Monetary Policy and Cross-Border Interbank Market Fragmentation: Lessons from the Crisis

2.1 Households

The household sector is made up of a mass λ ∈ [0,  1] of patient households with discount factor β and (1−λ) of impatient households with discount factor β ^B  < β. The patient households are referred to as the savers and the impatient households as the borrowers.

2.2 Firms

We introduce nominal rigidities in the price of consumption goods following Calvo (1983). To this end, we assume there are two types of firms in the model economy: intermediate goods firms that are price takers in perfect competition, and final goods firms that operate under monopolistic competition. There is ‘price-stickiness’ introduced in the latter sector as only a fixed proportion of firms is able to update prices each period.

2.3 Financial Intermediation

There are two types of banks: savings banks that take deposits from domestic households and lend in the currency union-wide interbank market and lending banks that provide loans to both domestic firms and households and finance these using interbank borrowing and their own net worth. A financial friction emerges due to idiosyncratic loan return shocks faced by lending banks. Costly state verification leads to an external finance premium as in Bernanke, Gertler, and Gilchrist (1999). In addition, in light of the empirical evidence that borrower banks often have to pay a premium that reflects not borrower but country-specific risks when accessing the international interbank market (cf. Section 1), we add a further friction whereby cross-border interbank credit faces additional monitoring costs that depend on the prevailing risk in the lending market.

Savings banks operate under perfect competition with free entry, but aggregate shocks can lead to unexpected profits or losses. The banks are owned by the patient households who are paid all bank profits, or recapitalize banks if and when necessary. Lending banks face idiosyncratic shocks when extending credit to the real economy that are costly for creditors to observe. Limited liability implies that these banks earn profits in equilibrium. Lending banks are treated slightly differently to savings banks in that they pay a fixed dividend rate to ensure they cannot become fully self-funded, equivalent to the assumption of an exogenous exit rate or higher banker discounting (see e.g., Bernanke, Gertler, and Gilchrist 1999; Gertler and Kiyotaki 2010). The friction implies that equity is always more valuable than debt, without which banks would not pay dividends in equilibrium. Another difference is that savings banks can access central bank credit whereas lending banks cannot. This is in part motivated by the risk exposure and specialization of lending banks; savings banks are well diversified and the central bank requires a proportion of safe assets as collateral.

2.4 Monetary Policy

The monetary authority sets the nominal short-term interest rate in response to deviations of the consumer price inflation rate from the union-wide inflation target Π ‾ E M U and off-trend output growth

with weights φ π and φ y attached to inflation and output growth respectively. There is inertia in the rule governed by φ r . The union-wide variables Π t E M U and Y t E M U are weighted averages of the home and foreign country variables:

With a single policy rate, the economy as presented to this point features a unit root stemming from a single savings rate across both economies. As savers in both countries face the same return on assets, long-run effects from transitory shocks would prevail. For instance, if one of the economies were to draw a positive supply shock, its net foreign asset position would improve and the economy will have a current account surplus that would persist in the long run, with a permanent increase in the wealth of savers. To restore the stationary property of the model, we assume, consistent with past modeling practice in open-economy models, that the central bank applies a small premium on the refinancing rate that depends on the net foreign asset position NFA _t of the home country.^[13] The rates paid on central bank credit C B t are determined by

where ϑ t is a stationary mean one shock to the premium, and κ the premium elasticity. R t P = R t P * is the central policy rate, and R _t and R t * the rates paid on central bank credit.

Central bank funds are in zero net supply, so if savings banks in the home country borrow from the central bank, it follows that foreign country savings banks are depositors, and R t > R t * . The risk premium will cause the net foreign asset position of banks in each country to adjust until N F A t = N F A t * = 0 and R t = R t * . The structure of the premium implies that there will be small positive profits in equilibrium which are transferred equally to savers in the union. In the numerical simulations, we choose κ sufficiently low to allow the rates to be very close, generating persistent effects of shocks while ensuring that the model is stationary.

