Intermediate Conclusion

I extend the von Peter’s (2009) model to add an equity market so one can compare the impact of a productivity shock on equity assets and that on the collateral assets of a loan. One has seen that the introduction of an equity market does not change the von Peter’s main contribution. To quote the von Peter’s (2004) version of this work,

Loss given default (LGD) depends on the performance of collateral (the asset price). In the presence of uncertainty one could say the banking system is exposed to mar- ket risk via credit risk. (von Peter 2004, p. 16)

4.2. FINANCIAL STABILITY MODEL 127 The contribution of the current thesis has been to segregate the collateral assets of loans on the asset side of the banking system balance sheet from other assets, to track more precisely assets that can incur financial stability issues. An asset price bubble for assets that are not bank loan collateral—in this case, equity—poses limited financial stability risk, since the bubble bursting will reduce the total value of equity without directly hurting the financial system. Price bubbles for bank loan collateral assets, however, can be a very direct financial stability risk, since they can damage bank capital. When bank capital is affected by a shock, the cost for the economy is significant, because a situation of credit rationing arises and depleted bank capital needs to be recreated.

Section 4.1.5 shows that the amount of securitized product has increased dramatically during the last two decades. It is not easy to know the exact amount of securitized products on banks’ balance sheets, since banks do not like to share this information. Even though no hard numbers are available to substantiate this statement, there are strong reasons to believe that for financial institutions the amount of securitized products is large. One way of illustrating this is by ex- amining failed banks, since one can then access the exact structure of their balance sheets. The following figure, from Morris & Shin (2009), shows the asset side of the balance sheet of Lehman Brothers at the end of 2007 before bankruptcy.

128CHAPTER 4. ASSET PRICE INVOLVEMENT IN MACRO-PRUDENTIAL POLICY

One can see that collateralized lending comprised 44% of the bank’s assets. To examine the evolution of such a situation, the case of Northern Rock (Shin 2008) is shown here.

Figure 4.4: Composition of Northern Rock’s Liabilities

From almost nothing in 1998, the amount of securitized notes was around a third of North- ern Rock’s balance sheet. One can see that Northern Rock’s securitized notes on balance sheet exhibit growth similar to that of the overall market. This section develops a general framework to study collateralized loans. If one remembers that securitized notes are nothing more than packaged collateralized loans, it is clear that the development of securitization carries undeni- able systemic risk. It is important to note that during the global credit crisis banks failed not only because of a lack of liquidity, but because they had securitized products or collateralized loans on their balance sheets. The fact that such products were on the balance sheets of failed banks caused larges cost due to the vicious circle: large loan losses caused their collateral asset to be fire sale, which caused the asset price to decrease, which in turn caused larger loan losses.

4.2. FINANCIAL STABILITY MODEL 129 a recession. The steps are as follows: Due to poor liquidity management, a few financial in- stitutions fail. The failed financial institutions then sell their collateralized loans, depreciating the value of these loans. Finally, through feedback, these loans depreciate further, decreasing the price of their collateral (as in most of the real estate cases in 2007); this, in turn, hurts the capital of all remaining banks. Finally, because the entire banking system has been affected by a reduction of capital, the flow of credit is interrupted, causing a costly crisis.

Some elements are now in place to answer the first research question. If the collateral assets of loans on the asset side of the banking system balance sheet suffer a sufficiently large depre- ciation, a loss of capital for the banking system ensues, triggering a costly financial crisis. On the other hand, if assets that are not loan collateral suffer a large depreciation, wealth is lost but this does not directly lead to a financial crisis and, since the economy has not lost its ability to function, it can regrow.

A significant limitation of this model is the assumption that every loan made in the economy is guaranteed by collateral, which is, of course, hardly the case. In reality, uncollateralized loans are very common, from credit cards to commercial paper. The presence of such loans can, of course, induce different behaviors in the economy. Another limitation is the unrefined method for defining the amount of liquidity in the economy, that is, total firm profits. Most of the work on the 2007 crisis focuses on different approaches to liquidity management and their shortcom- ings. However, the mechanism at work in a financial crisis such as that of 2007 can be better understood using the model developed here, since its assumptions do not compromise the criti- cal elements in such a crisis.

130CHAPTER 4. ASSET PRICE INVOLVEMENT IN MACRO-PRUDENTIAL POLICY