DNB WORKING PAPER. DNB Working Paper. A macroprudential approach to address liquidity risk with the Loan-to-deposit ratio. No. 372 / February 2013

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1 DNB Woking Pape No. 372 / Febuay 2013 Jan Willem van den End DNB WORKING PAPER A macopudential appoach to addess liquidity isk with the Loan-to-deposit atio

2 A macopudential appoach to addess liquidity isk with the Loan-to-Deposit atio Jan Willem van den End * * Views expessed ae those of the autho and do not necessaily eflect official positions of De Nedelandsche Bank. Woking Pape No. 372 Febuay 2013 De Nedelandsche Bank NV P.O. Box AB AMSTERDAM The Nethelands

3 A macopudential appoach to addess liquidity isk with the Loan-to-Deposit atio Jan Willem van den End a Mach 2013 Abstact This pape maps the empiical featues of the Loan-to-Deposit (LTD) atio with an eye on using it in macopudential policy to mitigate liquidity isk. We inspect the LTD tends and cycles of 11 euo aea counties by filteing methods and analyze the inteaction between loans and deposits. We popose that the tend of the LTD atio is maintained within an uppe and lowe bound to avoid bad equilibia. To manage the LTD atio between the boundaies we fomulate two macopudential ules. One that stimulates banks to issue etail deposits in an uptun and one that incentivizes banks to ceate loanable funds to suppot lending in a downtun, facilitated by a sufficiently long adjustment peiod. Key wods: Financial stability, Banks, Liquidity, Regulation JEL Codes: C15, E44, G21, G32, G28 De Nedelandsche Bank, Economics and Reseach Division, P.O. Box 98, 1000 AB Amstedam. The autho would like to thank Clemens Bonne, Leo de Haan, Miguel Mendonca Boucinha, Pete van Els, Maaten Geldeman, Jan Kakes and Jan Willem Slingenbeg fo valuable comments on ealie vesions. a Coesponding autho. Phone , Fax , 1

4 1. Intoduction Deposit-taking and lending by banks ae closely elated. Both activities eflect the liquidity tansfomation function of banks and shae a simila ovehead (Kashyap et al, 2002). Hence it is useful to analyze loans and deposits in tandem, as is done though the Loan-to-Deposit (LTD) atio. It is a coe indicato fo liquidity mismatch isk. The LTD atio measues the coveage of loans with stable funding, usually deposits fom households and non-financial companies. When loans exceed the deposit base, banks face a funding gap fo which they have to access financial makets. So a high funding gap implies a high dependence on maket funding, which can be moe volatile and/o expensive than etail funding, in paticula if it concens unsecued maket funding. The macopudential dimension elates to the link between funding mismatches at the bank level and system wide liquidity isk. If a substantial shae of banks opeates with a funding gap, advese shocks to maket funding can stain the banking secto as a whole, affecting cedit supply and economic gowth. Some studies investigate the link between the liquidity atios and stess, by using the LTD atio - among othe vaiables - as signalling indicato fo liquidity poblems at banks (fo instance Le Leslé, 2012 and Betz et al., fothcoming). Ou pape goes one step futhe by linking the LTD atio to macopudential policy and funding estictions in paticula. The policy measues focus on the funding side of banks balance sheets (i.e. the denominato of the LTD atio), since the numeato is influenced by othe macopudential instuments, like the countecyclical capital buffe and loan-to-value limits. Accoding to Goodhat et al. (2013) no single egulatoy tool is going to be sufficient to addess the multiple souces of systemic isk. Thei model fo instance suggests that capital alone is unlikely to be sufficient to contain the poblems aising duing a cisis. This undelines the added value of funding measues based on the LTD atio to mitigate systemic liquidity isk. The LTD atio can be used by the macopudential authoity to addess both stuctual (long-tem) and cyclical (shot-tem) liquidity isks. The stuctual dimension efes to the mismatch between loans and custome deposits following fom the business models of banks. Thei funding mix eflects stuctual developments of etail and wholesale funding makets. These show up in the tend of the LTD atio. The macopudential authoity could taget a long-tem tend level of the atio at which the banking secto functions well and does not face excessive funding isks o impaied intemediation (both pesenting a bad equilibium). The cisis showed that this can pay off: economies whee banks had elatively low LTD atios weatheed the cisis elatively well (Cecchetti et al, 2011). The LTD atio will fluctuate aound its tend as a eflection of shot tem financial cycles. The atio 2