2.5 Market Clearing Conditions

In each economy, the labor market is in equilibrium when total supply by households equals the demand from intermediate good producers

The corresponding domestic capital market equilibrium condition is given by

Total demand for domestically produced goods include the demand from domestic households H t T = λ H t + ( 1 − λ ) H t B , demand from foreign consumers X t T = λ X t + ( 1 − λ ) X t B , demand from capital producers I t K ( 1 − ζ K ( I t K / I t − 1 K − 1 ) 2 ) and from housing good producers I t D ( 1 − ζ D ( I t D / I t − 1 D − 1 ) 2 ) which are net the adjustment costs, and demand by the government, which is given as a proportion g _t of output Y _t . The implied real resource constraint is then

with g _t following a stationary stochastic process. The net foreign asset position evolves according to the following nominal law of motion:

where the trade balance is defined as

The bilateral terms of trade are given by

and, as discussed previously, the central bank funds are in zero net supply worldwide, so

4.1 The Interbank Market and the Transmission of Monetary Policy

Figure 1 shows the impulse responses of a number of variables to a reduction in the union-wide policy rate and compares these to a modified version of our model in which the interbank frictions are shut off, that is, the model collapses to one of complete financial markets where the spread between bank lending rates and the policy rate is fixed to its steady-state value.

Figure 1:

Impulse response functions to a negative monetary policy shock. s(⋅) is the external finance premium. Relative deviations from the stochastic steady state except rates, which are in levels.

In both instances, the interest rate controlled by the monetary authority drops by about the same amount initially. In our baseline model, however, the unanticipated reduction in interest rates leads to an increase in the value of collateral held by lending banks. This, in turn, lowers their funding costs in the interbank market as the perceived risk of default falls. Lending banks operating under perfect competition will pass through the relief in funding costs to their final customers, causing mortgage rates and financing costs faced by non-financial firms to drop by more than the initial reduction in the key policy rate.

It is this additional fall in the borrowing conditions of households and firms that then leads to more investment, more housing demand and, ultimately, higher domestic demand and inflation in the currency union. In other words, like in Bernanke, Gertler, and Gilchrist (1999), the transmission of a conventional change in monetary policy is more powerful in affecting broader macroeconomic conditions. However, unlike in Bernanke, Gertler, and Gilchrist (1999), the amplification in transmission comes directly from banks operating in an interbank market characterized by uncertainty on the part of savings banks when extending short-term credit to counterparties in need of liquidity.

This implies that there are major differences to a situation where the financial accelerator operates directly at the balance sheet of firms. The impact on aggregate demand, as well as the strength of the pass-through of interbank conditions to final borrowing conditions, will ultimately depend on three factors: the relative share of saver and borrower households in the economy, the structure of lending banks’ balance sheets and the degree of competition in the lending market. Starting with the latter, the less concentrated the lending market is, the stronger is the pass through and the more pronounced are the effects on the real economy. That is, modifications of our model along the lines of Gerali et al. (2010), introducing monopolistic competition in the banking sector, can be expected to dampen the accelerator effect as banks would pass on lower interbank funding costs at a pace slower than under our baseline model. Similarly, the larger the share of bank lending to households, the larger the impact on output, given the role played by private consumption in aggregate demand. And, finally, although the friction lowers borrowing costs for firms and impatient households, Figure 1 also shows that the policymaker keeps the interest rate higher relative to the fixed spread economy due to increased output and inflation. Saver households hence face a higher savings rate, causing them to consume less non-durable and durable goods in response. This effect offsets, to some extent, the increase in housing investment coming from borrowers.

We illustrate this last point in 1: the red dashed line shows our baseline model, assuming, however, a smaller share of savers λ = 0.5. As expected, because the financial friction reduces borrowing costs beyond the initial change in the policy rate, the more borrowers there are, the larger the accelerator effect. Fewer savers, in turn, imply that the offset from a higher policy, and hence savings rate, will also be smaller.

