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2 The Global Macroeconomy (Subject) / Lecture 5 - Leverage (Lesson)
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- M.5.1 Leverage (Companies & Countries) For Companies: L=Assets/Equity When High: High value of Assets compared to Equity Higher credit risk (more loans that could go back) Higher liquidity risk (funds from international money markets could dry up) Higher profits in return Leverage increases as assets grow (usually in good times) Leverage for Countries: L = Debt/GDP When High: High debt-level (Public or private, domestic or foreign) compared to GDP -> Japan has a very high public debt, US has a high private debt vs. public debt
- M.5.2 Financial Innovation Changes due to financial innovation: financial system has evolved in a way to allow increasing levels of leverage and therefore risk via (1) Maturity mismatch Bank puts money in Borrowers account Liability Created & Money paid out Loan is repayable later but money is immediately available Effect: Creates Purchasing Power (Money can go into investment or asset speculation) -> Loans/Money ratio ↑ Partly made possible by the increasing importance of the interbank market Need to monitor how much credit and what type of credit banks create 98% of UK money takes from, only 2% coins liabilities of the state (2) Securitization & Shadow banking Loans are securitized, made tradeable and used as collateral in obtaining wholesale funding Traditional Banking: Assets (Use of funds): 40% Government Bonds, 50% Loans/ mortgages, 10% Traded AssetsLiabilities (Sources of funds): 90% deposits, 10% Equity Modern Banking Assets (Use of funds): 40% Government Bonds, 10% Loans, 50% Tradeable AssetsLiabilities (Sources of funds): 50% deposits, 10% Equity, 40% Whole Sale Funding
- Deleveraging in Financial Crisis From High Debt to Deleveraging Maturity mismatch an leverage Before the Crisis: More and more short-term funding Roll over short-term funding liquidity every day Cheap short-term funding cheap (low FED rates) , Long-term funding expensive - Assets (Use of funds): 10 years- Liabilities (Sources of funds): Equity, Long-Term Funding, Short-term funding - CP (3 months), Repo (1day) vs. Crisis: Deleveraging - Fire-Sale Equity shrinks, Volatility Increases Short-term Financing is harder to obtain No roll over (since margins widen) Sell assets at Fire-Sale prices! - Assets (Use of funds): Low market liquidity- Liabilities (Sources of funds): No Equity, Expensive Long-Term Funding, Short-term funding Not Available!
- Pro and Con of Leverage Evidence suggests: Leverage is associated with financial crisis and is possibly a cause. Pro: Allows expansion of nominal and real GDP (if associated to lending to new productive investment) Con: Increases Instability Business cycles are a little bit longer than leverage cycles Minsky, 1978: Financial system generates economic instability through endogenous credit bubbles with waves of euphoria and anxiety Kindleberger (1978): documents episodes of credit-driven instability throughout financial history
- M.5.3 The Leverage Cycle Innovation - may be out of line with ability of economy to what the steady state is) Optimism on growth - Economy can be above Steady State for a short period of time Credit Expansion (iterative) - Incentive for credit expansion Absorbation of innovation Reduction in growth prospects Scaling back of expected credit 3 Possibilities to Exit Cycle: Crisis Slow Deleveraging (China increased private Debt) Structural Reform (increase the efficiency of the system, push up level of growth)
- M.5.3 Pro-cyclical Dynamics related to Asset Prices Rising asset prices – The Way Up in Leverage Cycle (Leverage is high and rising, Collateral required is low) Improves net worth of borrowers Permits accumulation of extra debt Fuels further asset price appreciation Feedback loop between leverage and asset prices is a primary channel linking financial and housing markets with macroeconomic performance Reversal in asset prices – The Way Down in Leverage Cycle (Leverage is low and falling, Collateral required is high) Tightening of debt limits Downward pressure on asset prices
- Summary Since WW2 and especially since 2000 private credit has been rising in relation to both money and GDP Leverage of financial institutions is a key factor We can identify a leverage cycle with phases of leveraging up leading to financial crises Banking crises are the costliest for the real economy and they spread out from the healthy to the unhealthy part of the financial system
- Vicious spiral of Deleveraging Toxic assets spread around the system Decline in equity value Assets have to be sold Everyone is selling assets Price of assets drops Decline in equity value More fire sales of assets Fear of counterparty risk: interbank and money market collapse Pervasive, long-term effect on the real economy: Sectorial responses: Corporate Sector: Deleveraging Financial sector: Deleveraging Personal sector: Deleveraging Government: Auserity programmens Recovery: The recovery from the financial crisis has been unusually slow .. Eventually sustained by central bank intervention (quantitative easing)
