The cost of deviating from the optimal monetary policy: a panel VAR analysis.

Transcription

1 Departement of Economic and Buine Studie Univerity of Genova The cot of deviating from the optimal monetary policy: a panel VAR analyi. Chiara Guerello Working Paper 1/2014 ISSN

2 The cot of deviating from the optimal monetary policy: a panel VAR analyi. Chiara Guerello Abtract Exploiting the Panel VAR gmm etimator feature, macroeconomic country factor are combined with micro-economic bank data to tet for the rik taking channel in the Euro Area. According to prior expectation baed on an extended DSGE model, the analyi prove that the monetary policy feed the bank rik taking by increaing the bank leverage, but i not able to affect the level of credit rik. Wherea, deeper invetigation point out the Taylor gap to add to bank rik appetite in all it form, while movement in the interet rate, to the extent of reaction to the target variable, mooth the bank rik. Keyword: Rik taking channel; Taylor gap; Monetary policy; Credit rik: Panel VAR JEL: E51; E52; G21 chiara.guerello86@vodafone.it Addre: Department of Economic (DIEC), Univerity of Genoa, via vivaldi 5, Genova, Italy 1

3 1 Introduction Thi eay enter the debate on whether the Central Bank ha to incorporate ome bank rik indicator in it reaction function (Borio and Zhu (2012)), or it i an excluive role of the bank upervior to control over the financial ector tability (Nier and Merrouche (2010)). It i invetigated to which extent the monetary policy affect, through the o called rik taking channel,the built up of rik in the financial ytem and might contribute to globally non-linear dynamic in the economy (boom but cycle). Specifically, it dientangle which component of the real interet rate (monetary policy rule or random hock) affect the financial intermediarie perception of rik, and hence their level of leveraging and credit rik, and with which relevance. A defined by Borio and Zhu (2012) the rik taking channel of monetary policy i the tranmiion mechanim of the movement in the interet rate that work through the conequently movement in rik perception and, hence, in the degree of rik in bank aet portfolio, on the pricing of aet, and on the price and non-price term of founding. In Europe, due to the central role played by bank in the founding proce, the rik taking channel i mainly explicated by quantitative and qualitative movement of the financial intermediarie balance heet. According to Angeloni et al. (2010) the tranmiion channel to the overall bank rik can be divided in two main effect affecting different balance heet component. A firt, more quantitative, regard the expanion/contraction of the balance heet after an expanive/retrictive monetary policy. A point out by Adrian and Shin (2010), the problem relie in the mimatch of the maturitie, becaue the bank prefer hort term founding when the hort term interet rate decreae and the yield curve become upward loping and teeper. A it regard the typologie of founding choen by the bank, it i uually called leverage effect, and i computed a ome relative meaure of hort run aet. Thi leverage effect, due to change in the cot of founding, make the balance heet rikier without any change in the aet mix. A econd channel, more qualitative, work through the aet mix: indeed, after of a prolonged looe monetary policy, bank how a tronger propenity to riky aet (ee Rajan (2006). The impact of interet rate on valuation, income and cah flow (for intance due to the reduction of the expected default probability of the borrower) affect the rik perception and the rik tolerance of the lender, a well a, relaxed the capital requirement. A it i related to the overall quality of the loan portfolio of the bank, it i uually named credit rik and meaured a the default probability of the loan portfolio. Even if the rik taking channel i an enhancing mechanim of the financial accelerator channel(bernanke et al. (1999)), there are ituation in which tabilizing force are le 2

4 effective (for example the cae of collective moral hazard propoed by Farhi and Tirole (2013)) and a looe monetary policy could cumulatively lead to an over-extenion of the balance heet, a built up of financial imbalance and a bank crii if it unwind. Many influential work ha empirically aeed the exitence of the rik taking channel for monetary policy. The reult are robut to different etimation method and credit rik proxie. However, the trength of the reult i arguable for Europe, for different reaon: 1. Angeloni et al. (2010) performed a VAR model with data at country level for US and European Monetary Union (EMU). The negative caual relation of monetary policy to credit rik and leverage i trongly ignificant and one way only for US. For the Euro Area thi caual relation move in the two direction, and the reult are le table. Even if the qualitative effect i peritent and ignificant for both area, the impact of the monetary policy on the overall balance heet vanihed in everal pecification. 2. Briimi and Deli (2010), accounting for the bank heterogeneity by a local GMM etimator, verified the preence of the rik taking channel only for mall bank. Healthier bank, with trong market power are not reponive to movement in the interet rate for what concern the aet rik. For ome unit the reult are overturned. The reult are ignificant for both US and Euro Area. 3. Deli et al. (2012) uing a factor augmented panel var to account for bank heterogeneity for US data, howed that, on average, the negative correlation between interet rate and credit rik hold only in the medium period, in the very hort period (firt lag) i the oppoite. 4. Ozuca and Akbotanci (2012), in oppoition with the actual literature, found a trong and robut negative relation between monetary policy and credit rik for a panel of Turkih bank. Learning from the finding lited above, in thi eay i ued a rich panel of European bank. A VAR pecification allow to overcome the endogeneity problem avoiding the ue of proxie for the interet rate, a well a, to conider other influencing economic factor a the financial market index or the GDP. Other bank pecific characteritic, quite table over the time, are accounted by a bank fixed effect. Even if the preliminary impule repone function analyi point out the bank indifference to the nominal interet rate while taking their aet rik portfolio deciion, many argued that keeping the nominal interet rate too low for too long (roughly between