Overall, therefore, our simulations tend to suggest that, contrary to previous findings in the literature (e.g., Hilberg and Hollmayr, 2011), the presence of an interbank market can, and in many circumstances is very likely to, amplify changes in the key policy rate. And although the mechanism is similar to the well-known financial accelerator, there are noticeable differences in the way our model setup can give rise to changes in the transmission of monetary policy.

4.2 Asymmetric Shocks and Cross-Country Spillovers

A key result of the previous section is that union-wide shocks will propagate differently through the economy once financial frictions are allowed for and that it matters whether these frictions are operating on the banking or the firm side. In this section we will focus on the implications of our interbank market setup for the propagation and impact of idiosyncratic country-specific shocks. Specifically, we look at how a positive shock to the variance of the idiosyncratic loan return shock ω(b) will affect the behavior of banks in the cross-border interbank market and analyze the footprint this will ultimately leave on aggregate demand.

Recall that savings banks incur additional monitoring costs when taking positions in the cross-border interbank market. These costs are a function of the prevailing level of “economic” risk (cf. equation (2.29)). Therefore, a shock that raises the skewness of the distribution of ω(b) in one country but not in the other, and hence increases the relative risk of bank default, will cause savings banks to raise the risk premium they charge to borrowers resident in the economy hit by the shock, even though the average loan return remains unchanged.

This can be seen in Figure 2: in our baseline model the funding rate in the cross-border interbank market, R t I B , F , increases by significantly more than compared to a model in which banks are insensitive to both macroeconomic and counterparty risks.^[15] As a result, banks with a liquidity deficit will partly substitute more expensive foreign borrowing with domestic borrowing, forcing consumers to dial back more vigorously their imports in response. Naturally, this effect will be stronger the more heavily the economy’s banking sector relies on cross-border interbank market funding, (1−τ ^IB ), or, similarly, the more difficult it is to switch foreign with domestic funding (θ _IB ). This also means that, should countries differ in their financial structure, symmetric shocks too can cause differences in banks’ funding costs across the currency union. For example, an economy which predominantly finances loans to firms and households using funds from abroad will see its overall funding costs increase more sharply in the face of an adverse shock, thereby causing a steeper economic contraction than compared to an economy that mainly relies on domestic funding. This stylized finding has been one of the key aspects of the crisis in peripheral euro area economies: because many banks funded large parts of their liquidity needs abroad, the sudden market freeze meant that aggregate imports fell drastically, thereby reinforcing the macroeconomic fallout caused by the collapse in domestic demand and the rise in funding costs.

Figure 2:

Impulse response functions to a transitory risk shock in the home country, comparing baseline model with a version with ζ _σ  = 0. Relative deviations from the stochastic steady state except rates and relative NFA, NFA/P ^C Y, and the probability of bank default, F, which are in levels.

Cross-border monitoring costs are, however, only an amplifier of a natural response of our modeling choice. As can be seen in Figure 2, banks resident in the foreign economy would have increased their cross-border interbank rates even in the absence of these costs and despite a measurable reduction in the union-wide monetary policy rate. The reason has to do with the built-in increase in the risk of bank default: with output contracting in response to the shock, domestic banks’ leverage rises, causing foreign banks to increase their lending rates.

What is more, with lending to the real economy having become riskier in the wake of the shock, domestic savings banks too will ration their supply of interbank funds and will increase the rate they charge on the remaining funds, causing a contraction in credit supply to the real economy. The consequences are well-known: with credit less abundant and more expensive, both households and firms reduce their investment and housing activities, amplifying the contraction in aggregate demand that would have prevailed in the absence of frictions in the interbank market.

