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Financial StressGreg Tkacz

ECON 493: Seminar30 October 2015

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Outline1 Asset Prices and the Economy

2 Defining Financial Crises

3 Defining Financial Stress and Constructing Financial Stress Indexes (FSIs)

4 Forecasting Stress and Crises

5 Homework

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1. Asset Prices and the Economy Asset price movements (e.g. stock, bond or housing prices) can impact

economic activity through several different channels:

1. Wealth Effect: Asset prices impact wealth, which in turn can impact consumption decisions. The MPC could change if consumers feel richer or poorer.

2. Credit Channel (Demand): Change in wealth impacts the value of collateral, so firms and households can borrow more if the value of their collateral increases.

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3. Credit Channel (Supply): When asset prices fall, bank loan losses can increase, so banks could willingly make credit more difficult to obtain as they try to remain solvent.

4. Expectations: Asset price movements can contain information about expected future GDP growth and inflation, and this in turn can impact current spending decisions.

• In all cases asset prices would impact aggregate demand: The AD curve would shift to the right as asset prices increase, and shift to the left as they fall.

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• Stock and Watson (JEL 2003) is a comprehensive survey on the impact of asset prices on GDP and inflation.

• They conclude that asset prices sometimes impact output and inflation, in some countries, for some time periods, so they cannot make any solid claims regarding the link between asset price movements and the economy.

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• Three of the studies surveyed by Stock and Watson consider non-linear effects between asset price movements and the economy. These are Galbraith and Tkacz (JIMF 2000), Atta-Mensah and Tkacz (2001) and Tkacz (IJF 2001).

• These studies uncovered a common theme: As the yield curve steepened, the relation between its movements and GDP growth weakened.

• This is evidence of an asymmetry: If short-term interest rates fall following a loosening of monetary policy, which leads to a steeper yield curve, the impact on the economy becomes subdued.

7• This is consistent with the “pushing on a string” effect of monetary policy from Friedman (AER 1968). i.e. When borrowing conditions improve, there is no guarantee that firms and households will necessarily want to borrow more.

• When discussing the immediate lessons of the Great Depression (or “Great Contraction” as he called it), Friedman notes (page 1):

Monetary policy was a string. You could pull on it to stop inflation but you could not push on it to halt a recession. You could lead a horse to water but you could not make him drink.

• Could such a story apply to the movements in asset prices more generally, thereby helping us explain the inconsistent evidence uncovered between asset price movements and the economy?

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• Tkacz and Wilkins (J. of Forecasting 2008) examine potential non-linear effects between stock price movements and housing price movements and their impact on GDP growth and inflation.

• The rationale is that more extreme movements, such as sharp corrections, could impact the economy, whereas “normal” movements would have benign effects on the economy.

• The model considered:

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• Conclusion from Tkacz and Wilkins: Housing and stock prices aid in predicting GDP growth and inflation, usually up to 8 quarters ahead, but improvements are not huge in an economic sense.

• Caveat: This paper was published just as the 2008 financial crisis was unfolding, so interesting new data points were rapidly being generated.

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2. Defining Financial Crises A financial “crisis” is usually associated with some extreme event, such as:

A sudden severe drop in the price of a financial asset;

A flight out of a country’s currency;

An inability of firms and households to borrow or an unwillingness of banks to lend;

Examples of extreme asset price movements:

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15A full-blown financial crisis can be catastrophic. The chain of events can proceed as follows:

• An important asset price suffers a sudden contraction “for some reason”. In developing countries this can be due to inept or corrupt public policies; in developed countries this can be due to “irrational exuberance” in asset markets that are dominated by speculators.

• The immediate loss of financial wealth can lead to an immediate drop in consumption.

• Firms, seeing that demand is shrinking, curtail expansion plans, so capital investment drops.

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• Firms lay-off workers, and unemployment rises;

• With firms experiencing lower profits and households losing their jobs, loan defaults rise – banks can cover some loan losses, but not many simultaneous losses.

• Banks use their reserves to cover loan losses, so restrict credit expansion.

• Firms, who have experienced falling sales, and households, who have lost jobs, are both in dire need of credit, but banks are curtailing credit.

• Due to inability to access credit, firm and household bankruptcies rise, which leads to more loan defaults, and banks are now beginning to fail. Without banks and credit, economy begins to collapse.

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Part 1: Households default on their loans

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Part 2: Economic activity falls

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Part 3: Banks reduce their loans (note how credit falls after a recession), which exacerbates a downturn

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• Formal definition of a financial crisis (from Mishkin):

A financial crisis occurs when information flows in financial markets experience a particularly large disruption, with the result that financial frictions (i.e. the factors that prevent the efficient flow of capital from savers to borrowers) increase sharply and financial markets stop

functioning. Then economic activity will collapse.

• Like an earthquake, a financial crisis is clearly something that should be feared and avoided, and also that has varying degrees of severity. However, how can policy-makers monitor financial conditions to determine whether a financial crisis will occur?

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3. Defining Financial Stress and Constructing Financial Stress Indexes• Canada, like many developed countries, has never experienced a full-blown financial crisis that has resulted in a complete inability of firms and households to access funds.

• This is partly due to a sound banking system, which has only experienced two failures in the past 90 years.

