creatingthefiresalesproblemanddownwardpricingspirals(pecuniary externalities).Duetotheinterconnectedness ofbanks,problemsinoneinstitutioncanspreadtoothers,amplifyingtheinitialcrisis.Inthiscase,microprudentialregulationcomplementsmacroprudential

26 Thisisduetothefactthatdecliningdemandformortgagesandowner-occupiedhousingaftertheabolitionresultsinanincreaseofthedemandforrentalunits,whichraisestheirprice.Moreover,undertheassumptionofconstantgovernmentrevenue,incometaxesinthemodelwillbelowered,whichalltogetherhasaslightpositiveimpactonthehomeownershiprate.27 Imputedrentreferstotheimpliedincomethatahomeownermakesbecausehedoesnothavetopayrenttoalandlordcomparedtoarenterthathastopayrentalcosts.Insomecountries,theimputedrent,asarentthatthehomeownerpaystohimself,istaxed.


regulationandhelpstomitigatesystemicrisk(seeFreixas,LaevenandPeydró,2015).Ifeachindividualbankinginstitutionislessleveragedduetoindividuallyimposedcapitalrequirements,itislikelythatlessmacroprudentialregulationwillbeneeded.

Capitalrequirements,oftenconsideredfromtoday’sperspectiveasmacroprudentialtools,werefirstdesignedformicroprudentialpurposes,sincetheyensurethatbankshareholdersput‘skininthegame’,loweringtheincentivesforrisktakingonthesideofthebankersandincreasingpublicconfidenceinthebankingbusiness.Thishelpstoobtainfundsthatcanbechanneledtotheproductivesectorintheeconomy,whichinturnfostersgrowth(MehandMoran,2010).Inaneventofbankdistress,bankcapitalactsasabufferandpreventsproblemsinonefinancialinstitutionfromspreadingtotherestofthesystem.Intheabsenceofcapitalregulation,bankleveragecanbeabovethesociallyoptimallevelduetoexistingfrictions,suchaspreferentialtaxtreatmentofdebt,depositinsuranceorthecorporatestructureofbanksthatimplieslimitedliabilityofshareholders,whichallleadtoahighleverageofthebankingsector.Anappropriatecapitalregulationhastofindacompromisebetweenitsbenefits,thatisreducingbanks’failurerisk,loweringthecostsofrecessionsbymitigatingcapitalcrunchandfosteringoptimalallocationofcredit,anditscosts,thatiscurbingeconomicactivity.28

Whicharethechannelsthroughwhichcapitalregulationcancontributetofinancialstabilityandwhatarethecosts?Theexistingmacroeconomicliteratureprovidesmanyinsightsintothis.Capitalrequirementscanimprovebanks’solvencyprospects,makingbankrunsandliquidityproblemslesslikely.Highleverageandmaturitymismatchlieattheheartofthemodernbankingbusiness,whichmakesbanksvulnerabletorolloverrisk.29 The greatertheleverageofthebank,thegreaterthisrisk(AngeloniandFaia,2013).Thus,capitalregulationcanreducetheprobabilityofabankrun(AngeloniandFaia,2013andGertlerandKiyotaki,2015).30However,thisincreaseinfinancialstabilitycomesatacost,thatiscapitalrequirementscanlowerbankintermediation,andthusoutputandconsumptionintheeconomy(CorbaeandD’Erasmo,2014andChenandColumba,2016).Thisisoftentheresultofincreasedbankfundingcosts(ifequityismoreexpensivethandebtdue,forexample,totaxreasons).Theresultingsurgeinlendingspreadscurbslending(Almenbergetal.,2017).31 Giventhetrade-offbetweenhigherfinancialstabilityandlowercreditintermediation,someresearchersconcludethatthesocialwelfaregainsareahump-shapedfunctionofcapitalrequirements(Clercetal.,2015;ChenandColumba,2016;Begenau,2016andBoissayandCollard,2016).Thatis,aboveacertainlevelofcapitalregulation,thecostsinducedbyreducedcreditintermediationarehigherthanthebenefitsfrommakingthebankingsectormoreresilienttofailures.

Despitetheirbenefits,fixedcapital(andliquidity)requirementscanleadtoexcessivecreditcontractionincrisistimes,becausehighlyleveragedbanksreducetheirlendingtomeetregulatorylimits.Massivedeleveragingcanleadtocollateralfiresalesthatdriveassetpricesdownandputfurtherstrainonbanks’balancesheets.Fixedcapitalrequirementscanthusincreasethecyclicalityofbanklending.Insuchasituation,countercyclicaltoolsmaybewelfare-enhancing,astheymaycontributetothestabilizationoftheaggregateoutput.ThisisconfirmedbyGertler,KiyotakiandQueralto(2012),AngeloniandFaia(2013)andDavydiuk(2017).Clercetal.(2015)showinsteadthatcountercyclicalcapitalratiosaddstabilitytotheeconomyathighlevelsofcapitalrequirementsbut,atlowlevelsofcapitalrequirements,theyamplifythebusinesscycles.

28 SeeFreixas,LaevenandPeydró(2015)andAlmenbergetal.(2017).29 Rolloverriskistheriskassociatedwiththerefinancingofdebt.Inthecaseofbanks,thisriskreferstoasituationinwhichbanksneedtorenewtheirmaturingfunding,buttheycannotdosoduetoforexamplemarketfreeze.30 Liquidityrequirements(CovasandDriscoll,2014)anddepositinsurance(DiamondandDybvig,1983)areothertoolstoreduceproblemslinkedtomaturitymismatchandreducetheoccurrenceofbankruns.31 Inamodelinwhichhouseholdshaveapreferenceforholdingsafeandliquidassetsprovidedbythebanks,Begenau(2016)showsthatbankfundingcostsdonothavetogoupunderhighercapitalrequirements.


