1/18

More pluralism, more stability?1

Presentation by Claudio Borio

Head of the BIS Monetary and Economic Department

Seventh high-level SNB-IMF conference on the international monetary system

Zurich, 10 May 2016

I would like to thank the organisers for the kind invitation to speak at this prestigious conference. I am delighted and honoured to be in such distinguished company.

The question I would like to address today is whether a more pluralistic international monetary system – one with more international currencies on a more equal footing – would enhance global monetary, financial and macroeconomic stability.

This is a perennial question. It was, for instance, just as prominent under the Bretton Woods system as under the arrangements that have followed – which some regard as a “non-system” (eg Padoa-Schioppa and Saccomanni (1994)). And it presupposes the answer to another, more fundamental, question: what is the Achilles heel of the international monetary and financial system (IMFS)?

Note that I am choosing my words carefully. For, the “financial” dimension is just as important as the “monetary” one, although the shorthand “international monetary system” is much more common. This tendency perhaps harks back to post-war arrangements in which, for quite some time, finance played a subordinated role owing to constraints on capital flows and foreign exchange transactions. As we all know, that world is long gone.

There are three takeaways from my presentation.

First, there is no doubt that the dominance of one currency creates challenges for the IMFS. Fundamentally, the domestic interests of the country of issue need not coincide with those of the system as a whole.

Second, it is less clear, though, whether a more pluralist system, even if it was achieved, could help address the IMFS’s main weakness. To my mind, that weakness is its inability to prevent the build-up and unwinding of hugely damaging financial imbalances, or outsize financial cycles, thereby amplifying weaknesses in national arrangements (Borio (2014a)). This is what, with a colleague, Piti Disyatat, we have termed its “excess (financial) elasticity” (Borio and Disyatat (2011)). Think of an elastic band that you can stretch out further and further but that, as a result, snaps back more violently.

Third, addressing this weakness would require stronger anchors at national and international level. Some progress has been made, especially at national level. But much more needs to be done.

In what follows, I will first recall some basic facts to illustrate the US dollar’s dominance in the IMFS. Here I will consider the dollar’s three familiar roles, as a means of payment, a store of value and a unit of account. I will then explore the possible problems that this can create and put forward three propositions. I will finally turn to possible solutions and make three observations.

1 I would like to thank Bob McCauley, in particular, for help in the preparation of these remarks.

Banking Regulation, Market Liquidity, and theMacroeconomy

Frederic Boissay (BIS), Fabrice Collard (TSE), Ulf Lewrick (BIS)

BIS Research Network Meeting — Basel, 28 September 2018

The views expressed in this presentation are our own and do not necessarily reflect those of the BIS. 1/25

Backdrop / Motivation (I)

US Non–Financial Corporations’ fundingDebt securities–to–loan ratio

.5

1

1.5

2

2.5

1957

1967

1977

1987

1997

2007

2017

Source: US Financial Accounts

• In the US, banks play a crucial rolein corporate bond markets: 95% oftrading volume is intermediated bybanks

• For US NFCs, market funding hasrecently become twice as large asbank funding

2/25

Backdrop / Motivation (II)

• On the one hand, regulatory reforms make banks’ traditional activities (risk, liquidity,maturity transformation) more efficient/resilient

• On the other hand, some reforms (like the leverage ratio) may have unintended adverseconsequences on banks’ market–making activities, and corporate bond markets

• By forcing banks to fund all assets, regardless of their underlying risk and purpose, with aminimum of —costly— equity, the leverage ratio may discourage banks from holding bondsfor market–making purposes, reduce market liquidity, and raise firms’ cost of funding

• Greenwood, Hanson, Stein, Sunderam (2017): “the Supplementary Leverage Ratio is (...) discouraging some banksfrom investing in the safest assets (...). We would urge that the SLR be dialed back (...)”

• FT (24 Sept 2018): “Regulatory changes have made it more expensive for banks to hold large inventories of bonds,which has hindered their role as liquidity providers in fixed income markets”

3/25

Question of the paper

• Does leverage ratio regulation hinder the functioning of bond markets?• Does it push up bid–ask spreads? Does it reduce trading volumes?

• Taking these effects into account, what is the net impact of banking regulation on theeconomy and welfare?

