Economics serving society

Working papers

Working papers serie, SCOR-PSE Chair on Macroeconomic Risk

WP n°2020-03 - Financial Cycles with Heterogeneous Intermediaries

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By Nuno Coimbra (Paris School of Economics) and Hélène Rey (London Business School, CEPR and NBER)

Executive Summary
In the aftermath of the great financial crisis, the question of excessive risk-taking by banks and other financial intermediaries became very important in the minds of policy makers and academics alike. Understanding its causes and origins is essential in designing adequate regulations, since risk is also a fundamental and inherent aspect of the financial sector. One important concern is understanding whether monetary policy affects risk-taking in the financial sector and also when and how the two are linked. Did the period of historically low rates before the crisis worsen financial stability? Is the current low interest rate environment also leading to the build-up of systemic risk?

This paper looks at how competition between different financial intermediaries can generate a strong connection between policy rates and financial stability. Interest rates affect the composition of the financial sector and how assets are distributed between riskier and less risky financial intermediaries.

When interest rates become very low, riskier financial intermediaries find it very cheap to grow using leverage and competition can push safer, more conservative ones out of risky financial markets. For example, a cautious bank who wanted to provide mortgages during the boom might find it hard to compete with a neighboring bank which is willing to provide No-Income-No-Job-no-Assets (NINJA) mortgages at very cheap rates. As the name suggests, these were very risky mortgages where the lender did not even require the borrower to provide any information on their job, income or wealth. The easier it is for the riskier bank to find cheap funds to provide these mortgages, the harder it will be for the conservative bank to find clients for his own mortgages. This means that low interest rate environments can lead to lower financial stability through its effect on the composition of the financial sector.

A macroeconomic model with heterogeneous financial intermediaries helps clarify the full effect of interest rates on the composition of the financial sector. When interest rates fall, there are two competing effects. The first, already explained above, means that competition for financial assets drives up asset prices and decreases expected returns, which can lead to a decrease in the market share of safer banks and financial intermediaries. This leaves the financial sector more concentrated into riskier, highly-levered intermediaries generating low risk-premia and higher systemic risk. The second effect works through the cheaper cost of liabilities. If the cost of liabilities falls, then more conservative intermediaries might find it now worthwhile to increase their holdings of risky assets and so the market becomes less concentrated and financial stability is improved. The first effect tends to dominate when interest rates are already low to begin with, while the second one dominates for environments with higher rates. So an expansionary monetary policy worsens financial stability in low interest rate environments, but can actually improve it when rates are high to begin with.

In conclusion, when interest rates are not very low, central banks who need to stimulate the economy do not face any trade-off in terms of financial stability. But when interest rates are already low, further cuts might come at a cost in terms of systemic risk and central banks would do well to recognize this.


WP n°2019-02 - From Microeconomic Favoritism to Macroeconomic Populism

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By Gilles Saint-Paul (Paris School of Economics, ENS-PSL and NYU-AD)

Executive Summary
Why would people support macroeconomic policies that are likely to lead to sovereign crises, balance of payments crises, and the like? A rational explanation is based on favoritism – an institutional feature of society implying that some social groups have better access to public goods than others. A favored group that bears a low fraction of the costs of a crisis but benefits in the short-run from unsound policies is likely to support fiscal indiscipline. This paper formalizes the role of favoritism for public spending, indebtedness, and crisis in an illustrative model based on Saint-Paul et al. (2017), and studies support for political parties implementing it, so-called «populists». It argues that favoritism shaped the recent history of French pension reforms and confirms its effect on macroeconomic policy across a panel of countries.

ENGINEERING CRISIS: STRATEGIC FISCAL INDISCIPLINE

Favoritism generates fiscal indiscipline if the decisive voter is favored relative to the mean in crisis times. When the government’s fiscal capacity is insufficient to cover its obligations and society enters a fiscal crisis, people’s access to their entitlement of publicly provided goods must be rationed. Under favoritism, this adjustment is mostly burdened on unfavored groups. By pursuing unsound fiscal policies, the favored decisive voter can engineer future crisis and manages to have the public good on average financed by others. For example, increasing the level of public debt implies more rationing in crisis times but relatively less so for favored groups who also benefit from increased private consumption possibilities through higher debt. Absent crisis, Ricardian equivalence holds and debt has no effect on society. Thus, the incentive to raise more debt stems from states of fiscal crisis only. It becomes stronger the greater the probability of a crisis. Similarly, favoritism increases public spending. Since favoritism need not be a structural property of society, the paper then studies how favoritism arises as an outcome of collective choice between either a populist or a technocrat. The populist implements favoritism regardless of fiscal and macroeconomic conditions. The technocrat sticks to anonymity and rations access to publicly provided goods only in a crisis. It is shown that the support for the populist is greater, the greater greater the likelihood of a crisis.