5 and 2005) tranformed the benign effect of the rik taking channel in a collective overtaking of rik and the boom-but cycle that led to the 2008 financial crii. But what doe it mean too low? Since 2002, the European central bank, and ECB in firt, were operating with a well etablihed paradigm, etting the price tability a a primary cope for the monetary policy. Thi practice i explicated by an interet rate rule, called Taylor rule, that linked the interet rate directly and excluively to the inflation rate. Thi hitorical rule i conidered a benchmark to define when an interet rate i too low. The deviation from the optimal rule, called Taylor gap, entered many invetigation but it effect on the rik taking channel are till unclear. On one ide Nier and Merrouche (2010) howed that the current account imbalance and the compreion of the pread between the hort rate and the long rate had driven the recent adding up in the bank leverage more than the difference in the monetary policy tance. In oppoition, Altunba et al. (2011) found a poitive relation between the overall portfolio quality and interet rate and negative one between the portfolio quality and different meaure of Taylor gap. Before arguing in favor or againt an extenion of the Taylor rule to include the leverage and/or the credit rik, it i worth to invetigate how thi two component (the precribed interet rate and the Taylor gap) interact with the rik variable. The main contribution of the paper i to analyze contemporaneouly the different rik variable and different monetary policy component to deeply dientangle how the rik taking channel effectively work. Many previu finding of the literature are put together to provide a complete and exhautive view of the phenomenon, and hence make the policy advice concluive and reliable. In order to provide a proper view of the phenomenon, we decide to bae our expectation on a extended DSGE model, rather that rely on a fragmented literature. The model, in addition to provide a benchmark to which compare the empirical reult, provide a quite realitic explanation of the dynamic and tranmiion channel behind the correlation empirically analyzed. The eay i divided a follow: ection 2 introduce a dynamic tochatic general equilibrium model that how the rik taking channel dynamic. Section 3 decribe the data and the econometric model. Section 4 diplay the main empirical reult and ection 5 conclude. 4

6 2 A DSGE model for an economy with rik taking channel 2.1 Model: feature and propertie A Dynamic Stochatic General Equilibrium model i ued to decribe the theoretical dynamic of the rik taking channel. It how the effect of three different hock, monetary, macroeconomic and financial, to an economy with a relevant financial ector. Specifically the model i an extended verion of the neoclaical growth model, a deigned in Schmitt-Grohe. and Uribe (2004), in which a financial ector how friction a in the Bernanke et al. (1999) and the banking ector i deigned a in Chritiano et al. (2010). Combining thee feature in a very imple way allow for an endogenouly determined level of bank leverage(hort term aet over depoit) and credit rik (the amount of entrepreneur that default). Therefore it i poible to conider the dynamic of the two component of the bank rik conidering only three hock. The model include four nominal rigiditie, price and wage tickine a la Calvo (Calvo (1983)) and Yun (1996) with indexation to pat inflation and money demand for both houehold and firm, and even real rigiditie (internal habit in conumption, monopolitic competition in factor and product market a well a in the liquidity ervice market (bank are aume to be perfectly competitive only in the loan market), invetment adjutment cot, variable cot of adjuting capacity utilization, and monitoring cot of entrepreneur productivity). The ytem i olved by an algorithm propoed by Schmitt-Grohe. and Uribe (2004). It allow for approximating the model in Taylor erie till the econd order. In thi way it i poible to conider the inefficiencie generate by the price and factor tickine, becaue two recurive variable repreenting the price and wage diperion arie in the linearized model. In addition it allow for a tochatic volatility repreentation of the hock and to properly deal with the non linearity of the model. Finally, it allow for a ditorted teady tate, in which the financial friction are till effective. In thi ection i decribed the exact nonlinear repreentation of the complete et of equilibrium condition. 5

7 2.1.1 Houehold The repreentative houehold i a family with a continuum of member, each of them i a worker. They maximize an utility function determined by the conumption growth, the labor upplied, and the liquidity ervice provided by holding money, depoit and hort term marketable ecuritie. The cot of conuming a certain amount c t of intermediate good i determinate by the total expenditure minimization:.t. min 1 0 p i,t c i,t di the firt order condition i then: c t = [ 1 0 c λ f i,t ] 1 λ f (1) λ f c i,t = ( P it ) ( λ f 1 ) c t where P t = [ P t 1 0 P 1 λ f i,t ] λ f (2) The labor deciion are taken collectively at union level, that give the labor upply ide a monopolitic power. The upply of labor follow: h t = h d t 1 0 ( w j t ) λw 1 λw d j (3) w t The houehold decide alo the wage level, but, due to the wage tickine, they can reoptimized it only with probability ξ w, otherwie they adjut it according to pat price inflation: w j t = w j t 1 π t 1 (4) Becaue the labor demand curve i identical acro all the labor market, the wage and employment can be aumed identical, and all the houehold face the contraint: 1 = [(1 ξ w ) 1 λw t + ξ w (w t 1 π t 1 ) 1 λw 1 ] 1 λ w (5) w 1 w t [ 1 ξ w( π t 1 π t ) 1 1 λw 1 λ w ] 1 λ w = φ L K wt F wt (6) K wt = h 1+σ L d,t + βξ w [ w t+1 w t 1 π t+1 ] λw 1 λw (1+σ L) K w,t+1 (7) F w,t = h d,t λ z,t λ w + βξ w ( w t w t+1 ) λw 1 λw ( w t+1 w t ) 1 1 λw 6 1 π t+1 F w,t+1 (8)