• Study these questions through the lens of a [dynamic] general equilibrium model• Novelty: the dual role of banks as both lenders and market–makers

4/25

Main Takeaways

• Regulation has a varied impact on measures of corporate bond market liquidity→ It raises the bid–ask spread→ But it also raises the volume of trades

• The regulator accepts a higher bid–ask spread, to improve banks’ funding liquidity and theefficiency of financial intermediation

→ The impact on market liquidity is not necessarily an unintended consequence

• Exempting bonds from the leverage ratio would only marginally reduce the bid–ask spreadand have no effect on the real economy and welfare after re–calibration

5/25

Macro–model: real flows between agents

BanksHouseholdsat

Firmet , dt `t

bht

bbt

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

bbt

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

Frictions on the interbank market → Regulatory leverage constraint: etdt +et

≥ τ

at : Savings; et : Equity; dt : Deposits; bt : Bonds; `t : Loans

6/25

Macro–model: real flows between agents

BanksHouseholdsat

Firmet , dt `t

bht bb

t

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

bbt

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

Frictions on the interbank market → Regulatory leverage constraint: etdt +et

≥ τ

at : Savings; et : Equity; dt : Deposits; bt : Bonds; `t : Loans

6/25

Macro–model: real flows between agents

BanksHouseholdsat

Firmet , dt `t

bht

bbt

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

bbt

Frictions on the secondary bond market → Bond inventory constraint: bbt ≥ (1 + κ)bh

t

Frictions on the interbank market → Regulatory leverage constraint: etdt +et

≥ τ

at : Savings; et : Equity; dt : Deposits; bt : Bonds; `t : Loans

6/25

Households’ “preferred habitat”

• A continuum of households incur idiosyncratic financial transaction costs

• Household “(qd , qe , qbh )” earns net returns qd rdt , qer e

t and qbh rbh

t on deposits, equity, andbonds, and invests in the asset with the highest net return ≈ “preferred habitat”

max{at+1,ct}t=0,...,∞

Eq

[Et

( ∞∑i=0

βτ max{1j

t+1+i}j∈{bh,d,e}

u(ct+i ))]

s.t. : ct + at+1 = rtat + πt with rt ≡ Qdt rd

tdtat

+ Qbh

t rbh

tbh

tat

+ Qet r e

tetat

• For a household, it is costly to move away from its preferred habitat

7/25

Banks arbitrage between loans and bonds

• Banks maximize profits by choosing ex ante whether they invest in loans (`t) or bonds (bbt )

• Once banks have lent to the firm, they learn their idiosyncratic “loan servicing cost”• Bank q` gets unit return q`r `

t , with q` ∈ [0, 1]• High–q` banks purchase loans from low–q` banks on an “interbank” market, against claims

that promise return r it → the minimum return of a loan is r i

t

• There is a threshold q`t = r i

tr`t

, above (below) which banks borrow (lend) from (to) other banks

• Banks face a bond portfolio management cost and get unit return Qbb rbt on bonds

• If r it > Qbb rb

t , then banks prefer to invest in loans, rather than in bonds

8/25

Frictions on the secondary bond market

• Banks sell bonds to households, but must hold an inventory of κ per intermediated bond

• They charge households a fee ωt for making the bond market (“bid–ask” spread):

ωt = κ

Opportunity cost of holding bonds︷ ︸︸ ︷Et−1

(Ψt−1,t(1 + ∆t)

(r it −Qbb

rbt

))Et−1

(Ψt−1,t(1 + ∆t)rb

t)

9/25

Frictions on the interbank market

• Frictions hinder ex post reallocation of corporate loans from low–q` to high–q` banks• The loan servicing cost q` is private information• Banks can terminate loans early, get private benefits ζ, and abscond/default

• High–q` banks have to limit their borrowing to φt :

φt = `tζ

r it − rd

t1− et

dt +et

1− bbt

dt +et

+ ...

10/25

Pecuniary externality and regulation

• Pecuniary externality: More capital ( etdt +et

) raises the borrowing limit (φt), which raises theequilibrium interbank rate (r i

t ), improves lending efficiency (q`t ), raises the borrowing limit,...