The consequence is that interbank markets characterized by risky lending and costly state verification have the potential to render monetary policy less effective by contributing to the fragmentation of trades across borders, something that has become evident in the euro area during and after the sovereign debt crisis. At that time, the transmission of the ECB’s monetary policy to banks in the periphery had become severely impaired: although it cut its main refinancing rate by 85 basis points between July 2012 and June 2014, bank lending rates to firms in Spain, for example, fell only by some 20 basis points over the same period, reflecting, in part, effective credit rationing in the (cross-border) interbank market. In response to these impairments, the ECB, starting in June 2014, decided on a number of non-standard measures that aimed at restoring the transmission of monetary policy. Some of these measures are the subject of our analysis in the next section.

5.1 Long-Term Refinancing Operations

In our model economy, savings banks have access to funding from the central bank (cf. Section 2.3.2). In addition to standard one-period loans to banks, in this policy exercise, the operations of the central bank may take the form of multi-period loan contracts, similar to the ECB’s LTROs^[16]. To prevent corner solutions whereby savings banks will choose only short-term or only long-term funding, the central bank sets a single target policy rate on multi-period bonds and allows the short-term rate to be set via the zero-arbitrage condition. As discussed in Section 2.3.2, the short-term central bank funds will be in zero net supply union-wide. This is also the case with long-term funds. Indeed, in equilibrium, we will find that savings banks will not hold long-term bonds at all; the availability of these loans is sufficient to introduce a wedge between the policy rate on long-term refinance operations and the household saving rate.

To maintain tractability and keep the number of state variables manageable, we follow Rudebusch and Swanson (2012) ^[17] and introduce multi-period loan contracts using geometrically decaying repayments over an infinite horizon. This setup reflects the aggregation of a large number of loans at different points of repayment and of different maturities. As well as introducing just one new state variable rather than potentially very many with long maturities, the appeal is that using infinitely long loans with geometrically declining repayments allows us to control the average maturity ψ ∈ [0, 1) with just one parameter, nesting the possibility of ψ = 0, in which case it collapses to a standard one-period loan contract.

Every period t, a savings bank can take out a new loan CB _t and agree to repay an infinite number of declining payments such that the total amount due at period t is given by

When ψ > 0, R t L T is no longer equivalent to an interest rate. To analyze the role of the LTRO policy, we assume that the central bank chooses R t L T so that the average interest rate on long-term borrowing equals the policy rate R _t . As we are using perpetual loan repayments, we measure the average duration using Macaulay’s duration of a stream of payments. It is then straightforward to calculate the equivalent average nominal interest rate on the amount borrowed from the total amount repaid. We find this leads to the following relationship between the rate R t L T and the policy rate R _t :

with average loan duration d = R/(R−ψ), where R is the steady-state policy rate^[18].

We can then express equation (5.1) in recursive form as

The important thing to note is that even if the bank does not borrow from the central bank in equilibrium, as will be the case with purely symmetric shocks, the availability of these loans is sufficient to have an important impact on the household saving rate, a point we will return to later. Using equation 5.3 as a constraint in the profit maximization problem of the savings bank leads to the following first-order conditions:

This, with equation (5.2), gives the spread between the policy rate R _t and the deposit rate R t S . ϕ t is the real present value of the Lagrange multiplier on the law of motion of repayments due and is a nominal pricing kernel for central bank credit. When d = 1 and ψ = 0, then R t L T = R t = R t S as in the standard model, and ϕ t is just the nominal stochastic discount factor. As the loan duration increases so ψ > 1, the implied future stream of payments increase and ψ t > Λ t , t + 1 Π t , t + 1 .^[19]

Figure 3 shows the LTROs at work, comparing the impulse response functions to the same risk shock analyzed before, once with d = 1 and once with d = 16 ^[20]. This calibration mimics the four-year loan duration of the ECB’s targeted LTROs introduced in 2014. The policy has two major effects. First, in the face of an adverse shock, fewer cuts in policy rates are required to achieve the equivalent stimulus in a multi-period loan economy. The reason is that the reduction in policy rates lowers the average rate of interest for a longer period and hence further reduces the effective present funding costs of forward-looking banks. That is, long-term refinancing operations with fixed interest rates, such as the latest series of targeted LTROs, ensure planning certainty for banks and thereby, in practice, provide major help with respect to maturity transformation between longer-term lending and often short-term refinancing. And with banks immediately passing on the additional funding cost relief to the ultimate borrowing conditions of households and firms, policymakers are able to frontload required accommodation and thereby mitigate the economic downturn.