8 The houehold at the end of the period received an interet on the current depoit, jut inveted hort term marketable ecuritie and the lat period hort term aet. The houehold problem can be ummarized a:.t. max E 0 k=0 where w,t = (1 ξ w )( w t w t ) λw 1 λw ln(c t bc t 1 ) φ L ( w,t h t ) 1+σ L 1 + σ L + φ M (m t ) 1 σm 1 σ M + +φ D (d t ) 1 σ D 1 σ D + φ DM (dm t ) 1 σdm 1 σ DM + ξ w ( w t 1 ) λw 1 λw ( π t ) lambdaw λw 1 w,t 1 (9) w t π t 1 P t c t + m h,t m h,t 1 + (1 + rt d )d t d t + (1 + rt dm )dm t 1 dm t+1 + (1 + r a )a t 1 a t <= h d,t w j,t ( w j,t ) λw 1 λw d j w t The firt order condition for the Houehold are: Firm 0 +(1 )(1 ι) n t+1 W e W e and 5 (10) ι λ z,t = 1 βb (11) c t bc t 1 c t+1 bc t λ w λ w 1 φ L w h σ L 1 1 1xi w βπ = λ z,t w (12) λ w 1 ξ w βπ 1 λ w λ z,t = β(1 + r A t )λ z,t+1 (13) φ M m σ M h,t r DM = λ z,t βλ z,t+1 π t (14) φ D d σ D t = rt D λ z,t (15) t+1 ra t+1 = φ DMdm σdm t+1 (16) λ z,t+1 A main feature ditinguihe the firm behavior from the tandard New Keyneian one: they face a cah-in-advance contraint for which they need holding money to elf-financing. 7

9 The problem faced by the repreentative firm i: max E t k=0 r t+ Q t+ P t+ ξ π [( P t P t ) 1 1 λπ k =1 ( π t++1 π t+ )y t+k r k k f i,t+k w t+k h i,t+k ( )] + mc i,t+ [(u t+k k 1 + r t+) f α (z t+ h d,t+ ) 1 α ψ t+ The firt order condition for the firm are: Entrepreneur K π,t = y t p t λπ 1 λπ F π,t = mc t y t p t λπ 1 λπ ( P t P t ) λπ 1 λπ 1 = (1 ξ π ) p t 1 1 λπ λ z,t+1 + ξ π βe t ( π t ) 1 λ z,t π t+1 1 λπ ( λ z,t+1 + ξ π βe t ( π t ) 1 λ z,t π t+1 1 λπ ( k ( π t++1 )y t+k ] π t+ =1 + ξ π ( π t 1 π t ) 1 1 λπ (17) p t = 1 K π,t λ π F π,t (18) p t ) 1 λπ 1 K π,t+1 p t+1 (19) p t ) 1 λπ 1 F π,t+1 p t+1 (20) y t π = (u t+k k f t+) α (z t+ h d,t+ ) 1 α ψ (21) π = (1 ξ π ) p t λπ 1 λπ + ξ π ( π t π t 1 ) λπ λπ 1 π,t 1 (22) Conidering the entrepreneur among the actor allow to introduce a financial ector characterized a in Bernanke et al. (1999). The credit upply ide i characterized by perfect competition and aymmetric information deigned true a monitoring cot paid by the houehold/bank if the credit i not repaid. The demand ide i deigned uch that repreent a riky invetment. There are a large number of entrepreneur who combine net worth and loan to buy capital, that at the end of period i tranformed according to the productivity of the project (ω i a hock log-normal ditributed, with time varying variance, the rik premium hock σ t ). The entrepreneur repaid the debt only if the productivity i above a threhold that determine jointly with the interet rate, the loan contract. Allowing for the productivity hock, the financial friction are introduced in the form of aymmetric information due to the productivity be oberved by the bank at a monitoring 8

10 cot. After oberving the hock, the entrepreneur determine the price of capital utilization and rent out capital ervice to the firm. In order to avoid that entrepreneur et enough net worth that they are no longer credit contraint, each period they exit the market with probability ι and their net worth i in part conumed and in part given to the houehold. Each period enter the market a many new entrepreneur a the population remain contant. Therefore, defining repectively the probability of default G(ω t, σ t ) = ωt and the gro hare of profit accruing to the bank 0 ω t df(ω t, σ t ) Γ( ω t ) = ω t (1 F(ω t, σ t )) + G(ω t, σ t ) the entrepreneur maximization problem can be ummarized a follow: max E t k=0 [(u t+k r K t+k a(u t+k)) + (1 δ)q t+k ]ω t+k K t+k S.T. Firt Order Condition Γ( ω t+1 ) µg(ω t+1, σ t+1 ) = 1 + r t 1 + r k,t+1 (1 n t+1 Q t K t+1 ) (23) n t+1 = ι π t [r k,t r t 1 µg(ω t, σ t )]K t Q t 1 + ι π (1 + r t 1)n t (24) credit t+1 = Q t K t+1 n t+1 (25) 1 + r k,t+1 = (u t+1r K t+1 a(u t+1) + (1 δ)q t+1 )K t+1 π t+1 Q t (26) (1 Γ( ω t+1 )) 1 + r k,t+1 Γ ( ω t+1 ) r t Γ ( ω t+1 ) µg (ω t+1, σ t+1 ) r K t = a (u t ) (27) ( 1 + r k,t r t (Γ( ω t+1 ) µg(ω t+1, σ t+1 ))) = 0 (28) 9

11 2.2 Bank A propoed by Chritiano et al. (2010), the repreentative bank combine feature of a commercial bank and invetment bank. It founding are repectively compoed by houehold depoit for the commercial part, and hort term aet and marketable ecuritie for the invetment part. Similarly it aet portfolio i compoed by riky aet and reerve. The liquidity ervice, provided by the bank for founding purpoe, origin another real friction in the model: aimetric information between houehold and bank. A credit crunch i due to either a contraction in entrepreneur demand for credit becaue the pread rie, or a contraction in the loan upply a the bank found themelve at an higher cot. On the output market the bank are competitive and the profit retained from the riky loan activity are equal to zero. A preented before the zero profit condition for the bank i: ωt+1 [(1 F( ω t+1 ) ω t+1 + (1 µ) ωdf(ω)](1 + r k,t+1 )Q t+1 K t+1 = (1 + r t+1 )B t+1 0 The part on the right of the equation i minimum gain the bank ha to retain from the next period loan. The left hand ide correpond to the found that the bank received at the end of the period: repectively the interet from the non-bankruptcy entrepreneur and the net entrepreneurial loan ubidiary from bankrupt entrepreneur. From the liabilitie ide of the balance heet, we can ee that the bank create three different liabilitie: bank depoit, hort term marketable ecuritie and hort term aet. The firt two clae provide liquidity ervice to the houehold, and are produce by the bank by tranforming the reerve and the capital, according to a Cobb- Dougla production function. d t + ςdm t = χ b (u t k t b) ϵ E (1 ϵ) The reerve are included in the production function to conider the precautionary aving of a bank concerned about the poibility of unexpected withdrawal and bank run. The depoit conit in the cah reerve for the bank, but only a part can be ued in the production. The other amount, τ b d t, i the minimum reerve required to hold againt depoit. E t = (1 τ b )d t The hort term marketable ecuritie and the hort term aet are iued at the end of the period to finance the new bank riky loan: credit t+1 = dm t+1 + a t 10

