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

Macroeconomic Imbalances and Risks to Financial Stability

B. Winkler, Ad.van Riet, P. Bull, B. Winkler, Ad.van Riet, P. Bull, B. Winkler, Ad.van Riet, P. Bull

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137353016
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Based on the crisis experience, the book offers an overview of lessons for macrofinancial analysis and financial stability. It illustrates the interlinkages between the financial side and the real side of the economy and highlights the role of balance sheet variables and sectoral balance sheet positions in the evolution of the financial crisis.

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 three thematic parts, each covering a specific field of interest.

1.2 Part I: Flow of funds and macrofinancial analysis

As pointed out by Winkler (2010), the flow-of-funds accounts, by themselves, are not informative about the underlying drivers of financial processes, nor can they be used to forecast the implications of flow-of-funds developments for economic dynamics and vice versa. To this end, empirical tools for flow-of-funds analysis have to be developed. The most commonly adopted modelling approach for flow-of-funds analysis involves the use of empirical macroeconomic portfolio balance models in the spirit of James Tobin (1969). Several contributions in Part I, entitled ‘Flow of Funds and Macrofinancial Analysis’, also identify a continued need to develop modelling tools based on the flow-of-funds framework.

This is highlighted in particular in the contribution by John Duca (Federal Reserve Bank of Dallas and Southern Methodist University) and John Muellbauer (Nuffield College and Institute for New Economic Thinking at the Oxford Martin School). They explicitly go back to the portfolio balance view of Tobin and his Yale colleagues, in which portfolio choice across a wider range of assets matters for saving behaviour and real– financial linkages. The authors illustrate the relevance of flow-of-funds balance sheet variables for household behaviour by examining the crucial role of credit market liberalization for consumption outcomes in the case of the United States. For this purpose, they augment a life-cycle consumption function with credit constraints and disaggregated wealth effects that can vary over time depending on financial innovations. A key element in this respect is the introduction of shifts in credit availability, both in unsecured household credit and in mortgage credit, and the consequent induced behavioural shifts. They then introduce this consumption function into a larger system which endogenises key portfolio choices made by households, such as changes in mortgage debt, mortgage refinancing, housing equity withdrawal or the acquisition of residential housing. The authors conclude with a plea to strategically integrate flow-of-funds accounts into tractable macroeconometric models that better incorporate real and financial sector linkages and are useful for assessing financial stability.

Richard Barwell (Bank of England at the time of writing) and Oliver Burrows (Bank of England) construct a flow-of-funds framework for the United Kingdom to analyse financial flows, balance sheets and asset prices and the building up of financial fragilities during the ‘Great Moderation’. Their analysis of the DotCom bubble around the turn of the millennium and of the great credit expansion shows that there were many linkages between the balance sheet developments that led to financial instability. The rapid expansion of household debt during the credit and housing boom found its counterpart in increasingly stretched bank balance sheets. The non-financial corporate sector realised balance sheet growth considerably in excess of income growth by rapid borrowing from banks. The rise in corporate debt was used to finance acquisitions of commercial property and to increase the return on equity. The UK banking sector became highly exposed to the value of the assets and income streams of households and corporates, while also expanding its non-UK activities. The authors conclude that the flow of funds offers a useful framework to spot the build-up of financial fragilities in an economy.

Shuji Kobayakawa and Ryoichi Okuma (both Bank of Japan) start from the observation that the financial systems in Japan and the euro area have much in common, both being bank-based, in contrast to the United States, where banking assets are much smaller as a ratio to GDP. An important difference is, however, that Japanese depository corporations raise funds primarily through deposits by households (through retail funding),while their counterparts in the euro area depend largely on deposits from each other (through wholesale funding). The authors also analyse the network of lending and borrowing relationships between different sectors using the detailed flow-of-funds accounts for Japan. This shows that the funds raised by the general government have increased with each sector contributing. Loans from depository corporations to private non-financial corporations and households are the principal channels of funding for the private sector. The authors conclude with an overview of the further development and enhancement of the flow-of-funds accounts for Japan, also stressing their importance for assessing the stability of the financial system.

Janez Fabijan (Banka Slovenije) calls for developing a comprehensive and consistent statistical information system of quarterly financial and broader sectoral accounts in each euro-area country. He refers to Slovenia’s experience with building up such a coherent statistical information and decision support system for policy purposes. Given the natural role of the financial sector as an intermediator of funds, granular data for this core sector are of vital importance. The availability of such more granular data in Slovenia allowed a closer analysis of bank deleveraging after 2008. The core of the concept used in Slovenia is a matrix reporting system for financial intermediaries, which also forces them to redesign their information systems for stronger risk management in the future.

1.3 Part II: Flow of funds and macroeconomic imbalances in Europe

The second part of this volume, entitled ‘Flow of funds and macroeconomic imbalances in Europe’, brings together work on sectoral balance sheets and rebalancing in the wake of the crisis for the euro area as well as individual European Union (EU) economies.