FRENCH PENSION REFORMS… FAVORITISM AT WORK?

The recent history of French pension reforms is used as an example for this paper’s mechanisms. In particular, it was rational for French public sector employees to support the reduction in the retirement age from 65 to 60, implemented by the Mitterand administration following his 1981 presidential victory, despite overwhelming evidence that it was fiscally unsustainable. Civil servants, having their own special pension system, had good reason to anticipate that subsequent adjustments were likely to hit other social groups proportionally more. Indeed, the first attempt to balance the accounts of the pension system, the 1993 Balladur reforms, made it more difficult for private sector employees only to retire at the age of 60 by raising the duration of their contributions from 37.5 to 40 years. Formal statistical evidence in favor of the model’s predictions is provided by merging four country-level databases, the IMF’s World Economic Outlook for macro indicators, the Institutional Profiles Database (IPD) for indicators of favoritism at the institutional level, the Database of Political Institutions (DPI) for indicators of party ideology, and the CRAG-Bank of Canada database of sovereign defaults to get proxies for fiscal crises. Overall, the results support the theory. Unequal treatment from administrations, a proxy for favoritism, is more likely to generate high debt, high public expenditures, and high deficits, as well as (indirectly through debt) sovereign default. Furthermore, adverse fiscal conditions such as high public debt, high deficits, and low fiscal capacity are more likely to lead to a populist government.


WP n°2019-01 - Trading ambiguity: a tale of two heterogeneities

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By Sujoy Mukerji (Queen Mary University of London), Han N. Ozsoylev (Koç University) and Jean-Marc Tallon (Paris School of Economics, CNRS)

Executive Summary
The financial literature largely assumes that investors know the distribution of asset returns. In most real-world situations, however, decision makers are uncertain about the data-generating process underlying asset returns. This has important implications for portfolio choice, because investors may prefer portfolio allocations that are robust across the set of return distributions believed to be possible. Novel to the literature, the paper shows that such ambiguity potentially explains several puzzling cross-sectional regularities.

Two heterogeneities are key: First, the heterogeneity in the uncertainty about the mean of an asset’s return distribution. This uncertainty parameter encapsulates the ambiguity of assets. It is high, for example, for stock returns of new-technology companies whose risks have not yet been fully learned. Second, investors differ, additionally to their risk aversion, in their tolerance for ambiguity. Together, these heterogeneities give rise to a parsimonious extension of the standard mean-variance framework (referred to as robust mean-variance) in which investors face a three-way trade-off between expected return, variance, and ambiguity. The paper considers, in turn, the implications for portfolio choice, equilibrium prices and returns, and trade upon the arrival of public information.

More ambiguity-averse investors are shown to hold less of the more ambiguous assets. This finding not only confirms the failure of the classical mutual funds theorem (Tobin, 1958) in the presence of heterogeneous ambiguity-aversion, but the direction of departure is also empirically compelling. Indeed, conservative investors are commonly encouraged to hold more bonds, relative to stocks. Such financial planning advice is inconsistent with standard mean-variance investors (asset allocation puzzle), but can be accommodated in this framework.

Turning to equilibrium prices, the authors show that despite the failure of the mutual funds theorem, a single-factor pricing formula emerges. As in the standard consumption asset pricing model (CAPM), the single factor is the excess return of the market portfolio. However, the CAPM beta is adjusted by the extent to which the ambiguity of the asset return is correlated with the ambiguity of the market portfolio. Two uncertainty premia explain the cross-section of expected returns: a risk premium and an ambiguity premium. The latter has the potential to explain the size and value premia documented by Fama and French (1992, 1993). High book-to-market firms, which tend to be in financial distress, and small-cap firms, due to their over-reliance on external financing, likely carry a high ambiguity premium.

In the dynamic extensions of the model implications of public signals for trading volumes are analysed. Earning announcements or aggregate uncertainty shocks are shown to induce trading if and only if agents are heterogeneously ambiguity averse. Such trade occurs because public signals change the return-risk-ambiguity trade-off, making investors seek a different allocation across ambiguous assets depending on their different ambiguity tolerances. Trade results from uncertainty sharing considerations and leads to no or very small price movements, which is consistent with the empirical literature.

The paper concludes by proposing strategies to estimate the ambiguity of individual assets returns. Since ambiguity about the return distribution is taken to be the uncertainty about the mean of the return distribution, a measure can be obtained from a Bayesian estimate of this parameter.