• As price takers, banks do not internalise these effects and have too little capital ex ante

→ Regulation requires banks to hold a minimum level of capital: etdt +et

≥ τ ⇔ et`t +bb

t≥ τ

11/25

Key mechanism 1: the regulator’s trade–off

• A regulator sets τ? to maximize welfare, i.e. to minimize aggregate transaction costs:

Banks’ transaction costs︷ ︸︸ ︷(1−Q`t )r `t `t︸ ︷︷ ︸

Loans

+ (1−Qbb)rb

t (bbt − bh

t )︸ ︷︷ ︸Bonds

+

Households’ transaction costs︷ ︸︸ ︷(1−Qd

t )rdt dt︸ ︷︷ ︸

Deposits

+ (1−Qbh

t )rbh

t bht︸ ︷︷ ︸

Bonds

+ (1−Qet )r e

t et︸ ︷︷ ︸Equity

• Lower costs for banks are balanced against higher costs for households

• Savers bear the cost of regulation (not firms or banks)

12/25

Key mechanism 2: general equilibrium effects of capital regulation

Firms

↑ kt

↓ `t

↑ bt

Banks

↓ `t

↑ bbt − bh

t

↑ et

↓ dt

Households

↑ et

↓ dt

↑ bht

↑ at

→ Leverage regulation induces households to demand more bonds, which lowers the equilibrium bond yield

13/25

Key mechanism 3: banking regulation and market liquidity

Bid

–ask

spre

ad,ω

t

Volume of market–making servicesbh

t bh′

t

A

B C

D

Partial equilibrium effect General equilibrium effect

14/25

Regulation: bank–based versus market–based intermediation

Bank–based intermediation:Corporate loans Lending efficiency Interbank loans

0.075 0.080 0.085 0.090 0.095 0.100τ

1.92

1.94

1.96

1.98

2.00

`

0.075 0.080 0.085 0.090 0.095 0.100τ

0.978

0.980

0.982

0.984

0.986

q`

0.075 0.080 0.085 0.090 0.095 0.100τ

0.6

0.7

0.8

0.9

1.0

1.1

φ/(d + e)

Market–based intermediation:Bond issuance Bid-ask spread Firms’ unit cost of funding

0.075 0.080 0.085 0.090 0.095 0.100τ

2.62

2.64

2.66

2.68

2.70bb

0.075 0.080 0.085 0.090 0.095 0.100τ

1.000

1.005

1.010

1.015

1.020

1.025pe

rcen

ts

ω

0.075 0.080 0.085 0.090 0.095 0.100τ

4.265

4.270

4.275

4.280

4.285

4.290

4.295

perc

ents

rb

15/25

Optimal leverage ratio

Banks’ versus households’ transaction costsBanks Households Aggregate

0.075 0.080 0.085 0.090 0.095 0.100τ

0.0028

0.0030

0.0032

0.0034

0.0036

0.0038

0.0040

0.0042

χ`/a

0.075 0.080 0.085 0.090 0.095 0.100τ

0.0250

0.0252

0.0254

0.0256

0.0258

0.0260

0.0262

0.0264

χa/a

0.075 0.080 0.085 0.090 0.095 0.100τ

0.03525

0.03530

0.03535

0.03540

0.03545

0.03550

0.03555

χ/a

Welfare

0.075 0.080 0.085 0.090 0.095 0.100τ

−24.48

−24.46

−24.44

−24.42

−24.40

−24.38

−24.36

16/25

Narrow versus comprehensive leverage regulation

• Should the regulator exempt bonds (and re–calibrate)?

• et`t≥ θ (“Narrow”) versus et

`t +bbt≥ τ (“Comprehensive”)

Leverage ratio Bid-ask spread Firms’ funding cost

0.075 0.080 0.085 0.090 0.095 0.100τ ,θ

0.0825

0.0850

0.0875

0.0900

0.0925

0.0950

0.0975

0.1000e/(d + e)

0.075 0.080 0.085 0.090 0.095 0.100τ ,θ

1.000

1.005

1.010

1.015

1.020

1.025

perc

ents

ω

0.075 0.080 0.085 0.090 0.095 0.100τ ,θ

4.265

4.270

4.275

4.280

4.285

4.290

4.295

perc

ents

rb

Narrow leverage regulation, Leverage regulation, ?/? Optimal requirements,•/• non regulated equilibrium.