Philippe De Rougemont and Bernhard Winkler (both European Central Bank) offer an overview of ECB analysis on selected features of the financial crisis in the euro area, in part drawing on ECB (2011). They emphasise the theme of ‘sector rotation’ as evident in sectoral net lending and also balance sheet developments during various stages of the crisis, for example with the non-financial corporate sector as it quickly cut outlays and increased savings, abruptly turning into a net lender to the rest of the economy after the Lehman Brothers shock, reversing the previous expansionary net borrowing positions. The authors note that governments took on a similar ‘intermediation role’ by taking over impaired assets and leverage from bank balance sheets post-Lehman Brothers, while additions to financial sector balance sheets sharply retrenched from their boom levels. They also pay attention to other changes in intermediation patterns during the crisis, such as the substitution of bank finance with market funding and the buffering role of trade credit and inter-company loans. Furthermore, they look into the evolution of intra-euro area imbalances through the lens of the sector accounts, by showing the evolution of sectoral net lending for two country groupings (current account surplus and deficit countries), in particular highlighting the associated divergence in non-financial corporations’ profit measures and wages across the two groups.

Carlos Cuerpo and Alexandr Hobza (both European Commission) provide an overview of the new EU surveillance framework for macroeconomic imbalances through the lens of various indicators built from the flow-of-funds data. The emphasis in the analytical framework is on early warning and sustainability of macroeconomic trends, the adjustment capacity and potential spillovers. They underline that a proper assessment of the nature and origin of excessive imbalances is essential in order to target the policy responses on the underlying root causes. Against this background, the authors try to identify which euro-area countries face a debt overhang and what are the prospects for balance sheet repair in financial corporations, other firms and households. In addition, they examine how private sector deleveraging pressures are affected by the savings–investment balances of the public sector and of the economy as a whole. Looking ahead, they conclude that households and firms in a number of euro-area countries will face a protracted austerity period and considerably lower levels of credit than in the past.

Christophe Van Nieuwenhuyze (Belgian National Bank) conducts an aggregate analysis of the debt positions of the euro-area countries, covering both public and private debt, because a country’s solvency is also determined by the financial position of the private sector. He also takes account of the financial assets of the various sectors to arrive at their net debt positions. As it turns out, euro-area countries differ a lot in terms of their total net (external) financial assets. The experience of the financial crisis has shown that the financing of persistent current account deficits within the euro area cannot be taken for granted. Therefore, policies should concentrate on reducing the substantial differences between the euro-area members in terms of their total net financial assets (rebalancing). This implies that the deficit countries (countries with a negative net financial asset position or an aggregate net debt) should increase their net savings, preferably by improving their competitiveness. Van Nieuwenhuyze emphasises that the surplus countries (countries with net financial assets) can contribute to the rebalancing by correcting rigidities in their domestic markets. He therefore welcomes the EU’s new macroeconomic imbalances procedure, which also monitors the external position of a country, for example by means of the net international investment position.

1.4 Part III: Flow of funds and financial stability

The final Part III, entitled ‘Flow of Funds and Financial Stability’, looks at the use of tools based on flow of funds for financial stability purposes, such as network analysis of interconnectedness and systemic risks.

Nuno Silva, Nuno Ribeiro and António Antunes (all Banco de Portugal) develop a new systemic risk indicator based on contingent claims analysis by combining balance sheet information from the financial accounts with assumptions on the volatility of asset returns. They based this indicator on first estimating all sets of shocks in the system of sectoral balance sheets that would deplete the equity base of at least one sector, and then deriving the probability of such shocks happening. The authors apply the methodology to the case of Portugal for the period 2002–10, considering shocks to equity for four sectors as well as shocks to liabilities for non-financial corporations and households, paying separate attention to household mortgages. The resulting systemic risk indicators for Portugal point to an elevated level of systemic risk since the end of 2007.

Against the background of the need to improve financial stability analyses, Virgilijus Rutkauskas (Bank of Lithuania) provides insights into the use of flow of funds in financial stability assessments undertaken at the Bank of Lithuania. In the case of Lithuania, unlike for many other countries, the complete matrix of holding sectors is also known. This allows taking into account the interconnectedness between separate sectors and the characteristics of financial instruments when assessing the potential impact of systemic shocks and how they could affect the financial system and the economy, including possible second-round effects. Rutkauskas notes that this macro approach could be complemented with a micro approach, thus further enriching the analysis of financial stability. He finishes with a word of caution: a lot of future work will be needed to identify all the risks and mismatches in the financial system, to evaluate how they could trigger losses and to conduct system-wide stress-tests with second-round effects.

Michael Andreasch (Oesterreichische Nationalbank) undertakes an analysis of the sectoral financial interlinkages of the financial sector in Austria. He first presents selected results based on the ‘from-whom-to-whom’ relationship between the sub-sectors and sectors of the Austrian economy and their relationship with foreign creditors and debtors. Taking a macroeconomic viewpoint, he then compares the developments in Austria with those in other European countries in terms of the size of financial positions and thei...

Table of contents

• Cover
• Title
• 1 Introduction and Overview
• Part I Flow of Funds and Macrofinancial Analysis
• Part II Flow of Funds and Macroeconomic Imbalances in Europe
• Part III Flow of Funds and Financial Stability
• Index