Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Paradox of Prudence&
Linkage betweenFinancial & Price Stability
Markus Brunnermeier
Reserve Bank of South Africa Pretoria, South Africa, Oct 26th, 2017
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Overview
1. From Risk in Isolation to Systemic Risk• Volatility Paradox
• Direct Spillovers – domino effects
• Indirect Spillovers – amplifiers vs. absorbers
• Paradox of Prudence (becoming an amplifier)
2. From Separation Principles to Interlinkagesacross stability concepts• … and redistributive monetary policy
3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
The 2 Components of Systemic Risk
1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series
“Volatility Paradox” contemp. measures inappropriate
• Low VaR ⇒ low margins ⇒ high margins ⇒ high leverage ⇒ low risk-weights⇒ less capital ⇒ high leverage
• Shock leads to large adjustment• High VaR ⇒ …
Procyclicality• Countercyclical puffer… See paper
More subtle: better idiosyncratic risk sharing higher endogenous risk
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
The 2 Components of Systemic Risk
1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series
“Volatility Paradox” contemp. measures inappropriate
• Low VaR ⇒ low margins ⇒ high margins ⇒ high leverage ⇒ low risk-weights⇒ less capital ⇒ high leverage
• Shock leads to large adjustment• High VaR ⇒ …
Procyclicality• Countercyclical puffer… See paper
More subtle: better idiosyncratic risk sharing higher endogenous risk
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
The 2 Components of Systemic Risk
1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series
“Volatility Paradox” contemp. measures inappropriate
• Low VaR ⇒ low margins ⇒ high margins ⇒ high leverage ⇒ low risk-weights⇒ less capital ⇒ high leverage
• Shock leads to large adjustment• High VaR ⇒ …
Procyclicality• Countercyclical puffer… See paper
More subtle: better idiosyncratic risk sharing higher endogenous risk
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
The 2 Components of Systemic Risk
1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series• “Volatility Paradox” contemp. measures inappropriate
2. Spillovers/contagion – cross sectional• Direct contractual: domino effect – network
Network effects Bankruptcy of bank A
leads to default of B • 1st, 2nd, 3rd round effects• Random recovery rate
Data implications:• Position data• High frequency• High granularity
6
pre
ven
tive
cris
is m
anag
emen
t
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
The 2 Components of Systemic Risk
1. Systemic risk build-up during (credit) bubble … and materializes in a crisis – time-series• “Volatility Paradox” contemp. measures inappropriate
2. Spillovers/contagion – cross sectional• Direct contractual: domino effect - network• Indirect: price effect (fire-sale externalities)
credit crunch, liquidity spirals
• Adverse GE response amplification, persistence7
Loss of
net worth
Shock to
capital
Precaution
+ tighter
margins
volatility
price
Fire
sales
nonlinearity
pre
ven
tive
cris
is m
anag
emen
t
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Absorbers vs. amplifier
Shock absorber
Shock amplifier
Distributionexogenous endogenous
Direct Indirect
Contractual links “Virtual links”
Loss through bankruptcy/default
Similar exposurethan other levered players
Position data Response indicator- expectations/constraints
8Fat tail
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Absorbers vs. amplifier Response Indicator
Liquidity mismatch – not maturity mismatch
See Brunnermeier, Gorton & Krishnamurthy (2012)
A L
Micro-prudential Macro-prudential
Market Illiquidity exogenous depends on funding structure of other holders
Technological Illiquidity- Irreversibility
Market Illiquidity- Price Impact
Fund Illiquidity- Maturity- Haircut/margin sensitivity
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
From Risk in Isolation to Spillover RiskFrom 𝑉𝑎𝑅 to Δ𝐶𝑜𝑉𝑎𝑅
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
“Paradox of Prudence”
Fallacy of Composition in Risk Space
1. Keynes’ Paradox of Thrift
2. “Paradox of Prudence” Brunnermeier & Sannikov (Handbook chapter 2017)
• Each institution tries to reduce risk exposure (micro-prudent)
• Increases endogenous (systemic) risk (macro-imprudent) Liquidity spirals, fire-sales,…
Disinflationary spirals, …
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Overview