12 Given the balance heet decribed above and conidering that the bank face a monopolitic competitive market on the input market, the rapreentative bank optimizing problem can be ummarized a follow: S.T. F.O.C. max Π t = (1 + r t )credit t + d t + a t + dm t+1 credit t+1 (1 + r d t )d t (1 + rt dm )dm t (1 rt a )a t 1 rt K u t kt b d t + ςdm t = χ b (u t k b t ) ϵ ((1 τ b )d t ) ( 1 ϵ) (29) r t+1 = r a t+1 (30) r dm t+1 r t+1 = λ b,t+1 ς (31) kt b rt K u t = λ b,t (d t ςdm t ) (32) r d t = λ b,t (1 π t (1 dm t d t )) (33) Capital producer A in Chritiano et al. (2010), the capital producer buy the capital from firm and bank (K t = k f t + kt b ), and generate new phyical capital, being contrained by a convex adjutment cot function for the invetment. S.T. max Firt Order Condition β k λ z,t+k (Q t+k K t+k Q t+k K t+k (1 δ) I t+k ) k=0 K t+1 = (1 δ)k t + S (I t, I t 1 )I t (34) 1 Q t S I t = r t+1 Q t+1 S I t+1 (35) 11

13 2.2.2 Market clearing condition and functional form The market clearing condition for product and factor repectively are: (u t+k k t+ ) α (z t+ h d,t+ ) 1 α ψ = π [c t + I t + a(u t )K t + µg(ω t+1, σ t+1 )(1 + r k,t )Q t 1 K t π t The main functional form are et a follow: + 1 ι (net t+1 W e )] ι (36) h = w h d,t (37) a(u t ) = γ 1 (u t 1) + γ 2 2 (u t 1) 2 (38) S It,I t 1 = 1 χ 2 (1 I t I t 1 ) 2 (39) F( ω t, σ t ) = 1 ln( ωt) µ σln t 2π 0 e ω2 t 2 dω (40) Finally to cloe the model, the monetary policy i the optimal one propoed by Guerello (2012), pecifically: Shock r t = α R r t 1 + α π π t+i + α Y y t+i + α c credit t+i + ε (41) Three different hock are conidered in the model: a technology hock, a financial hock, and a monetary one. They are able to account for the mot of the volatility of real economy, financial ector, and interet rate. Specifically the technology hock affect directly the the production function of the repreentative firm. It can be define a an unobervable component that upward hift the production function, while maintaining the input contant. Defining the financial hock, the work of Chritiano et al. (2010) i followed. They propoed a financial hock that i related to the bank expectation about the productivity of the rik invetment. They proved that thi hock, i able to explain roughly 60% of macroeconomic variability. The rikine hock i deigned a the variance of the productivity ditribution and affect the external rik premium through the number of bankruptcy project. The monetary hock i included to account for the tochatic deviation from the optimal rule. The oberved interet rate in the lat decade ha diverged from the optimal one, howing that there are other factor that concur in determining the monetary policy. Since the 12

14 divergence from the optimal interet rule have been quite relevant (above the 10%), it i important to conider a tochatic component in the interet rule, of the form of an additive hock. All the hock dynamic are deigned a an autoregreive tochatic component, with conditional heterochedatic error. Specifically: Calibration z t =ρ 0,z + ρ 1,z z t 1 + var(z t 1 )ϵ t 1 (42) σ t =ρ 0,σ + ρ 1,σ σ t 1 + var(σ t 1 )ϵ t 1 (43) ε t =ρ 0,ε + ρ 1,ε ε t 1 + var(ε t 1 )ϵ t 1 (44) The calibration follow the work of Schmitt-Grohe. and Uribe (2004), Chritiano et al. (2010) and Guerello (2012) a reported in the Table(1). In teady tate the labor input and the capacity utilization are et to unit, and the profit to zero. The target for inflation ha been choen uch that the optimal interet rate matche the long run interet data, a reported in Chritiano et al. (2010). The monetary policy parameter are taken from Guerello (2012). They are choen a to maximize the unconditional houehold utility, in a model with financial friction but without bank agent and liquidity ervice. The interet rule choen imply a quite mild repone to inflation, but a negative repone to both output gap and credit. The flexible monetary policy propoed allow the central bank to overcome the effect of both technology and financial hock. Additionally other impler rule are conidered Impule repone function In order to ae our prior expectation for the empirical part of thi paper, it i intereting to invetigate the dynamic of the model decribed in thi ection after movement in the interet rate. The model i perturbed by two different hock: an unexpected monetary hock in order to collected the movement of the interet rate that are not related to the movement in the interet rule target variable, and a technology hock that i the main hock in explaining the variability of GDP and inflation. A reported in table (6), after an unanticipated monetary hock the interet rate jump but jut after only a period experience drop larger then the initial jump due too the adjutment to the target variable. The driving force of the economy i the cot of capital. From eq(35) we can ee that a the interet rate increae the expected cot of capital increae too with ome degree of inertia due to the convexity of the invetment adjutment cot function. 13

