Alistair Milne

The Relevance of P-Star Analysis to UK Monetary Policy

Recent articles have attempted to restore the use of a simple measure of the money supply as an indicator of future price levels, P[star], and to reestablish a causal link from money to prices. In this paper we argue that the P[star] approach is flawed. It is certainly more complex than traditional monetarist approaches but the fundamental questions of causality are in no way either affected or resolved. We argue that the P[star] relationship does not have a causal link with prices but rather the causality runs from prices to money. We also find that there is some causality running from money to real income, so that monetary conditions do seem to have some predictive power for future levels of activity. Copyright 1994 by Royal Economic Society.

Firm behaviour under the threat of liquidation

Abstract We study the optimal behaviour of a firm whose cash flow is determined by a diffusion process, facing liquidation if internal cash balances fall below some threshold. There is a conflict between the desire to pay dividends to satisfy shareholders and the need to retain cash as a barrier against possible liquidation. Stochastic optimal control characterises the value function and gives optimal decision rules for the firm. The firm has a precautionary motive for retaining earnings; the internal cost of funds and local risk-aversion are both decreasing functions of cash held, and, in natural extensions to our model, output and investment are both increasing functions of cash balances.

Debt Relief for Low Income Countries: Is it Effective and Efficient?

Although a great deal of attention has been paid to IMF conditionality and to the effects of IMF programmes, relatively little attention has been paid to their completion rate. However, the record is that the clear majority of Fund programmes are uncompleted. Is this a cause for concern and why is it that the completion rate is low? In principle, a number of factors could be at work. Gaining a better understanding of what these are should allow policy reform at the IMF to improve performance. While there are things that we do not know and need to know about programme completion, we know enough to delineate the broad direction that policy should take.

Alternative Routes to Banking Stability: A Comparison of UK and German Banking Systems

The banking systems of Britain and Germany are among the most stable in the world. In both countries bank failures are exceedingly rare, and even periods of difficulty among more than a few banks very uncommon. Yet the two systems are very different. They differ both in structure and in how banks in the two countries behave. In this chapter we compare the two systems, so as to bring out the key features which have contributed to their stability and to see if anything can be said about the prospects for their continuing stability in the future. We start, though, by looking at recent periods of major instability — not in Britain and Germany, where there have been no such episodes for many years but in other countries, so as to highlight the kind of events which can bring serious disturbances to a country’s financial system. Then we turn to describing the systems of Britain and Germany, showing how both have experienced substantial liberalisation in recent years. This leads to a comparison of banking profitability in the two economies, and to an appraisal of the factors which may have contributed to the radically different experience of the two countries in this regard. This enables us to offer some suggestions as to the impact of liberalisation and of inflation on banking sector stability.

Systemic Risk in Financial Services

The current banking crisis has reminded us of how risks materialising in one part of the financial system can have a widespread impact, affecting other financial markets and institutions and the broader economy. This paper, prepared on behalf of the Actuarial Profession, examines how such events have an impact on the entire financial system and explores whether such disturbances may arise within the insurance and pensions sectors as well as within banking. The paper seeks to provide an overview of a number of banking and other financial crises which have occurred in the past, illustrated by four case studies. It discusses what constitutes a systemic event and what distinguishes it from a large aggregate system wide shock. Finally, it discusses how policy-makers can respond to the risk of such systemic financial failures.

Risk-Adjusted Measures of Value Creation in Financial Institutions

Measuring value creation by comparing the RAROC of an exposure (the return on risk capital) with a single institution-wide hurdle rate is inconsistent with the standard theory of financial valuation. We use asset pricing theory to determine the appropriate hurdle rate for such a RAROC performance measure. We find that this hurdle rate varies with the skewness of asset returns. Thus the RAROC hurdle rate should differ substantially between equity which has a right skew and debt which has a pronounced left skew and also between different qualities of debt exposure. We discuss implications for financial institution risk management and supervision.

The Production Smoothing Model of Inventories Revisited

An error correction specification which nests the linear-quadratic production smoothing and stock-adjustment models of inventories is estimated on U.S. seasonally adjusted two-digit SIC data. The restrictions of the general model to the production smoothing specification is accepted for four out of six of the production-to-stock industries and for total nondurables. The estimation results do not suggest any use of inventories to smooth the level of production, but there is evidence of smoothing of the rate of change of production for three production-to-stock industries and for both total nondurables and total durables. Coefficient estimates may, however, be biased. Copyright 1994 by Royal Economic Society.

The Business Models and Economics of Peer-to-Peer Lending

This paper reviews peer-to-peer (P2P) lending, its development in the UK and other countries, and assesses the business and economic policy issues surrounding this new form of intermediation. P2P platform technology allows direct matching of borrowers’ and lenders’ diversification over a large number of borrowers without the loans having to be held on an intermediary balance sheet. P2P lending has developed rapidly in both the US and the UK, but it still represents a small fraction, less than 1%, of the stock of bank lending. In the UK – but not elsewhere – it is an important source of loans for smaller companies. We argue that P2P lending is fundamentally complementary to, and not competitive with, conventional banking. We therefore expect banks to adapt to the emergence of P2P lending, either by cooperating closely with third-party P2P lending platforms or offering their own proprietary platforms. We also argue that the full development of the sector requires much further work addressing the risks and business and regulatory issues in P2P lending, including risk communication, orderly resolution of platform failure, control of liquidity risks and minimisation of fraud, security and operational risks. This will depend on developing reliable business processes, the promotion to the full extent possible of transparency and standardisation and appropriate regulation that serves the needs of customers.

The lending channel under optimal choice of monetary policy

Building on Cecchetti and Li (2005), we show that the bank lending channel affects monetary policy trade-offs only when interest rates affect marginal costs of production (ie when there is a cost channel of monetary policy) in the New Keynesian monetary policy model. In our calibrated model the resulting impact of the bank lending channel on output-inflation trade-offs is quantitatively small and of ambiguous sign. When bank capital varies counter cyclically and bank loan rates have a relatively large impact on marginal costs, variation of bank loan margins improves monetary policy trade-offs. The new Basel accord, by increasing capital requirements during economic downturns, offsets this beneficial impact.

Standard Setting and Competition in Securities Settlement

This paper examines the impact of messaging and technical standards on competition in the supply of securities transaction management services. Two simple switching cost models are used to clarify the impact of standards on barriers to entry and on the incentives to adopt harmonised and simplified securities processing standards. Policy implications are discussed briefly. Key words: securities settlement, standards, inter-operability, switching costs JEL classification numbers: L15, L86