1. From Risk in Isolation to Systemic Risk• Volatility Paradox
• Direct Spillovers – domino effects
• Indirect Spillovers – amplifiers vs. absorbers
• Paradox of Prudence (becoming an amplifier)
2. From Separation Principles to Interlinkagesacross stability concepts• … and redistributive monetary policy
3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Separation Principles Perspectives
Separation of task and accountability
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Interlinkages Perspectives
From YouTube video: “Money and Banking” by Markus.Economicus
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Interlinkages Perspectives
From YouTube video: “Money and Banking” by Markus.Economicus
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Interlinkages: MacroPru & MoPo
Liquidity spiral, fire sales
Disinflationary spiralEndogenous systemic risk
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Interlinkages: MacroPru & MoPo
In EME many MacroPru = MoPo measures
Inside money creation by private banks
Central bank balance sheet• Reserve holding due to liquidity regulation (LCR)
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
A L
Ris
ky C
laim
A LR
isky
Cla
im
The “I Theory of Money” Technologies 𝑏
…
Net worth
Inside Money(deposits)
A L
Outside Money Pass through
Ris
ky C
laim
Ris
ky C
laim
Ris
ky C
laim
Outside Money
Intermediaries• Can diversify within sector 𝑏
• Monitoring
• Create inside money
• Maturity/liquidity transformation
A L
𝐵1
Money
Ris
ky C
laim
Insi
de
equ
ity
A LA L
A LA L
𝐴1
Money
HH
Net
wo
rth
Technologies 𝑎
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Technologies 𝑏
A L
Ris
ky C
laim
A L
Shock impairs assets: 1st of 4 steps Technologies 𝑎
…
Net worth
Inside Money(deposits)
A L
Outside Money Pass through
Ris
ky C
laim
Ris
ky C
laim
Ris
ky C
laim
Losses
A L
𝐴1
Money
Ris
ky C
laim
Insi
de
equ
ity
𝐵1
A LA L
A LA L
𝐴1
Money
HH
Net
wo
rth
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Technologies 𝑏
Shrink balance sheet: 2nd of 4 steps
A
Technologies 𝑎
Inside Money(deposits)
…
Net worth
Inside Money(deposits)
A L
Pass through
Losses
Deleveraging Deleveraging
…
Ris
ky C
laim
Ris
ky C
laim
Ris
ky C
laim
Outside Money
Switch
A L
Ris
ky C
laim
A LA L
𝐴1
Money
Ris
ky C
laim
Insi
de
equ
ity
𝐵1
A LA L
A LA L
𝐴1
Money
HH
Net
wo
rth
“Paradox of Prudence”
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Technologies 𝑏
Liquidity spiral: asset price drop: 3rd of 4 Technologies 𝑎
A L
Ris
ky C
laim
A LA L
𝐴1
Money
Ris
ky C
laim
Insi
de
equ
ity
𝐵1
Inside Money(deposits)
Outside Money
…
Net worth
Inside Money(deposits)
A L
Pass through
Ris
ky C
laim
Ris
ky C
laim
Ris
ky C
laim
Losses
Deleveraging Deleveraging
A LA L
A LA L
𝐴1
Money
HH
Net
wo
rth
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Technologies 𝑎 Technologies 𝑏
Disinflationary spiral: 4th of 4 steps
A LA L
A LA L
𝐴1
Money
HH
Net
wo
rth
A L
Ris
ky C
laim
A LA L
𝐴1
Money
Ris
ky C
laim
Insi
de
equ
ity
𝐵1
Inside Money(deposits)
Outside Money
…
Net worth
Inside Money(deposits)
A L
Pass through
Ris
ky C
laim
Ris
ky C
laim
Ris
ky C
laim
Losses
Deleveraging Deleveraging
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Redistributive MoPo: “I Theory of Money”
Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price • ⇒ “stealth recapitalization” - redistributive• ⇒ risk premia
Liquidity & Deflationary Spirals are mitigated
…
Net worth
Inside Money(deposits)
A L
Reserves Pass through
𝑁𝑡
Long-term Bonds
Ris
ky C
laim
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Redistributive MoPo: “I Theory of Money”
Adverse shock Liquidity & Deflationary Spirals
Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price • ⇒ “stealth recapitalization” - redistributive• ⇒ risk premia
Liquidity & Deflationary Spirals are mitigated
…
Net worth
Inside Money(deposits)
A L
Reserves Pass through
𝑁𝑡
Long-term Bonds
Ris
ky C
laim
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Redistributive MoPo: “I Theory of Money”
Adverse shock Liquidity & Deflationary Spirals
Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price ⇒ “stealth recapitalization” - redistributive
⇒ Liquidity & Deflationary Spirals are mitigated
⇒ risk premia MoPo with risk premium focus
…
Net worth
Inside Money(deposits)
A L
Reserves Pass through
𝑁𝑡
Long-term Bonds
Ris
ky C
laim
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Redistributive MoPo: “I Theory of Money”
