David Aikman

Funding liquidity risk in a quantitative model of systemic stability

We demonstrate how the introduction of liability-side feedbacks affects the properties of a quantitative model of systemic risk. The model is known as RAMSI and is still in its development phase. It is based on detailed balance sheets for UK banks and encompasses macro-credit risk, interest and non-interest income risk, network interactions, and feedback effects. Funding liquidity risk is introduced by allowing for rating downgrades and incorporating a simple framework in which concerns over solvency, funding profiles and confidence may trigger the outright closure of funding markets to particular institutions. In presenting results, we focus on aggregate distributions and analysis of a scenario in which large losses at some banks can be exacerbated by liability-side feedbacks, leading to system-wide instability.

Taking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulation

Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; and (iii) when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.

Reputation, Risk-Taking and Macroprudential Policy

This paper examines the role of macroprudential capital requirements in preventing inefficient credit booms in a model with reputational externalities. Unprofitable banks have strong incentives to invest in risky assets and generate inefficient credit booms when macroeconomic fundamentals are good in order to signal high ability. We show that across-the-system countercyclical capital requirements that deter credit booms are constrained optimal when fundamentals are within an intermediate range. We also show that when fundamentals are deteriorating, a public announcement of that fact can itself play a powerful role in preventing inefficient credit booms, providing an additional channel through which macroprudential policies can improve outcomes.

Mapping heat in the U.S. financial system

We provide a framework for assessing the build-up of vulnerabilities to the U.S. financial system. We collect forty-six indicators of financial and balance-sheet conditions, cutting across measures of valuation pressures, nonfinancial borrowing, and financial-sector health. We place the data in economic categories, track their evolution, and develop an algorithmic approach to monitoring vulnerabilities that can complement the more judgmental approach of most official-sector organizations. Our approach picks up rising imbalances in the U.S. financial system through the mid-2000s, presaging the financial crisis. We also highlight several statistical properties of our approach: most importantly, our summary measures of system-wide vulnerabilities lead the credit-to-GDP gap (a key gauge in Basel III and related research) by a year or more. Thus, our framework may provide useful information for setting macroprudential policy tools such as the countercyclical capital buffer.

Monetary versus Macroprudential Policies Causal Impacts of Interest Rates and Credit Controls in the Era of the UK Radcliffe Report

We have entered a world of conjoined monetary and macroprudential policies. But can they function smoothly in tandem, and with what effects? Since this policy cocktail has not been seen for decades, the empirical evidence is almost non-existent. We can only fix this shortcoming in a historical laboratory. The Radcliffe Report (1959), notoriously sceptical about the efficacy of monetary policy, embodied views which led the United Kingdom to a three-decade experiment of using credit controls alongside conventional changes in the central bank interest rate. These non-price tools are similar to policies now being considered or used by macroprudential policymakers. We describe these tools, document how they were used by the authorities, and craft a new, largely hand-collected dataset to help estimate their effects. We develop a novel identification strategy, which we term Factor-Augmented Local Projection (FALP), to investigate the subtly different impacts of both monetary and macroprudential policies. Monetary policy acted on output and inflation broadly in line with consensus views today, but credit controls had markedly different effects and acted primarily to modulate bank lending.

Financial Vulnerabilities, Macroeconomic Dynamics, and Monetary Policy

We define a measure to be a financial vulnerability if, in a VAR framework that allows for nonlinearities, an impulse to the measure leads to an economic contraction. We evaluate alternative macrofinancial imbalances as vulnerabilities: nonfinancial sector credit, risk appetite of financial market participants, and the leverage and short-term funding of financial firms. We find that nonfinancial credit is a vulnerability: impulses to the credit-to-GDP gap when it is high leads to a recession. Risk appetite leads to an economic expansion in the near-term, but also higher credit and a recession in later years, suggesting an intertemporal tradeoff. Monetary policy is generally ineffective at slowing the economy once the credit-to-GDP gap is high, suggesting important benefits from avoiding excessive credit growth. Financial sector leverage and short-term funding do not lead directly to contractions and thus are not vulnerabilities by our definition.

Mapping Heat in the U.S. Financial System: A Summary

This Note reports a selection of results from research intended to quantitatively measure the buildup and reduction of vulnerabilities in the U.S. financial system over time.