15 The increaing movement of the Tobin Q lead to a built up in both the invetment and the capital, a well a credit and GDP. However, after a period, when the cot of the hort marketable ecuritie i determined to an higher level, the higher cot of founding puhe the bank to tight the upply of loan. Hence, a the upply of loan drop and the demand diminihe too a the net worth increae, the total loan drop uddenly after a period. The bank rik meaure how different reaction. The credit rik, proportional to the productivity minimum no default level, increae a the external premium increae, but a the interet rate drop in the econd period it revert to the teady tate value. Intead, the leverage rik, meaured a the ratio of aet to depoit, i influenced by movement in depoit and hort marketable ecuritie. The former increae uddenly, the latter with a lag of retard. Hence the leverage jump in the firt period and then after how a cyclical movement. Similar variable dynamic i oberved after a technology hock. However a technology hock both increae GDP and decreae inflation. hence it i a negative anticipated monetary hock. What come out from the analyi of the imulated dynamic of ome central bank i that unexpected or anticipated monetary hock have oppoite effect on the bank rik appetite. Since the damageful component of the monetary policy i the tochatic part, the only way to mooth it effect, with regard to the optimal operative interet rate rule, i to chooe a quite paive monetary policy (high degree of interet rate moothing). A reported in table(6) by the dotted line, if interet rate rule i deigned a paive and reacting to credit the effect of any interet rate hock, either unexpected or anticipated, on the leverage rik are moothed and the effect on the credit rik are not relevant. Hence, a long a the monetary policy i paive, the bank rik i not feed by the monetary policy a credit rik doe not repond to interet rate and leverage how a mall waving movement around the teady tate. Therefore any danger of boom buting cycle i contained. 3 Regreion pecification Rik meaure The firt purpoe of the eay i to invetigate the tranmiion channel of monetary policy to bank leverage and credit rik. In order to identify the different tranmiion channel, two different indicator of rik are adopted. The firt i a meaure of the leverage that approximate the rik due to the balance heet movement: when the balance heet become wider, and it i financed by hort term liabilitie, the probability of default increae becaue the bank i more expoed to mimatching problem. Specifically the ratio of aet to depoit i employed, a in Angeloni et al. 14

16 (2010), becaue i a direct meaure of the bank capitalization. It i preferred to pure meaure of the bank default probability, a EDF or Z-core, largely ued in literature 1 becaue they account for the health of the bank and the ytem, and do not reflect excluively the bank rik management. The econd meaure, approximating the credit rik, report the quality of the loan portfolio. Among the many meaure employed 2 the mot ued i the ratio of non-performing loan to total loan. It ummarize the current health of the bank loan portfolio, and indicate the percentage of loan that would probably default or generate lo for the bank in the hort term. Interet rate meaure Different meaure of interet rate have been employed, the average marginal refinancing rate and the overnight inter-banking rate, a well a, meaure of the monetary policy tance computed a the Taylor gap, the difference between the optimal interet rate rule precription and the current interet rate. Three optimal interet rate rule have been conidered, which coefficient are taken to maximize the conumer utility in a DSGE model with financial friction (for detail ee Guerello (2012)). Specifically: 3 i t ln =1.5 ln in f lation t 2 i t (45) ln = ln in f lation t ln outputgap t (46) 2 i t ln = ln i t ( )( ln in f lation t ln outputgap t ln loangap t ) (47) 1 Gambacorta (2009) and citetagm10 ue EDF for Euro Area bank and Ozuca and Akbotanci (2012) employed either Z-core or EDF for Turkih bank. In addition etimated meaure of the bank default probability are employed. i.e. Karapetyan (2011) ue a logit model baed on balance heet data to generate a meaure of bank rik for Norwegian bank. 2 Angeloni et al. (2010) chooe the ratio of credit and mortgage loan on total loan, Deli and Koureta (2011) ue both riky aet to total aet and non performing loan to total loan, Briimi and Deli (2010) prefer a wider meaure ummarizing the problem loan to total loan. 3 Outputgap and loangap have been calculated a the detrended value of GDP and gro loan 15

17 Other factor The mot of the literature ue uni-variate model to tet the rik taking channel. It i preferred to etimate the effect of the monetary policy on bank rik alongide with the effect of bank rik on the buine cycle. A VAR model i etimated, incorporating macro and financial variable: a meaure of country real GDP and the main financial market index. Thi approach ha everal advantage: it overcome the problem of endogeneity of either the interet rate or Taylor gap, a well a, educe the repone of credit rik and leverage to movement in the interet rate. Converely many influential paper 4 underline the heterogeneity of the bank repone to the monetary hock. Of particular interet, the work of Briimi and Deli (2010), by a local GMM, invetigate the heterogeneity of bank to the extent of the credit rik repone to monetary policy. They found that large and healthy bank do not repond to interet rate for what concern their loan portfolio management trategie. Looking at the pat literature, in thi invetigation micro level data at bank level are combine with macro variable at country level. Data decription The databae i incluive of both micro data (credit rik, aet to depoit ratio and loan to aet ratio) of a et of almot 100 bank, taken from Capital IQ data-et, and macro data (GDP, market index and interet rate) of 10 European countrie 5 taken from the ECB Data-Warehoue. The ample cover a period of 9 year from 2003 to 2011, incluive of the recent financial crii. The ample frequency i annual. Even if while dealing with monetary policy data i better to ue quarterly data, Altunba et al. (2010), Altunba et al. (2011) and Briimi and Deli (2010) howed the reliability of analyi baed on annual data. The panel i unbalanced with a mean length of roughly 7 year. However the reult are not biaed becaue the problem i purely informative and the enter/exit of bank from the ample i not related to the variable examined. The variable ummarizing tatitic are reported in table(6). 4 Altunba et al. (2011), Deli and Koureta (2011) how how the degree of bank rik depend on the bank characteritic (liquidity, capitalization and dimenion); Altunba et al. (2010) found it true for loan too. Finally, Deli et al. (2012) and Briimi and Deli (2010) highlight that more pecifically the bank pecific characteritic hape the tranmiion channel. 5 The country are elected a all the countrie inide the Euro Area from 2002, le the Greece due to the recent economic turmoil. Specifically the countrie are: Autria, Belgium, France, Germany, Ireland, Italy, Luxemburg, Netherlander, Portugal, and Spain 16

