A Flow-of-Funds Perspective on the Financial Crisis Volume I

Money, Credit and Sectoral Balance Sheets

B. Winkler, A. van Riet, P. Bull, B. Winkler, A. van Riet, P. Bull, Kenneth A. Loparo, B. Winkler, A. van Riet, P. Bull, Ad van Riet

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137352989
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Provides a comprehensive overview of a broad range of uses of the flow of funds within the central bank community as well as in the academic field, prepared by international experts in the field. Based on the crisis experience, it offers an overview of lessons for macrofinancial analysis and financial stability.

1

Introduction and Overview*

Bernhard Winkler, Ad van Riet and Peter Bull

1.1 Introduction

Flow-of-funds accounts are a component of the national accounts system reporting the financial transactions and balance sheets of the economy, classified by sectors and financial instruments. As described by Winkler (2010), the financial accounts track funds as they move from sectors, such as households, that serve as sources of funds (net lenders), through intermediaries (financial corporations) or financial markets, to sectors that use the funds to acquire physical and financial assets (non-financial corporations, government, rest of the world). These flows, together with valuation changes, result in changes to sectoral (net) asset positions and the composition of the corresponding balance sheets.

The financial crisis has driven home the importance of financial flows and balance sheets for an understanding of real–financial linkages and it has spurred a renewed academic and policy interest in flow-of-funds analysis. During the crisis policy-makers could rely neither on received wisdom and assumptions on liquid and efficient markets underlying the functioning of the financial system, nor on standard macroeconomic workhorse models, to give ready answers on the origins, transmission channels and policy implications of the financial crisis. In such circumstances flow-of-funds data could be seen, at least, to provide a promising framework to articulate relevant questions to be asked when confronting new challenges for monetary policy and financial stability, such as related to debt and asset market dynamics, leverage cycles, financial intermediation chains and feedback loops between the financial system and the real economy (see ECB, 2012).

The financial crisis has, hence, underlined the relevance of flow-of-funds analysis from a policy perspective, for example, for an understanding of factors behind the building up of macrofinancial imbalances and the accumulation of balance sheet vulnerabilities (see ECB, 2011). In this respect, the flow of funds provides a nexus between the ‘flow’ dynamics of money, credit and other financial intermediation flows and the implications for ‘stock’ dynamics in terms of sectoral balance sheets and the evolution of assets and liabilities. On this basis one can, for example, construct early warning indicators for financial boom-bust cycles. In particular, private and public sector debt indicators based on financial accounts data have become an important element in the enhanced surveillance of macroeconomic imbalances (in both the EU and the G20 context). Moreover, flow-of-funds approaches can be used for macroprudential risk analysis.

Central banks have traditionally taken a close interest in the working of the financial system and have for a long time invested in compiling financial accounts, most notably at the US Federal Reserve, but also at the Bank of Japan and at many European national central banks. For a comprehensive compilation of key academic papers and applications see Dawson (ed.) (1996). The set of studies included in De Bonis and Pozzolo (eds) (2012) is also highly recommended. Flow-of-funds analysis for the euro area is a relatively recent endeavour. For the European Central Bank it offers a natural platform for cross-checking and ‘bridging’ analysis under the economic and monetary ‘pillars’ that are a key feature of its monetary policy strategy (see Winkler, 2010).

The remainder of this introduction and overview summarises the contributions to the workshop proceedings collected in the present volume, sub-divided into two thematic parts, each covering a specific field of interest.

1.2 Part I: Money, credit and liquidity in the flow of funds

While mainstream macroeconomic models had got used to largely ignoring financial developments, the growing economic importance and complexity of financial sectors and markets has spurred a renewed academic and policy interest in flow-of-funds analysis. The contributions in Part I of this volume, entitled ‘Money, credit and liquidity in the flow of funds’, discuss in more detail the role of flow-of-funds analysis as a natural extension of and complement to monetary analysis.

By way of introduction to this theme, Carmelo Salleo (European Systemic Risk Board) recalls that the original version of the quantity theory of money, as expressed by the equation MV = PT, was formulated in terms of total transactions in the economy (T). This comprised both real and financial transactions (as well as intermediary transactions along the production chain). Multiplied by the price (P), the nominal value of all transactions must be equal to the quantity of money (M) adjusted for the number of times it is used, i.e. the velocity of circulation (V). Only subsequently was the transactions variable replaced (or approximated) by a measure of income (Y) for practical reasons. As the stability of this relationship between money and economic activity broke down, a search started for new interpretations for its components. Alternatively, the equation of exchange may be rearranged in terms of the three motives for holding money in varying economic and financial conditions: to finance transactions, as a store of value, for portfolio purposes. This could prompt searching for a ‘financial transactions-augmented’ model of money demand drawing on flow-of-funds statistics of the stocks and flows in the financial system. While a revisited quantity theory of money still offers a solid basis for understanding the dynamics of money, Salleo remains somewhat sceptical on the ability of central banks to use the quantity relation for monetary policy purposes. Instead, an extended monetary analysis framework is argued to play a potentially more useful role with respect to financial stability considerations.

