Markus Brunnermeier

The safe asset potential of EU-issued bonds

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Saturday, January 21, 2023

The lack of euro-denominated safe assets and the fragmentation of the market are problematic.

Key Points:

The lack of euro-denominated safe assets and the fragmentation of the market are problematic.
In the absence of a supranational euro-denominated safe asset, a flight to safety would entail capital flowing out of vulnerable countries and into safe havens.
Both initiatives were proposed in the context of the EU’s response to the recession in the wake of the coronavirus (COVID-19) pandemic.
As of December 2021, the amount of outstanding EU bonds had grown to €215 billion in total.
The first SURE bonds were issued in October 2020, while the first NGEU bonds were issued in June 2021.
By 2028 NGEU volumes are foreseen to reach €800 billion, more than twelve times the level in December 2021.
Including the approved funding for other smaller programmes, the total available amount of EU bonds is set to exceed €1 trillion by 2028.
This stability of EU yield spreads does not mean that EU bonds will automatically become a supranational euro-denominated safe asset.
A safe asset is traded in liquid markets.
Market liquidity ensures that investors can sell their asset at any time without causing a major change in the market price.
(2022) we also argue that a safe asset’s market liquidity should be sufficiently high to accommodate central banks’ monetary policy operations.
Finally, the perception of EU bonds as safe assets also hinges on the continuation of their favourable regulatory treatment.
For such an instrument to be viable, a deep and liquid repo market would need to evolve first.

Side effects of monetary easing in a low interest rate environment: reversal and risk-taking

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Friday, November 11, 2022

Since 2014, the European Central Bank (ECB) and other central banks have been pursuing a negative interest rate policy (NIRP).

Key Points:

Since 2014, the European Central Bank (ECB) and other central banks have been pursuing a negative interest rate policy (NIRP).
The controversy about monetary policy in a low rate environment hinges on the existence of a zero-lower bound (ZLB) on interest rates (Coibion et al., 2012).
In a low or negative interest rate environment, it becomes harder for banks to pass on the reduction in the policy rate to their depositors.
This means a policy rate cut translates into a lower interest rate margin and reduces the net worth of banks.
In our recent paper (Heider and Leonello, 2021), we present a simple conceptual framework to show how a policy rate cut affects both bank lending and risk-taking in a low or negative interest rate environment versus a high interest rate environment.
The substitutability between loans, deposits and bonds is the channel through which the policy rate affects loan and deposit rates.
Reversal occurs when a cut in the monetary policy rate reduces lending instead of increasing it (Brunnermeier and Koby, 2018).
The level of the policy rate at which lending is maximal identifies the reversal rate.
Reversal is related to but not directly triggered by reduced profits from a contraction in the net interest margin at the ZLB.
This implies that when the policy rate falls below the reversal rate, a policy rate cut leads to increased risk-taking.
With market power, an increase in the lending volume reduces the loan rate, which then further reduces the benefit from screening.
Our research suggests that there are potential side effects of monetary stimulus in a low interest rate environment: reduced lending and increased risk-taking by banks.

Low rates and bank stability: the risk of a tipping point

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Friday, November 11, 2022

This has spurred academic and policy discussions about the economic implications of such low rates for the banking sector.

Key Points:

This has spurred academic and policy discussions about the economic implications of such low rates for the banking sector.
It develops a model closely based on Allen and Gale (1998) and shows the existence of a critical policy rate level, dubbed the tipping point.
Past the tipping point, an interest rate cut has a negative net effect on bank capital and may indeed result in bank insolvency.
From the model, we learn which bank characteristics matter for the tipping point and how they affect it.
Using these theoretical results, we can use data on banks to quantify the tipping point.
To discuss bank solvency, we need to understand what constitutes the assets of a bank from an economic point of view.
A banks deposit franchise, which is generally not capitalised on bank balance sheets, is also a relevant bank asset.
With this concept of solvency in mind, the question becomes: what is the effect of a low policy rate on bank assets?
Past the tipping point, the deposit-franchise effect dominates and a policy rate cut hurts bank solvency.
Our observed value for average bank asset maturity (4.5 years) implies that a 0.55% policy rate is the tipping point.
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More work is required to obtain a sound quantification of the tipping point, also for the euro area.

Benefits of macroprudential policy in low interest rate environments

Retrieved on:

Friday, November 11, 2022

Short-term interest rates in the euro area and the United States

Key Points:

Short-term interest rates in the euro area and the United States
Notes: Benchmark short-term nominal interest rate (panel A) and natural rate of return (panel B) for the euro area and the United States.
Low levels of the natural rate for protracted periods of time pose challenges for the conduct of conventional monetary policy.
This can happen because the ELB on nominal interest rates precludes the policy rate from tracking the natural rate if the latter falls below the bound.
In economies with low natural rates, such as the euro area today, macroprudential policy can have benefits for the effectiveness of conventional monetary policy, in addition to safeguarding financial stability.
The natural rate which is a risk-free, short-term real interest rate therefore increases as well.
The above benefit points to a novel complementarity between macroprudential policy and conventional monetary policy, which takes place only in environments with low interest rates.
If these conditions hold, macroprudential policy boosts the natural rate above the ELB, and it does so unintentionally, simply as a by-product of safeguarding financial stability.
That is, macroprudential policy still improves the effectiveness of conventional monetary policy, but it does not allow the policy rate to accommodate aggregate demand appropriately without hitting the ELB.
In economies with low natural rates, macroprudential policy can have benefits for the effectiveness of conventional monetary policy, in addition to safeguarding financial stability.
These benefits arise because macroprudential policy boosts the natural rate simply as a by-product of containing systemic risk in financial markets which gives the central bank more room for stimulating aggregate demand, especially during downturns.