18 Econometric pecification For the etimation of the model, a ix variable panel VAR i employed, in order: log of loan to aet, log of GDP, log of non-performing loan to total loan, log of aet to depoit, log of interet rate, log of market index. The panel VAR methodology allow for uing highly diaggregated data and account for ome degree of heterogeneity among the individual and countrie conidered, even if the repone i conidered the ame for all the ubject. The panel VAR methodology combine the traditional VAR approach, which treat all the variable of the ytem a endogenou, and the Arellano and Bond (1991) GMM etimator for panel data that allow for unoberved individual heterogeneity. Allowing a bank fixed effect to enter the equation, it i accounted for the bank pecific heterogeneity. Y i,t = A 0 + A(l)Y i,t 1 + α i + u i,t i = 1, 2,..., N t = 1, 2,..., T (48) The code and the trategie propoed by Love and Zicchino (2006) are followed. A uggeted by Canova and Ciccarelli (2013), if the data generating proce featured dynamic homogeneity, the bet etimator i the pooled etimator with fixed effect, becaue it capture idioyncratic but contant heterogeneity acro variable and unit, and thi i the cae. Since the bank fixed effect are correlated with the regreor 6 the mean differencing procedure produce biaed coefficient. It i better to ue a forward mean differencing procedure called Helmert procedure, that preerve the orthogonality between the tranformed variable and the regreor. Thi analyi i centered on the tudy of the orthogonalized impule repone function, and, due to the mall ample, the confidence band are etimated by a Monte Carlo imulation. In addition, the variance decompoition i advanced to determine the relevance of different monetary policy component for the volatility of the two rik variable. 4 Reult and dicuion 4.1 Some conideration on the baeline model In the firt place, we report what a ample of almot 100 European bank ay about the rik taking channel in Europe. The analyi i baed on the impule repone function over a period of 10 year. The impule repone function decribe the reaction of a variable to a unit innovation in another variable in the ytem, while holding the other hock equal to zero. 6 Lag of the dependent variable enter the equation a regreor and the dependency of the variable to the fixed effect hold at each point in time, hence alo for the lagged variable. 17

19 Since the actual variance-covariance matrix i unlikely to be diagonal, it i neceary to adopt a Choleky decompoition to obtain an orthogonal matrix. A the order of the variable et the identifying aumption, the variable that come earlier contemporaneouly affect the following variable and with a lag. In thi way the variable that come earlier are weakly exogenou becaue are affected by the later variable only with a lag. The order of the variable ha been choen following Angeloni et al. (2010). The underling aumption i that all the hock influence intantaneouly the tock market index and the interet rate, then balance heet variable adjut (it i irrelevant in which order) and the macro variable, in thi cae GDP, i the lat one. Since Deli et al. (2012) highlight that hock in bank rik appetite intantaneouly influence the amount of loan through the creation of new loan, we decide to place the growth rate of loan before the balance heet item, hence we aume that bank rik hock affect directly the amount of credit. The reulting order i GDP, leverage rik, credit rik, loan, interet rate, tock market index. Looking at table(6), the growth rate of total loan increae after a poitive hock in either GDP and real interet rate. For what concern the effective bank rik, we found clear evidence of the rik taking channel in the reult: indeed both leverage rik and credit rik increae after an expanionary monetary policy. In addition, table(6) point out that bank take over le rik after either an economic or financial expanion. It i confirmed the idea of Deli et al. (2012): indeed the bank profitability determine the individual level of rik, and a the profitability i pro-cyclical, the bank rik i countercyclical. Furthermore, a dicued by Borio and Zhu (2012), both a balance heet expanion and a built up in credit rik, if not exceive, i beneficial for the real economy. The problem arie when the force are no longer balanced and an overtaking in bank rik lead to a bank crii, a it recently happened. Thee reult are robut to different interet rate meaure (ee table(6)) and leverage meaure (Z-core).Many influential paper ued country or time fixed effect to take out any exogenou hock that affect the bank. Therefore, we conider, a in Love and Zicchino (2006), country-time fixed effect, taking out the country mean of each ingle year from the micro level variable (loan, leverage and credit rik). Table(6) how that the reult remain robut and, hence, we decide to relay on a model without country-time FE in the ret of the analyi. We believe that GDP and tock market index are able to capture the mot of the exogenou hock that affect the bank rik at an aggregate country level. 18

20 4.2 Capital regulation and rik taking channel Borio and Zhu (2012) identify two way in which the bank regulation, in particular the minimum capital tandard, affect the bank attitude toward rik. A thigh minimum threhold reduce the bank ability to extend their balance heet becaue enlarging the capital bae i more expenive than alternative founding reource. In the ame way it limit the ability of the bank to generate new loan, a it ha been prooved by Maddaloni and Peydró (2011). In 2006 a new bank regulatory act, called Bael II, ha changed the bank uperviion framework, and among the other, ha tightened the minimum capital requirement. In addition, it ha modified the way bank compute the rik of an aet, and, hopefully, ha changed the way they perceived the rik. Therefore it i intereting to invetigate how the rik taking tranmiion channel ha modified after A firt tep ha been run the analyi over two different ub-ample: before and after Table(6) report the finding. It i clear that after 2006 bank, to the extend of their rik management department, have become quite unreponive to monetary policy. There are not any evidence of the rik taking channel after the introduction of Bael II act. In order to invetigate the effect of Bael II act in a more detailed and robut way, we conider an interaction term in the analyi, following Maddaloni and Peydró (2011). A time dummy variable equal to 1 after 2006 i interacted with the real interet rate. Looking at table (7), we can ee that the effect of monetary policy i moothed with reference to leverage and loan. Thi upport the finding of Maddaloni and Peydró (2011), that the impact of monetary policy on the oftening of lending tandard i reduced by more tringent policy on either bank capital requirement. However, the effect of monetary tance on credit rik i enhanced by the new uperviory regime. A trong collaboration between monetary policy and bank uperviion, a advied by Agur and Demertzi (2012), eem to be able to...limit the amplification effect related to the rik-taking channel and increae the reilience of the banking ytem againt hock (Borio and Zhu (2012)). However i able to affect only the rik relative to the expanion of the balance heet, but it i unable to affect the quality of the credit undertaken by the bank. 4.3 Taylor Gap and rik taking channel Fata et al. (2009) how that worldwide the monetary policy wa over-looing before the recent financial crii. Indeed in the mot advanced economie, a US and Euro Area, the Taylor gap were negative, on average, one to three year before the but. It wa followed 19