Richard A. Werner (University of Southampton) presents a simple macroeconomic model that incorporates the special role of banks as creators of credit, the ‘Quantity Theory of Credit’, which can also be seen as a parsimonious flows-of-funds model. He stresses the importance of distinguishing between ‘good’ credit creation for income-generating transactions that contribute to GDP and ‘bad’ credit creation for financing transactions that may generate unsustainable capital gains that do not contribute to GDP, and how this is linked to the separation of economic activity into income accounts and financial accounts. He then shows how the Quantity Theory of Credit solves ten seeming ‘puzzles’ (such as the recurrence of banking crises and the ineffectiveness of fiscal policy in promoting GDP) that traditional macroeconomic or monetary models have struggled with, and discusses a number of policy implications that are relevant today. Given the importance of detailed data on the use of bank credit, he calls on central banks to collect and make available such data in a far more detailed and timely fashion than is currently the case. Furthermore, he urges central banks to publish the wealth of data they have concerning total transactions in the economy – thanks to their role as settlement system of bank flows – on a real-time, daily basis.

Roberto A. De Santis (European Central Bank), Carlo A. Favero (Bocconi University) and Barbara Roffia (European Central Bank) characterise money demand as part of a broader portfolio allocation problem where both domestic and foreign asset prices influence money holdings. By modelling international portfolio shifts they are able to obtain a stable broad money demand for the euro area over the period 1980–2011. This implies that fluctuations in international financial markets are among the key determinants of the observed path of euro area money growth. The authors conclude that model-based excess liquidity measures, namely the difference between actual M3 growth (net of the inflation objective) and the expected money demand trend dynamics, can be useful to predict inflation.

Claudio Borio, Robert McCauley and Patrick McGuire (all Bank for International Settlements) explore insights from combining the BIS international financial statistics with national flow-of-funds data to produce indicators of global liquidity, with a focus on global credit aggregates. Their aim is to better understand the international dimension of credit along two dimensions: foreign currency credit to residents, regardless of the lender’s location; and cross-border (external) credit, regardless of the currency of denomination. This is badly needed, given that financial globalisation and the use of international currencies outside their country of origin mean that the monetary authorities of these currencies have a direct influence on financial conditions in other jurisdictions. By contrast, the countries whose residents denominate a significant fraction of their debt (and assets) in these foreign currencies are constrained in their room for policy manoeuvre. Moreover, cross-border credit has a history of outpacing the growth of overall credit in economies experiencing credit booms, and therefore could raise concerns from national supervisors. The authors show that an increasing share of outstanding credit and a significant part of the recent boom-bust cycle was driven by external sources of credit, especially for US dollar lending and, to a lesser degree, for lending in euro. They note that monitoring direct cross-border credit, which is not channelled through the domestic banking system, presents challenges. The BIS data could be used for cross-checking the authorities’ estimates of residents’ international debt positions, especially the part owed by firms to banks abroad.

Ulrich Bindseil (European Central Bank) and Adalbert Winkler (Frankfurt School of Finance & Management) address the role of the central bank as lender of last resort in financial crises within a closed system of financial accounts. They compare the ability of central banks to respond to a dual liquidity crisis (a confidence crisis involving both the government and the banking sector) under the gold standard and within the framework of a monetary union. The system of financial accounts offers a framework to trace liquidity flows, identify quantitative constraints and relevant policy options and, hence, allows conclusions to be drawn on the ability of central banks to absorb shocks under alternative monetary regimes. The authors find that a central bank in a monetary union is much more able to respond to liquidity shocks than a central bank under the gold standard. Their analysis also suggests that a sufficiently strong underpinning of the monetary union in terms of banking and fiscal union is needed in order to be able to deal with solvency issues that might arise when fighting a liquidity crisis. When this ability is ensured and the integrity of monetary union is beyond doubt, the common central bank is as unconstrained in providing liquidity as a central bank of a nation state issuing a currency under a flexible exchange rate regime.