Adverse shock Liquidity & Deflationary Spirals
Monetary policy• Interest rate cut ⇒ long-term bond price • Asset purchase ⇒ asset price ⇒ “stealth recapitalization” - redistributive
⇒ Liquidity & Deflationary Spirals are mitigated
⇒ risk premia MoPo with risk premium focus
…
Net worth
Inside Money(deposits)
A L
Reserves Pass through
𝑁𝑡
Long-term Bonds
Ris
ky C
laim
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Difference to New Keynesian View
Consumption Boost approach to “Bottleneck approach”
(New) KeynesianDemand Management
I Theory of MoneyRisk (premium) management
Stimulate aggregate consumptionSubstitution effect
Alleviate balance sheet constraintsIncome/wealth effect
Woodford Tobin (1982) BruSan
Price stickinessPerfect capital markets
Both Financial FrictionsIncomplete markets
Representative Agent Heterogeneous Agents
Cut 𝑖Reduces 𝑟 due to price stickinessConsumption 𝑐 rises
Cut 𝑖Changes bond pricesRedistributes from low MPC to high MPC consumers
- -
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Difference to New Keynesian View
Consumption Boost approach to “Bottleneck approach” (New) Keynesian
Demand ManagementI Theory of Money
Risk (premium) management
Stimulate aggregate consumptionSubstitution effect
Alleviate balance sheet constraintsIncome/wealth effect
Woodford Tobin (1982) BruSan
Price stickinessPerfect capital markets
Both Financial FrictionsIncomplete markets
Representative Agent Heterogeneous Agents
Cut 𝑖Reduces 𝑟 due to price stickinessConsumption 𝑐 rises
Cut 𝑖Changes bond pricesRedistributes from low MPC to high MPC consumers
Cut 𝑖Changes asset pricesEx-post: Redistributesto balance sheet impaired sector
QE
- -
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Difference to New Keynesian View
Consumption Boost approach to “Bottleneck approach” (New) Keynesian
Demand ManagementI Theory of Money
Risk (premium) management
Stimulate aggregate consumptionSubstitution effect
Alleviate balance sheet constraintsIncome/wealth effect
Woodford Tobin (1982) BruSan
Price stickinessPerfect capital markets
Both Financial FrictionsIncomplete markets
Representative Agent Heterogeneous Agents
Cut 𝑖Reduces 𝑟 due to price stickinessConsumption 𝑐 rises
Cut 𝑖Changes bond pricesRedistributes from low MPC to high MPC consumers
Cut 𝑖Changes asset pricesEx-post: Redistributesto balance sheet impaired sector
QE- US: QE1 & QE3: MBS- Japan 1990: corporate bonds
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Difference to Monetarist View
Target broad money supply measure
When private/inside money creation contractsreplace “missing” inside money with outside money
Ignores that • Private financial institutions “diversify” some risk away• If these institutions contract – more risk in the system• Money demand rises
Outside vs. Inside money Inside money allows banks to diversify idiosyncratic risk Outside money doesn’t
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Difference to Monetarist View
Target broad money supply measure
When private/inside money creation contractsreplace “missing” inside money with outside money
Ignores that • Private financial institutions “diversify” some risk away• If these institutions contract – more risk in the system• Money demand rises
Outside vs. Inside money Inside money allows banks to diversify idiosyncratic risk Outside money doesn’t
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Interaction between MoPo & MacroPru
Redistributive MoPo insures ⇒ Moral Hazard
MacroPru complements MoPo• Not substitutes
Good MacroPru enables more aggressive MoPo• More redistribution ex-post
• More risk-transfers/insurance ex-ante
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Overview
1. From Risk in Isolation to Systemic Risk• Volatility Paradox
• Direct Spillovers – domino effects
• Indirect Spillovers – amplifiers vs. absorbers
• Paradox of Prudence (becoming an amplifier)
2. From Separation Principles to Interlinkagesacross stability concepts• … and redistributive monetary policy
3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Safe assets
“Good friend analogy” - like reserve assets
• Safe/available at any horizon - “when it counts”
• Precautionary buffer held in addition to more risky assets
Risk ⇒ demand for safe assets
“Safe asset tautology”• safe because it is “perceived to be safe”
• safe independent of fundamentals US Treasury downgrade