21 by a harp tightening of monetary policy in Looking at table(6), bank rik i reponive to real interet rate but not to the nominal interet rate. Thi ugget that the nominal interet rate component (repone to inflation and Taylor gap) cancel out each other effect on bank rik. Even if it ha been proved that a looing monetary policy doe not affect bank rik, houe and aet price, few ha been aid on the effect of a prolonged negative Taylor gap on bank appetite for rik. In addition, Fata et al. (2009) argue the advantage of including ome macro prudential indicator in the imple Taylor rule. Many paper upport the uperiority of flexible credit augmented Taylor rule, over the imple one, in preventing the but. We decide to extend our analyi to different meaure of monetary policy. We conider both the effect of the precribed optimal rule and the Taylor gap, computed a the difference between the nominal interet rate and the precribed one.in addition to the claical benchmark, the Taylor rule eq(45), we conider two flexible optimized Taylor rule, a largely ued rule that conider both inflation and output-gap eq(46), and an augmented one, comprehenive of interet rate moothing, output-gap and credit eq(47). Looking at table(6), in which are reported the impule repone function for model including an alternative monetary policy variable at time, it i clear that a looe monetary policy, to the extend that it i the optimal repone to inflation and macroeconomic fluctuation, doe not built up bank rik. However, an over-accommodating monetary policy, incentive bank rik taking, both leverage and credit rik, and could lead to dangerou burn but cycle. Indeed the negative correlation between either the leverage rik or credit rik meaure and the Taylor gap prove that, ince the Taylor gap ha recently been negative, an increae in Taylor gap increae the bank propenity toward rik. Thi finding reinforce the reult of Altunba et al. (2011), becaue, in addition to prove the negative correlation between Taylor gap and bank rik, it ha been pecified that thi relation hold for both leverage and credit rik. Once conidered a credit augmented Taylor rule, the analyi of the impule repone function tell that the reult remain robut for what concern the credit rik. However, the optimal interet rate doe not affect the leverage anymore, and the leverage repond, till negatively, to the Taylor gap only in the long run (from 2 to 4 year). Therefore, once accounted for credit in the operational rule, the interet rate doe not affect the leverage, and an over-looing monetary policy affect credit rik only if prolonged. On the other ide, the Taylor gap i till able to generate boom but cycle through the built up of credit rik. While table(6) provide information on the dynamic repone of the bank rik variable 20

22 to different monetary hock, table(9),table(10) and table(11) jointly how the forecat error variance decompoition and allow for aeing the relative importance of each of the monetary hock. Specifically thee table report the percentage of variation in each variable that i explained by a hock in another variable, accumulated over time. We report the total effect accumulated over three different period: hort run (the two year horizon), medium run (the ix year horizon) and long run (the ten year horizon). Differently from what found by Buch et al. (2010), macroeconomic factor, a well a, monetary policy do not play an important role in explaining both credit rik and leverage fluctuation. Even if macroeconomic hock together explain an increaing percentage of leverage variance (from four percent in the hort run to twelve percent in the long run), the role of monetary policy i only marginal. In the medium-long horizon the two monetary policy hock together explain roughly five percent of the aet to depoit variance, but in the hort run thi percentage i le than one. Among the two hock, the random hock are able to explain more than eighty percent of monetary policy contribution, but looe relevance a the time horizon increae. The monetary policy role i even more marginal if we conider a augmented Taylor rule with total credit (eq(47)). In thi cae, while macroeconomic hock jointly explain from five to nine percent of leverage fluctuation, monetary policy hock doe not explain more than one percent of aet to depoit ratio in either the hort or long run. Buch et al. (2010) found that, for US bank, non performing loan ratio variance i explained ubtantially (27 percent) by macroeconomic hock. Therefore, it i urpriing that for Europe we found that macroeconomic factor are not able to explain more than five percent of the non performing ratio, in the medium and long run, and le than one percent in the hort run. Thi reult may be affected by the different, and le tight, claification of the non performing loan in Europe. Finally it i intereting to notice that credit rik and leverage hock repectively explain the other rik meaure variance in a greater percentage than the monetary policy and jut little maller than the aggregate macroeconomic hock. Thi how how the rik meaure uually move together, trongly increaing the bank overall rik and default probability. 4.4 Monetary union and Taylor Gap The countrie inide the Euro Area uually face a larger effect of Taylor gap, a the optimal monetary policy i decided at central level, looking at aggregate level variable. The peritent and large difference among the performance of the member economie, amplify the effect of the Taylor gap on the bank rik. Indeed bank of mall and medium ize look at the macroeconomic performance of the country in which they operate, rather 21

