Slow recoveries, endogenous growth and macroprudential policy

Dario Bonciani, David Gauthier and Derrick Kanngiesser

Following the global financial crisis in 2008, central banks around the world introduced tighter banking regulations to increase the resilience of the financial sector and reduce the risks of severe financial disruptions during economic downturns. This fact has motivated a large body of literature to assess the role that macroprudential (MacroPru) policies play in mitigating the severity of recessions. One common finding is that the benefits of MacroPru are relatively minor within standard dynamic stochastic general equilibrium (DSGE) models. In a new paper, we show that MacroPru becomes significantly more important in a model that accounts for the long-term negative consequences of financial disruptions.

Empirical evidence on the long-run impact of financial shocks

To motivate our theoretical analysis, we first provide empirical evidence on the effects of financial crises for a panel of 24 advanced economies. We document an important difference between financial crises and traditional recessions. As displayed in Chart 1 we find that, following a banking crisis, total factor productivity (TFP), GDP, and research and development (R&D) substantially decline and do not revert to their pre-crisis level within 10 years, in line with previous literature. By contrast, other types of recessions are associated with milder and short-lived contractions in real activity.

Chart 1: Estimated effects of banking crisis and other recessions

A model of MacroPru with endogenous growth

We study the implications of MacroPru through the lens of a medium-scale DSGE model, into which we incorporate frictions in the financial sector and endogenous productivity growth. Financial intermediaries, built along the lines of Gertler et al (2012), fund themselves using short-term debt and outside equity. The cost of outside equity depends on the state of the world and moves in line with the return on assets. The risk exposure of financial intermediaries is, therefore, a result of their financing choice. We model MacroPru as a subsidy on outside equity, which increases the resilience of financial intermediaries to shocks adversely affecting asset prices and net worth.

Our approach to modelling MacroPru captures two important real-world features. First, the key objective of MacroPru is to avoid banks taking on too much debt, which may be particularly risky during economic downturns. In reality, this policy often takes the form of minimum capital or liquidity requirements. These two policy measures are however difficult to model in the context of a standard DSGE. Second, in line with the regulatory frameworks of many countries, the macroprudential intervention in our model is countercyclical, ie it becomes tighter when the (private) cost of debt is low and banks would, therefore, have the incentive to substantially increase their leverage.

The second key feature of our model is an endogenous growth mechanism in the spirit of Grossman and Helpman (1991) and Aghion and Howitt (1992). The labour-augmenting productivity of intermediate output firms depends on the aggregate level of intangible capital or 'knowledge'. This additional form of capital implies that the production function will feature increasing returns to scale and that the growth rate of the real variables in the model will depend on the rate of accumulation of intangible capital in the economy.

When a financial shock hits, there is a substantial fall in investment in both physical and intangible capital. This causes an initial drop in productivity growth, which damages intangible capital formation, and hence causes a permanent fall in output. By contrast, shocks originating outside the financial sector do not tighten financing conditions in the economy as much. Intangible investment (eg R&D) and hence productivity growth fall less in response to standard adverse demand and supply shocks. By facilitating the flow of credit towards investment, MacroPru positively impacts productivity growth and the long-term level of real activity. This stands in contrast with a model of exogenous growth where long-run growth is constant, hence limiting the potential role of MacroPru.

Financial intermediaries in our model take asset prices as given. The failure to recognise the external benefits associated with more stable asset prices constitutes an inefficiency that warrants a macroprudential policy intervention by providing additional incentives to rely more on equity finance. Monetary policy would not affect the cost difference between debt and equity and is therefore unsuited to nudge banks towards higher capital ratios.

Revisiting the gains from MacroPru

Following an adverse financial shock, we find that MacroPru can roughly halve the slowdown in productivity growth and the size of the long-run output hit. Accounting for its potential long-term benefits, we find that MacroPru improves household welfare by approximately 7% compared to the unregulated scenario. This result is around 10 times larger than commonly found in the existing literature using models without the endogenous growth mechanism. In our model, we find an optimal bank capital ratio of about 18%, which is roughly 4 percentage points higher than under exogenous growth.

We also highlight that MacroPru significantly reduces the probability of the monetary policy rate reaching the zero lower bound (ZLB). This probability is about 1.1 per cent in the absence of MacroPru and zero under MacroPru regulation. As shown in Chart 2, without MacroPru (blue and green lines) an adverse financial shock causes a substantial contraction in real activity and the economy's growth rate. The output losses become particularly severe when monetary policy is unable to respond to the fall in demand due to a binding ZLB constraint (green line). In the presence of MacroPru regulation, the financial system is more resilient, and asset prices fall less. This mitigates the tightening in credit conditions and significantly eases the fall in demand. As a result, the policy interest rate never reaches the ZLB constraint and the output losses are significantly smaller both in the short and the long-term.

Chart 2: Response to a credit contraction

Policy implications

Our work highlights the importance of taking the long-term costs of financial crises into account when assessing the benefits of macroprudential policy. The surprisingly small welfare gains commonly found in the theoretical literature are a consequence of ignoring long-term effects and endogenous growth channels. Because productivity growth and the balanced growth path of the economy are endogenous and subject to financial shocks, this justifies a stronger macroprudential response.

Dario Bonciani, David Gauthier and Derrick Kanngiesser work in the Bank's Monetary Policy Outlook Division.

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