Figure 3:

Impulse response functions to a transitory risk shock with central bank with and without LTRO policy response. Relative deviations from the stochastic steady state except rates, which are in levels.

The second interesting feature of LTROs is the asymmetric impact when economies are hit by idiosyncratic shocks. As we argued before, once d > 1 ( ϕ t > 0 ), the deposit rate in each country will no longer be fixed to the policy rate by the zero arbitrage condition. As equations (5.2) and (5.5) highlight, the spread between the policy rate and the deposit rate depends on the Lagrange multiplier, itself a function of the household stochastic discount factor. Specifically, using equations (5.2) and (5.5) we can give the spread as

where

So, asymmetric shocks will affect the spread differently in each country as a first-order effect. From equations (5.2) and (5.5), a first-order approximation suggests that

In other words, if the expected path of the nominal stochastic discount factor is greater in the domestic economy than in the E t ϕ t + 1 > E t ϕ t + 1 * foreign, then it follows that R t S > R t S * , which implies that .

This can be seen in Figure 3. Because consumers in the foreign economy, following the shock, expect a lower future marginal utility of consumption relative to the domestic country, LTROs, by easing financial conditions abroad by more, are able to fully offset any negative spillovers of the original shock to the rest of the currency union. Of course, the extent of the easing can differ from shock to shock, but LTROs can generally be thought of as a powerful stabilization tool in a currency union. This has been confirmed by recent ECB analysis (ECB 2017). They show that from June 2014 to July 2015, i.e., after the first TLTRO operation, non-bidders in vulnerable and non-vulnerable economies reduced their lending rates by about the same amount, while after the second operation, in the period from March to December 2016, the reduction in lending rates was larger in non-vulnerable economies, consistent with the predictions from our model. This emphasizes that the sheer existence of the policy is enough to reduce financing conditions across the currency union and, hence, to help central banks reach their price stability objectives.^[21]

5.2 Asset Purchases

The second policy instrument we analyze is asset purchases by central banks, which became an integral part of policymakers’ toolkit after, and in some jurisdictions even before, the outbreak of the global financial crisis. Several attempts have been made in the literature to quantify the effects of such purchases ^[22]. On the theoretical front, Chen, Cúrdia, and Ferrero (2012) and Gertler and Karadi (2013) have recently made useful progress in capturing the effects of asset purchases on the broader macroeconomy. In this paper, we want to focus on one element of the ECB’s asset purchase programme that has received less attention in the literature and that is particularly suited to study within the context of our model setup: its ABSPP.

The aim of this programme, launched in November 2014, is to facilitate credit provision to the real economy by freeing up bank balance sheet capacity. Although the effects of securitization are more complex in practice, mainly related to regulation, the general idea behind this programme can be illustrated by assuming that the central bank purchases assets directly from banks. Indeed, one of the main reasons for banks to engage in securitization is balance sheet relief: securitization typically involves a true sale of the underlying asset to a special purpose vehicle, removing assets from the balance sheet and thereby reducing the amount of capital that a financial institution is required to hold. We therefore follow Gertler and Karadi (2011) and treat asset purchases as if the central bank lends directly to the private sector, which is a convenient shortcut to analyzing the effects of the ECB’s ABSPP.

Specifically, the central bank issues one-period bond at the market rate and uses the proceeds to purchase a certain share Θ t of loans from lending banks. Profits are distributed to the households via lump sum transfers^[23]. The central bank budget constraint can be written as