17/25

Additional takeaways

• Market liquidity is part of the regulatory trade–off

• The cost of regulation is borne by savers, and regulation has distributional effects amongthem (e.g. depositors versus bondholders versus shareholders)

• Calibrated general equilibrium effects of regulation are material

• Dynamics [TBC]

18/25

19/25

Timeline A AppendixA.1 Timeline

Figure 13: Shocks and Decisions in Period t

End of period t− 1 Beginning of period t End of period t Beginning of period t+ 1

yt−1ct−1at

←N

ewfir

ms

and

bank

sar

ebo

rn

qbh

qd

qe

rdtdtetbbtbhtbt`tktstωt

←Su

perv

ision

εztεζt q`

φtritr`tretrbtrt

ytctat+1

←N

ewfir

ms

and

bank

sar

ebo

rn

qbh

qd

qe

rdt+1dt+1et+1bbt+1bht+1bt+1`t+1kt+1st+1ωt+1

←Su

perv

ision

εzt+1εζt+1 q`

φt+1rit+1r`t+1ret+1rbt+1rt+1

Agents’ decisions / market clearing Idiosyncratic shocks Aggregate shocks

28

20/25

Firms arbitrage between bonds and loans

• Firms finance their production with bonds and loans, and maximize their expected profit

maxkt ,bt ,`t

Et−1(Ψt−1,t

(ztkαt + (1− δ)kt − r `t `t − rb

t bt))

kt = `t + bt

rbt = r `tr `t = αztkα−1

t + 1− δ

21/25

Banks’ maximisation problem

• Banks choose deposits and bond holdings to maximise their expected return on equity:

maxdt ,bb

t

Et−1

(Ψt−1,t

[r it `t +

(1− µ

(q`t)) (

Q`t r `t − r it)

(`t +φt)+Qbbrbt(bb

t − bht)

+ωtrbt bh

t −rdt dt

])

s.t. : `t = dt + et − bbt and bb

t ≥ (1 + κ)bht and et ≥ τ(`t + bb

t )

⇒ ωt = κ

Opportunity cost of bonds versus loans︷ ︸︸ ︷Et−1

(Ψt−1,t(1 + ∆t)

(r it −Qbb

rbt

))Et−1

(Ψt−1,t(1 + ∆t)rb

t)

22/25

Calibration

TargetsTable 1: Financial Targets

Target Values Data sourcesrb 1.0428 Federal Reserve Bank of Saint Louis FRED database;

Moody’s seasoned Baa corporate bond yield c©; BAAri 1.0194 Federal Reserve Bank of Saint Louis FRED database;

Federal funds effective rate; RIFSPFF N.Ab/` 1.3019 US Financial Accounts; Firms;

Bond–to–loan ratio; FL104122005.A/FL104123005.Ae/(d+ e) 0.0814 US Financial Accounts; Depository institutions;

Leverage ratio; (FL704194005.A-FL704190005.A)/FL704194005.A(bb − st)/(d+ e) 0.0386 US Financial Accounts; Depository institutions;

Liquidity ratio; FL703063005.A/FL704194005.Aω 0.0100 Adrian et al. (2017)

Bid–ask spread on corporate bondsχi/(d+ e) 0.0230 FDIC Tables CB07 and CB09; banks’ total non–interest expenses to total assetsχa/a 0.0250 Foerster et al. (2017); Households;

Asset–management–expenses–to–total–asset ratio

Λ 0 The shadow cost of the leverage ratio rule is zero

We calibrate the model on annual US data for the years from 1988 to 2003. The sample thuspre-dates the run-up to the systemic banking crisis of 2007–09 and the associated build-up of bankleverage which, with the benefit of hindsight, proved unsustainable (Adrian and Shin (2010)). USbanks were subject to a variety of regulatory constraints during that period. Our focus is on capital“guidelines” and subsequent revisions issued in the early 80s by the US regulatory authorities. Thoseguidelines, among other requirements, established minimum leverage ratio requirements based onthe ratio of a narrowly defined measure of capital and the bank’s total assets. This ratio talliesclosely with the stylised leverage ratio requirement, τ , in our model. Minimum requirements differedfor different types of banks, but were broadly in a range of 5.5% to 7% (see Wall (1989)). Thiscompares with an average leverage ratio of 8.14% (see Table 1) for the period of observation. Onaverage, leverage ratio requirements were thus not strictly binding for banks. Nevertheless theyare likely to have constrained the banks’ risk-taking and leverage since banks generally maintain acapital buffer above the minimum requirements to avoid supervisory intervention.11

Against this background, we assume that the regulatory constraint (16)) binds in the steadystate, but at the same time also assume that the shadow cost of the constraint is negligible, i.e.Λt = 0 in the steady state. In other words, we calibrate the model so that, in the steady state,the privately optimal capitalisation level coincides with the regulatory minimum, τ = 8.14%. Thisprovides a useful steady state benchmark.