23 than at the aggregate performance of the European economy. Therefore it i intereting to evaluate how the monetary policy at central level can affect the bank appetite for rik, and which portion of bank rik variance i explained by the difference in the member macroeconomic performance. We contruct new variable for the optimal operative interet rule. In thi cae the benchmark interet rate i computed uing aggregate variable for CPI, GDP and total credit. Table(6) report the impule repone function for the three different Taylor rule conidered. Surpriing the reult reported for the ingle country optimal rule, are not longer upported. A the Taylor gap i negative, if the difference between the marginal rate and the benchmark increae, the bank rik decreae. However, a a more ophiticated benchmark i conidered (ee eq(47)), an over-looing monetary policy to the extend that doe not concern the financial tability objective, increae credit rik. Finally, a reported in table(13), table(14) and table(15), we perform a forecated error variance decompoition analyi. In addition to the optimal rule and the Taylor gap, we conider the difference between the agrregate optimal rule and the ingle country one. In thi way we ae the relevance of the different macroeconomic performance in explaining the credit rik and leverage. It i clear that a monetary union pay a cot in term of incentive to bank rik appetite. The larger Taylor gap i able to explain half of the monetary policy contribution to the credit and leverage rik variance. There withal, the Taylor gap computed at aggregate level explain le than one percent of the bank rik variance, in both it form (optimal operational rule and random hock). 5 Concluion The current literature provide ome evidence in favor of an active rik taking channel in Europe, that are not concluive. We tet both the preence of thi monetary tranmiion channel and the relevance of the different factor concurring in defining the monetary policy. Even if our reult provide evidence of an active rik taking channel, further conideration can be extrapolated from the reult over the mechanim of thi tranmiion channel. The analyi of the DSGE model propoed how that after a monetary hock it become more expenive for the bank to found themelve by hort-term aet, and hence it lead to a credit crunch. Actually the leverage jump after a negative monetary hock and drop after a poitive technology hock, hence a negative anticipated monetary hock. 22

24 In the ame way, conidering both the optimal rule and the Taylor gap in the regreion, the primary role played by the Taylor gap i highlighted, a well a, it ha hown a the bank rik increae after a adding up in the Taylor gap (in abolute term). However it ha hown that leverage and credit rik are moothed by a looe monetary policy, if it i precribed by the forecated value of inflation, GDP and credit. In addition, from forecated error variance decompoition analyi, it i clear that the monetary policy i not a relevant in explaining bank rik fluctuation a the other macroeconomic factor (GDP and market index). Wherea among the component of the monetary policy, the tochatic factor (Taylor gap) i ten time more powerful in explaining leverage volatility than the precribed interet rate. From the Central Bank point of view, the good new i that the monetary policy, to the extend of the optimal operational interet rule, i not affecting the bank rik appetite. The evidence of an active and damageful rik taking channel for the monetary policy, reflect the role played by the Taylor gap. Therefore, if the monetary policy i over-looing for a long time, the neutral role of the central bank in determining the level of bank rik could be overcome by feeding a damageful boom buting cycle. In concluion, a looe monetary policy i not damageful by itelf, but it could be riky if the interet rate i kept far away from what the real economy need. A the Taylor gap i mainly determined by policy objective miperception and the overconfidence on the weight the Central Bank give to the financial tability, uing different monetary policie, we hown that ha the objective of the financial tability i clearly tated, the Taylor gap effect i moothed, at leat for what concern leverage. Additional minor concluion are drawn from the reult. Firt it ha been proved that a joint work of Central Bank and Bank Regulator i beneficial for the economy. The work of Agur and Demertzi (2012) argue that a joint policy of Bank Regulator and Central Bank, whenever different intitution, allow to prevent and face any financial turmoil without huge cot for the economy in peace time. The reult of the paper upport and add to thi theory. Indeed they how that the rik taking channel ha been almot neutralized by the introduction of a more tightening capital requirement. It upport the improvement of the Bank regulation in the Euro Area by the Bank Union, a a unique intitution could coordinate in a better way the two policie. Finally omething ha been aid on the problem of the lack of convergence of the Euro Area fical policie. It ha been hown that a monetary union, a EMU, exacerbate the Taylor gap effect. The rik taking channel ha been amplified by the larger Taylor gap, a different countrie and economie need different level of interet rate. In addition, it ha been hown that the difference between the aggregate optimal operational rule and the 23

25 country one i able to explain roughly 90% of the monetary policy contribution to bank rik volatility, playing a central role. For the ECB, the rik taking channel i a factor to conider more accurately than for other Central Bank, becaue it could be damageful even if the monetary policy would be tighter that in the lat decade. 24

26 Reference T. Adrian and H. Shin. Financial intermediarie and monetary economic. FRB of New York Staff Report, (398), I. Agur and M. Demertzi. Exceive bank rik taking and monetary policy. ECB Working Paper Serie, Y. Altunba, L. Gambacorta, and D. Marque-Ibanez. Bank rik and monetary policy. Journal of Financial Stability, 6(3): , Y. Altunba, L. Gambacorta, and D. Marque-Ibanez. Doe monetary policy affect bank rik taking? ECB Working Paper Serie, I. Angeloni, E. Faia, and M. LoDuca. Monetary policy and rik taking. ECB Working Paper Serie, M. Arellano and S. Bond. Some tet of pecification for panel data: Monte carlo evidence and an application to employment equation. The Review of Economic Studie, 58(2): , B. S. Bernanke, M. Gertler, and S. Gilchrit. The financial accelerator in a quantitative buine cycle framework. Handbook of macroeconomic, 1: , C. Borio and H. Zhu. Capital regulation, rik-taking and monetary policy: a miing link in the tranmiion mechanim? Journal of Financial Stability, 8(4): , S. Briimi and M. Deli. Bank heterogeneity and monetary policy tranmiion. ECB Working Paper Serie, C. Buch, S. Eickmeier, and E. Prieto. Macroeconomic factor and micro-level bank rik. CESifo Center for Economic Studie & Ifo Intitute for economic reearch, G. A. Calvo. Staggered price in a utility-maximizing framework. Journal of monetary Economic, 12(3): , F. Canova and M. Ciccarelli. Panel Vector Autoregreive Model: A Survey. Centre for Economic Policy Reearch, L. Chritiano, R. Motto, and M. Rotagno. Financial factor in economic fluctuation. ECB Working Paper Serie,