Asdiscussedintheintroduction,macroeconomicmodelsarewell-suitedtostudytheoverallbenefitsandcostsofbankingregulationduetotheirgeneralequilibriumfocusthattakesintoaccountfeedbacksbetweendifferentsectorsoftheeconomy.However,mostofthesemodelsarebuiltas‘closedsystems’,andcannotpredicttheconsequencesofcapitalregulationonfinancialinstitutionsoutsidetheradaroftheregulatoryauthorities,theso-called‘shadowbanking’sector.Specifically,highcapitalrequirementscouldcontributetothedevelopmentofashadowbankingsectorwhoseriskinessexceedstheriskinessofalow-regulatedbankingsector,contributingtofinancialinstability.However,thisdoesnotnecessarilyneedtohappen.BegenauandLandvoigt(2017)showthatraisingcapitalratiosfromthestatusquoindeedincreasesthesizeoftheshadowbankingsector,whichexpandsitsoperationsbyscalingup,butnotbyincreasingitsleverage.Hence,theirstudyconcludesthatdespitetheriseintheshadowbankingactivity,theaggregatebankingsystembecomessafer.32Moremacroeconomicresearchonthesepossible‘unintended’consequencesofbankingregulationisneeded,aswellasontheinteractionofdifferentregulations.33 Countercyclicalcapitalbufferstrytoreducethetensionbetweenmicroandmacroregulation,thatistomaintaintherisksensitivityoftherequirementfordifferentfinancialinstitutionsand,atthesametime,mitigatethecyclicalityoftheregulation.Modelswithmanyheterogeneousbanksareparticularlywellsuitedtotacklethisissue(seeCorbaeD’Erasmo,2014,BoissayandCollard,2016andGrodecka,2016).

4 ConclusionsThemultifoldaimofthisarticlewastoi)increaseourunderstandingofthefinancialsectoranditsimportancefortherealeconomy,ii)reviewthemostrecentattemptsintheliteraturetoincorporatefinancialfrictionsinotherwisestandardmacromodelsandiii)evaluateboththecosts(forgonelendingandeconomicactivity)andthebenefits(amoreresilientfinancialsystem)ofmacroprudentialregulation.Systemicrisk,theprimarytargetofmacroprudentialpolicy,mayarisefromdifferentsourcesofmarketfailures.Wehavearguedthatidentifyingtheexactsourceofmarketfailureiskeytodesigningtheappropriateinstrumenttoaddressit.

Whiletraditionalmicroprudentialregulationhasalongtraditionineconomicpolicy,macroprudentialpolicyisstillinitsinfancy(GalatiandMoessner(2017).Thisposesaseriesofchallengesthatremaintobeaddressedbytheexistingeconomicliterature.

Importantly,differentpolicymeasurescoexistandinteractwitheachother.BoissayandCollard(2016),Greenwald(2016)andGrodecka(2017)attempttospecificallytakethisinteractionintoaccountinamacroeconomicframework.Furthermore,toorestrictivemeasurescouldcreateincentivesforeconomicagentstocircumventregulation,therebycreatingunintendedside-effectsofregulation.Thedevelopmentofalternativefinancingchannels,suchastheshadowbankingsystem(seeBegenauandLandvoigt,2017)orasurgeinunsecuredcreditinresponsetotoostrictLTVorLTIrequirementsexemplifiesthisproblem.Finally,acomprehensiveaccountofthebenefitsoffinancialregulationshouldexplicitlyconsidertheinteractionbetweenpolicyandtheoccurrencesoffinancialcrisis.Inmostoftheexistingliterature,whichoperatesinalinearframework,financialcrisesaretheresultsofbigexogenous‘financialshocks’.Someresearchers(Mendoza,2016)arguethat,asaresult,linearset-upsareill-suitedtocapturethetransitionfromregulartimestotimesoffinancialdistressand,therefore,thebenefitsofeffectivefinancialregulation.Furthermore,linearset-upscannothandletheimpactofriskonportfoliodecisionsofmarketparticipants

32 Thishappensbecause,contrarytothecommercialbankingsector,thereisnodepositinsuranceintheshadowbankingsectorandshadowbanksincorporatethis‘bankrun’probabilitywhilechoosingtheirleverage.Moreover,highercapitalrequirementslowerthefundingcostsofbanks,whichmakesthemmoreprofitable.33 Thefinanceliteraturehasstudiedtheinteractionsbetweendifferentformsofbankingregulation,seeforexampleKashyap,TsomocosandVardoulakis(2014),Walther(2016)orMankart,MichaelidesandPagratis(2017),buttheseaspectsofregulationhavenotbeencoveredextensivelybythemacroeconomicliterature.


(CovasandDriscoll,2014;BegenauandLandvoigt,2017andLaséen,PescatoriandTurunen,2017arenotableexceptions).Nevertheless,non-linearitiesbearclearcomputationalcoststhatneedtobetakenintoaccountwhenevaluatingthepotentialuseofsuchmodelsinpolicyanalysis.

ThedecadeaftertheunfoldingoftheworstfinancialcrisisaftertheGreatDepressionhasbroughtaboutagoldenageinmacro-financeresearch.Whiletremendousprogresshasbeenmade,theroadaheadisstillfullofchallengesandopportunitiesinthedirectionofi)deepeningourunderstandingofmacrofinanciallinkagesandii)buildingtherightpolicytoolkitforfinancialregulators.


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Financial frictions, financial regulation and their impact ... · microprudential regulation, that promote financial stability. Macroprudential policy is one such tool. It fosters