11Indeed, minimum requirements do not reflect supervisors’ – explicit or implicit – expectation that banks exceedthose requirements, in order for them to be considered well-capitalised.

15

Parameters

Overall, we need to calibrate eight additional financial parameters (see Table 2). These parameters(and the leverage ratio) are jointly calibrated so that, in steady state, the model matches the financialratios and interest rates listed in Table 1.12

We target the main interest rates of the model, the structure of firms’ liabilities, households’expense ratio, and banks’ expense and leverage ratios. Households’ expense ratio is based onCanadian data taken from Foerster et al. (2017), since, to our knowledge, this ratio is not availablefor the US. Banks’ total non–interest expenses–to–total–assets ratio is calculated using FDIC dataover the 1988–2003 sample period. On this basis, we obtain ζ = 5.45% for the private benefit fromearly liquidation; κ = 3.18% for the parameter of the inventory constraint; and Qbb = 66.33% forthe parameter of banks’ bond management cost. The other financial parameters govern households’transaction costs, which, in turn, determine their preferred–habitat. We find that most householdsprefer deposits to holding corporate bonds, while preferring bonds to bank equity.13 Table 2summarizes the outcome of the calibration.

Table 2: Calibration

Parameter ValueIntertemporal Elast. of Subst. σc 4.5000Capital elasticity α 0.3000Capital depreciation rate δ 0.0600Exogenous TFP z 1.0000Regulatory leverage ratio τ 0.0814Private benefit ζ 0.0545Bond inventory κ 0.0318Distribution – µ(q`) λ` 44.0351Distribution – µd(qd) λd 25.7263Distribution – µe(qe) λe 0.2324Distribution – µbh(qbh) λbh 20.3558Bond management cost Qbb 0.6633Discount factor β 0.9926

4 Effects of Banking Regulation

This section studies the effects of banking regulation on banks, the corporate bond market, andhouseholds at the steady state of the economy. Our focus is on the effects of a marginal increase inτ above 8.14%.14

12All rates are deflated with the CPI (source; FRED, series CPALTT01USA659N).13That is, λd > λbh > λe. With the form of the cumulative distributions in (33), those parameters are also indicative

of the degree of substitution between various assets. Thus, our calibration indicates that bonds are a closer substituteto deposits than bank equity, i.e. λd − λbh < λd − λe.

14We derive the optimal regulation later, in Section 5.

16

23/25

Regulation: households’ portfolio re–balancing and returns on assets

Portfolio re-balancing:Deposits Bonds Equity

0.075 0.080 0.085 0.090 0.095 0.100τ

0.390

0.395

0.400

0.405

0.410

0.415

d/a

0.075 0.080 0.085 0.090 0.095 0.100τ

0.5475

0.5500

0.5525

0.5550

0.5575

0.5600

0.5625

0.5650

0.5675bh/a

0.075 0.080 0.085 0.090 0.095 0.100τ

0.037

0.038

0.039

0.040

0.041

0.042

0.043

e/a

Returns on assets:Deposits Bonds Equity

0.075 0.080 0.085 0.090 0.095 0.100τ

1.65

1.70

1.75

1.80

1.85

1.90

1.95

perc

ents

rd

0.075 0.080 0.085 0.090 0.095 0.100τ

3.205

3.210

3.215

3.220

3.225

3.230

3.235

perc

ents

rbh

0.075 0.080 0.085 0.090 0.095 0.100τ

18.0

18.5

19.0

19.5

20.0

20.5

21.0

perc

ents

re

24/25

Funding Liquidity, Market Liquidity, and Optimal Regulation

Exogenous variation in market liquidity (variation in κ)Bid-ask spread Banks’ borrowing limit

0.000 0.025 0.050 0.075 0.100 0.125 0.150 0.175 0.200κ

0

1

2

3

4

5

6

perc

ents

ω

0.000 0.025 0.050 0.075 0.100 0.125 0.150 0.175 0.200κ

0.35

0.40

0.45

0.50

0.55

0.60

φ/(d + e)

Exogenous variation in funding liquidity (variation in ζ)Bid-ask spread Banks’ borrowing limit

0.02 0.04 0.06 0.08 0.10ζ

0.96

0.98

1.00

1.02

1.04

perc

ents

ω

0.02 0.04 0.06 0.08 0.10ζ

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

φ/(d + e)

25/25