• Yet, policy-makers want to ensure that a crisis does not happen here. Consequently they need to monitor “something” that can provide them with an early warning about an impending crisis.

• If you think as the crisis/no crisis states as being a binary outcome, the challenge is to develop a tool that approaches 1 when a crisis is near, and 0 when financial markets operate normally.

22Illing and Liu (Journal of Financial Stability 2006) developed the first Financial Stress Index that represents a continuous series where the extreme value captures a bona fide financial crisis. They define it as follows:

Financial stress is defined as the force exerted on economic agents by uncertainty and changing expectations of loss in financial markets and institutions. Financial stress is a continuum, measured in this paper with an index called the Financial Stress Index (FSI), where extreme values are called financial crises.

They construct the FSI using the four main credit channels in Canada:

1. Banking sector2. Foreign exchange market3. Bond market4. Equity market

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A major innovation of this paper is that previous authors had normally considered each type of credit market in isolation; the FSI would monitor all credit markets within a single index.

Some of the variables considered within each category:

1. Banking sector’s beta: If beta > 1, the total return of bank shares over the past year are more volatile than the volatility of the entire market

2. Deviation of the C$ from its “fundamental” value: If the C$ significantly deviates from its fundamental value (based on commodity prices, interest rate differentials and debt-to-GDP differentials), then a major correction is more likely, signalling higher stress

3. Risky spread: The spread between corporate and government bonds can signal higher stress

4. Stock valuation: Use some measures of over-valuation of stock prices

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The FSI was spawned in Canada; the rest of the world followed our lead. For example:

• United States: Hakkio and Keeton (Kansas City Fed, 2009) developed a FSI for the U.S., and heavily borrowed the methodology from Illing and Liu. Major difference: Because the U.S. is a much more closed economy than Canada, exchange rate movements do not influence the U.S. FSI.

One of the first and most influential composite indexes of financial stress was developed by economists at the Bank of Canada (Illing and Liu)

The Kansas City FSI is regularly updated, and available from the FRED website:

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Other countries that have built FSIs:

• Romania (Albulescu 2010)• Greece (Louzis and Vouldis 2013)• Germany (van Roye 2013) • USA again (from the Cleveland Fed) • Turkey (Cevik, Dibooglu and Kenc 2013)• Bulgaria, Czech Republic, Hungary, Poland and Russia (Cevik, Dibooglu and Kutan 2013)• France (Aboura and van Roye 2013)• etc

28• To construct a FSI, one must first standardize each variable (so that the scales are the same) and then find an appropriate weighting scheme.

• There is no universal consensus regarding the weighting scheme, so researchers typically present multiple FSIs (based on different weights) and use some judgment to determine which has been most useful at detecting stressful events in the past.

• Illing and Liu, for example, surveyed senior management at the Bank of Canada to determine which past events were considered the most stressful.

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• A simple benchmark FSI would place constant weights on each component; a more elaborate one would weight the components according to their importance as credit sources.

• For example, bank financing is more important in Germany than the U.S., where equity financing tends to dominate.

• In short: There is still room to innovate on how to assign weights to the FSI components.

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4. Forecasting Financial Stress and Crises

• With a FSI being constructed, the next challenge is to forecast it so that policy-makers could anticipate potential crises.

• Misina and Tkacz (IJCB 2009) was the first study to forecast financial stress. While other countries were catching-up building FSIs, Canada had already proceeded to forecast its movements.

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• The research director at the International Monetary Fund, Stijn Claessens, wrote the following regarding the FSI work in Canada:

It is, by the way, remarkable how the Bank of Canada has been at the forefront of the development of financial stress indexes, first with the paper by Illing and Liu (2006) and now with this paper (Misina and Tkacz 2009). Given that Canada seems to be one of the few countries that have largely escaped the global financial crisis, it is tempting to attribute this to development and application of FSIs in policymaking.

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To anticipate financial stress, Misina and Tkacz look at several potential financial and macroeconomic indicators:

1. Credit measures: Growth of business and household credit2. Asset prices: Stock and housing3. Macroeconomic variables: Investment, GDP growth, money growth, etc4. Foreign variables: Oil, U.S. variables, etc.

Over 100,000 different models were estimated and evaluated in order to uncover variables and specifications that are statistically significant predictors of financial stress.

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Domestic business credit (denoted in white above) is the most robust predictor of the quarterly change in financial stress

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Other researchers have since tried to predict the FSI. Some representative studies:

• 13 OECD countries (Slingenberg and de Haan 2011): Credit growth seems to be the best predictor

• 13 OECD countries (Christensen and Li 2014): Build composite indicators for the FSI using fancy techniques.

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5. Homework

In groups of two, you will:

1. Write a brief 3 to 5-page, double-spaced, literature review on the construction and forecasting of Financial Stress Indexes. You can consult the papers in the course outline, the ones provided in these slides, and the references therein.

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2. Construct FSIs for two countries. The countries will be assigned at random in class.

3. Prepare a 10 to 15-minute PowerPoint presentation that you will deliver on November 20. The presentation will briefly go over your lit review, you will present your newly-constructed FSI, and you will comment on whether a financial crisis is likely to occur in your chosen country in the short-term.

4. To maximize grades, you should attempt to relate movements in your FSI to past crises/recessions/stressful episodes in your assigned countries. Some background reading/digging will be required.