- M.5.2 Pro & Cons of Securitization Pro’s of Securitization Reduce costs by tapping broader sources of funding Reduce costs by regulatory arbitrage -> because ABS may attract less regulatory capital than underlying loans Assets taken off balance sheet (we leverage out some assets it looks like we have more Assets on Balance Sheet) System wide Benefit from dispersion of risks (Diversification) Con’s of Securitization Reduce incentive to check credit quality of borrowers (exacerbating the agency problem) Temptation to make ABS more complex / opaque (e.g. CDO2) to enhance returns (difficult to trace) Transparency is key! If you know what the underlying assets are (how much risk we are really holding, then this is a good thing)
- M.5.4 Eras of Financial Capitalism (Schularick and Taylor, 2012) Pre WWII trend in credit-money ratio: Money and credit in a stable relationship to each other, and to GDP [Exception was the Great Depression when money and credit aggregates collapsed] Post WWII trend in credit-money ratio: Money and credit began a long post-war recovery, trending up rapidly and then surpassing their pre-1940 levels relative to GDP by about 1970 Credit started to decouple from broad money and grew rapidly, via a combination of increased leverage and augmented funding via the nonmonetary liabilities of banks. Since WWII assets have grown faster than loans and loans faster than money Particularly from 2000 until the crisis – credit mainly driven by private credit (financial sector & household housing credit) The Great Mortgaging: Pre 1970: With very few exceptions, the bank's primary business consisted of non-mortgage lending to companies Post 1970: Banks in most countries had turned primarily into real estate lenders. The intermediation of household savings for productive investment in the business sector (standard textbook role of financial sector) constitutes only a minor share of the business of banking today Strong Increase in Real Estate Lending / Total Bank Lending
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- M.5.3 Debt Capacity Resources available to fund current and future spending and to repay current debt outstanding Sum of discounted future potential output YP NPVj,t = ∑ Yj,t / (1+pj)t Simplifies to NPVj,t = ∑ Yj,t • 1/ (pj-σj) where σ is growth rate of potential output, and p is discount factor
- Largest Banking Crisis from 1970-2011 1980: Latin American Debt Crisis 1990: Transition Economies 1995: Tequila Crisis 1998: Asian Crisis 2008: Great Recession
- The U.S. Banking Crisis Before: Attractiveness of Modern Bank Model Modern funding can be obtained quickly, whereas deposits take branches, resources, time. Lenders willing to lend because could exit quickly Mark-to-market assets feed price booms: price of housing rises → assets rise in value → banks can borrow more → banks lend more → house prices rise further. Amplification. Fragmented regulation across multiple countries Very large Global Banks: UBS, Credit Suisse, fortis, Dexia, RoyalBankof Scotland, Barclays, HSBC Holdings, BNP Paribas, Deutsche Bank -> By ratio to Home HDP -> Strong increase in Leverage since 2000 After collapse of Lehmam: Increased stress in financial markets in both advanced and emerging economies: Interbank market distress Equity prices down Equity market volatility high Contagion: 1, 2 and 3 multiply the effect of initial shocks 1. through interbank market [wholesale]2. through collateral [retail also]3. through balance sheets: from high debt to deleveraging
- Financial Contagion in modern, market-based financial system Empirical evidence to suggest that banks tend to target leverage, rather than targeting absolute balance sheet size Problem: Targeting leverage creates a ‘multiplier’ effect, as changes in asset prices cause proportionately larger changes in bank balance sheets, and hence in aggregate credit Financial Contagion in modern, market-based financial system: when financial intermediaries’ balance sheets is strong their leverage is too low (they hold surplus capital) and they must find ways to employ it. Balance Sheet Expansion in 2 Ways: + Increase Short-Term Debt (liabilities side) - Decrease Assets (asset side, search for potential borrowers) Adjustment of leverage by banks has consequences that amplify the financial cycle While at the beginning of the crisis there was divergence between sick assets (ABS, CDO, ...) and healthy markets such as stock market, sovereign debt and high-grade corporate bonds, now all markets are affected Although direct exposure to subprime is small, anticipated losses have created large disruption
- Primary channel to link financial and housing markets with macroecon. performance This feedback loop between leverage and asset prices Economies grow above Steady State for a short Time Credit Expansion: Asset Prices go up, Housing Prices go up Balance Sheet Effect: Because Assets go up, you have higher ability to lend more At some point this becomes unsustainable, and then it breaks
- M.5.3 Leverage Cycle - The Way Up & Down The Way Up: Leverage is low & falling; Collaterall required is high Weaker Balance Sheets Adjust Leverage Down Reduce balance sheet size Asset price decline The Way Down: Leverage is high & rising, Collaterall required is low Asset Price Boom Stronger Balance Sheet Adjust Leverage Up Increase Balance Sheet Size
- M.5.3 When is leverage risky? Optimism, becausse Debt Accumulation > Debt Capacity 3 Sources of Optimism on Debt Capacity that fuel leverage cycle: σj ↑ Pick-Up growth of potential output Yj,t: Underestimates - Cyclical expansion sending actual above potential output pj ↓: Reduction in Discount Rate