by S&P in 2011 ⇒ yield
German CDS spread ⇒ yield during Euro crisis
• Multiple equilibria
• Bubble
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Safe assets
“Good friend analogy” - like reserve assets
• Safe/available at any horizon - “when it counts”
• Precautionary buffer held in addition to more risky assets
Risk ⇒ demand for safe assets
Pool ofRisky assets
Safe asset
Deposits
Equity
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Safe assets
“Good friend analogy” - like reserve assets
• Safe/available at any horizon - “when it counts”
• Precautionary buffer held in addition to more risky assets
Risk ⇒ demand for safe assets
“Safe asset tautology”• safe because it is “perceived to be safe”
• safe independent of fundamentals US Treasury downgrade
by S&P in 2011 ⇒ yield
German CDS spread ⇒ yield during Euro crisis
• Multiple equilibria
• Bubble37
Pool ofRisky assets
Safe asset
Deposits
Equity
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Flight to Safety
Risk-on, Risk-off Flight to safe asset
If asymmetrically supplied by AE
Flight to safety cross-border capital flows
Who insures whom? (rich the poor?)• At times of global crisis issue new debt
- for AE: at inflated prices
- for EME: at depressed prices
• Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset
38
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Flight to Safety
Risk-on, Risk-off Flight to safe asset
If asymmetrically supplied by AE
Flight to safety cross-border capital flows
Who insures whom? (rich the poor?)• At times of global crisis issue new debt
- for AE: at inflated prices
- for EME: at depressed prices
• Question: is buffer large (long-term) enough s.t. no new debt issuance needed & sale off safe asset
39
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Flight to Safety
Risk-on, Risk-off Flight to safe asset
If asymmetrically supplied by AE
Flight to safety cross-border capital flows
At times of global crisis, issuance of new debt• For US at inflated prices eases conditions
• For EME at depressed prices worsens conditions
Question: Who insures whom? (rich the poor OR poor the rich?)
• “Correct” insurance only if buffer is large (and debt long-term) enoughso that no new debt issuance needed & sale off safe asset 40
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Different Approaches to Counter Risks
Buffer Approach (public)
IMF Facilities Approach
Swapline Approach
Rechanneling Approach
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Different Approaches to Counter Risks
Buffer Approach (public)
IMF Facilities Approach
Swapline Approach
Rechanneling Approach
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Buffer Approach
Buffers (public) more private imbalances
• Irrelevance theorem in BruSan2017 “International Monetary Theory: Mundell-Fleming Redux”
• International banks approach central bank as Lender of Last Resort in a Foreign Currency New additional rationale for Central Banks’
foreign reserve (safe asset) holding (in dollar)
Moral Hazard problem: banks hold fewer safe asset (in dollar) and rely on LOLR of CB
43
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Rechanneling Approach
Buffers (public) more private imbalances
Rechannel away from cross-border capital flows
4444
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Rechanneling Approach
Buffers (public) more private imbalances
Rechannel away from cross-border flows
• With ESBies in Europe (SBBS = sovereign backed securities)
4545
sovereign bonds ESBies
Junior Bond
A L
Poo
ling
Tran
chin
g
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Global Safe Asset (GSA) - without a Passport
46
Rechannel flight to safety via GloSBBieS (Global SBBS)• Now, GSA junior bond
• Difference to ESBiesjunior bond also has to absorb currency risk
Both are internationalShift to a new equilibrium
Sovereign Bonds (+ currency swap)
GSA in $
Junior Bond in $
A L
Poo
ling
Tran
chin
g
Bru
nn
erm
eier
“Pa
rad
ox
of
Pru
den
ce”
Conclusion
1. From Risk in Isolation to Systemic Risk• Volatility Paradox
• Direct Spillovers – domino effects
• Indirect Spillovers – amplifiers vs. absorbers
• Paradox of Prudence (becoming an amplifier)
2. From Separation Principles to Interlinkagesacross stability concepts• … and redistributive monetary policy
3. International: Safe assets and cross-border capital flowsFrom a Buffer Approach to a Rechanneling Approach• Global Safe Asset - GloSBBS