Riccardo De Bonis, Luigi Infante and Francesco Paternò (all Banca d’Italia) analyse linkages between financial and real variables for the United States and the euro area. They find that a deterioration in bank capital leads to tighter lending standards applied by banks to firms and households (as measured by bank lending surveys). In turn, tighter lending standards reduce credit, which finally affects different categories of spending (machinery and residential investment and consumption). Based on this three-step estimation, the authors quantify the first round impact of bank capital losses on GDP. A 1 per cent bank capital loss causes three years after the shock a GDP loss of about 0.5 per cent in the United States, and of about 0.2 per cent in the euro area. They explain the larger effect recorded for the United States by the greater influence of bank capital losses on consumer loans and consumption in the US.

1.3 Part II: Sectoral analysis of the flow of funds

The second part of this volume, entitled ‘Sectoral analysis of the flow of funds’, collects a number of contributions which study the portfolio and/or financing behaviour of individual institutional sectors, covering both financial intermediaries and non-financial private sectors (households and non-financial corporations).

Tobias Adrian (Federal Reserve Bank of New York) and Hyun Song Shin (Princeton University) examine the balance sheet management by financial intermediaries, which they contrast with conventional discussions of the balance sheet management by non-financial firms. Concerning the latter, the size of the assets of the firm is determined by taking the set of positive net present value projects as given. The composition of equity and debt is then the key factor in funding such assets. By contrast, the balance sheet management of financial intermediaries reveals that equity behaves like the predetermined variable, while the asset size of the financial intermediary is determined by the degree of leverage that is permitted by market conditions. The fact that equity is relatively sticky suggests that there are possible non-pecuniary benefits to bank owners. As a result, bank owners are reluctant to raise new equity, even during boom periods. The authors explore the empirical evidence for market-based financial intermediaries such as the Wall Street investment banks, as well as the commercial bank subsidiaries of the large US bank holding companies. They also explore the aggregate consequences of such behaviour by the banking sector for the propagation of the financial cycle and securitisation.

Celestino Girón (European Central Bank) and Silvia Mongelluzzo (Bocconi University) focus on the behaviour of bank leverage and bank balance sheet growth in the euro area financial sector as derived from flow-of-funds data, taking advantage of the fact that the system requires marked-to-market valuation of assets, liabilities and equity. Studying the period 1999–2011, they find that, before the financial crisis of autumn 2008, the bank leverage ratio behaved in a strongly procyclical manner for most of the euro area countries in their panel. Afterwards, the leverage ratio was less procyclical, signalling a precautionary reaction on the part of banks. This evidence suggests that strong credit and balance sheet growth are accompanied by an insufficient build-up of precautionary capital buffers, while severe downturns in the credit cycle are linked to a fast accumulation of capital. The authors note that this pro-cyclical behaviour of the bank leverage ratio might contribute to the amplification of the credit cycle.

Sanvi Avouyi-Dovi, Vladimir Borgy, Christian Pfister, Franck Sédillot (all Banque de France) and Michael Scharnagl (Deutsche Bundesbank) present a detailed empirical analysis of households’ financial portfolio structure during the period 1978–2009 in France and Germany. In the German case, the main data source is the newly compiled quarterly flow-of-funds dataset for households according to ESA 1995 that was built in the Bundesbank. Concerning the French portfolio data, the main data are taken from the quarterly financial accounts collected and published by the Banque de France. The aggregate financial portfolio structures of households have evolved dramatically in France and Germany over the period 1978–2009; however, at the end of the sample, both aggregate household portfolios display somewhat similar structures in the two countries. The authors also study the portfolio choices of German and French households, by estimating a Financial Almost Ideal Demand System (FAIDS) model. The analysis of cross-interest rate elasticities allows them to assess substitution effects between asset shares in the aggregate financial portfolios of households.

Jacob Isaksen, Paul Lassenius Kramp, Louise Funch Sørensen and Søren Vester Sørensen (all Danmarks Nationalbank) undertake a cross-country comparison of household debt and balance sheets for a large sample of OECD economies. Their study decomposes changes in net wealth due to savings and capital gains, linking the latter to determinants like financial liberalisation and private pension wealth. Regression of household debt ratios also highlights the interaction between debt and assets (housing or pension wealth) as well as with other sectors (public net assets) together with macro variables like the short-term real interest rate, inflation or NAIRU. They find that higher gross household debt ratios lead to a greater sensitivity of households to changes in interest rates and unemployment, as well as a greater volatility in private consumption. This may be accompanied by increased losses on bank lending to firms and risks to financial stability.

Turning to analysis of the non-financial corporate sector, Laurent Maurin (European Central Ba...

Table of contents

• Cover
• Title
• 1 Introduction and Overview
• Part I Money, Credit and Liquidity in the Flow of Funds
• Part II Sectoral Analysis of the Flow of Funds
• Index