5 tends to ise in good times, when maket funding is abundantly available to finance cedit gowth. The atio usually levels off in stessed maket conditions, when wholesale funding is substituted fo etail savings and cedit gowth diminishes. In a sense the LTD atio esembles the leveage atio (assets to equity), which also has stong po-cyclical featues (Adian and Shin, 2008). A specific featue of liquidity cycles is that they ae usually diven by the mutually inteacting foces of maket and funding liquidity (Bunnemeie and Pedesen, 2009). Afte a shot discussion of macopudential policy issues with egad to liquidity isk in Section 2, the applied concepts and methods ae explained in Sections 3 and 4. The stuctual and cyclical dimensions as well as a beakdown of changes in the LTD atio in a loan and deposit component ae analyzed empiically in Section 5. This povides a bette undestanding of the timing and desied macopudential policy eactions, as fomulated in Section 6. The final section concludes. 2. Policy issues Loan and deposit cycles can be influenced by monetay policy. Reseve equiements affect deposit taking by banks and thei ability to supply loans. Chadha and Coado (2012) show that an incentive to hold a highe faction of eseves to deposits helps to constain lending in a boom. Loweing eseves in a downtun can pevent a fall in lending. We focus on macopudential policy options to pevent po-cyclical bank lending o funding, in paticula countecyclical estictions to the LTD atio. Paticulaly in a cuency union macopudential policy has value added in steeing the national financial cycle, since monetay policy is based on the conditions in the cuency aea as a whole. The LTD atio complements the liquidity atios in the Basel III famewok, the Liquidity Coveage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR focusses on liquidity isk ove a shot tem hoizon, while the NSFR focusses on stuctual liquidity mismatches. The two atios take into account stessed values of liquid assets and liabilities, wheeas the LTD atio is a atio between the unweighted values of loans and deposits. Hence the LTD atio includes the intinsic chaacteistics of loans and deposits, independent of contactual o assumed matuities. This makes the LTD atio less pone to intepetation and simple to undestand. This is paticulaly useful in times of stess when maket paticipants moe likely tust staightfowad indicatos. Unlike the LCR and NSFR thee is no (mico- o macopudential) intenational egulation that sets quantitative limits to the LTD atio, mainly because the elation between loans and deposits depends on the stuctue of the domestic financial system. Hence, limits to the LTD atio ae usually not pat of supevisoy egulation. As fa as we know, two egulatos pescibe limits to the LTD atio. Until this 3

6 yea the Chinese supeviso has applied an uppe limit of 75% fo Chinese banks, wheeas the US authoities set a lowe bound to bank s statewide loan-to-deposit atios (Fedeal Reseve Boad, 2012). The latte should pevent banks fom issuing deposits in anothe state, while not investing these funds locally. Ou pape is a fist attempt to develop a macopudential famewok fo the LTD atio. While thee have been poposals to use the LCR and NSFR as macopudential indicatos (Jobst, 2012) o instuments (Van den End and Kuidhof, fothcoming), to ou knowledge thee ae no studies on the macopudential use of the LTD atio. In pactice, in some counties it is used fo macopudential easons, fo instance in some IMF pogams which establish indicative tagets fo the LTD atio. 1 Something to take into account when using an indicato like the LTD atio as an instument is Goodhat s law, i.e. once the atio is made a policy taget it will lose infomation content. In paticula it says that any obseved statistical egulaity will tend to collapse once pessue is placed upon it fo contol puposes (Chystal and Mizen, 2001). Howeve, this is less an issue in ou appoach, since the link between the LTD atio as indicato and the funding estictions that we popose as policy tool is not based on an estimated elationship but is an identity by itself. Moeove, the final objective of peventing liquidity stess is also influenced by othe tansmission channels, next to the funding gap. 3. Concepts The LTD atio depends on potfolio choices of households, non-financial fims and banks. The demand fo deposits and loans by households and fims elates to the optimization of thei balance sheets. As in the Makowitz potfolio famewok, optimizing agents base thei decisions on the isk and etun chaacteistics of loans and deposits, elative to othe assets and liabilities. Fo instance, if deposit ates ae elatively low, agents have an incentive to invest thei funds in altenative investments. While this applies in nomal times, in stess situations isk motives may dominate pice incentives. Agents may then pefe safe deposits, even if deposit ates ae low. Beg (2012) explains the elationship between loans and deposits in the context of the financial flow model. In that appoach deposits can ceate loans, since an incease of deposit funding impoves the liquidity position of banks and theeby thei oom to extend loans (loans ae the monetay countepat of deposits). Vice vesa, bank loans tend to ceate deposits, since the funds eceived by a boowe will end up in a deposit, eithe in the account of the boowe o in the account of his countepaty who eceives a payment. This does not mean that it is a closed system in which loan gowth equals deposit 1 Fo instance in the EU/IMF pogams of Ieland and Potugal. 4

7 gowth by definition. Banks can use altenative (wholesale) souces to fund thei lending, while fims and households can invest in altenative assets. Thee can also be leakages fom the non-financial to the financial secto o to foeign agents. The LTD atio also depends on the potfolio choices of banks in the context of thei liquidity management. Based on the model of Goodhat et al. (2013) we fomulate two constaints that a bank faces. The fist constaint elates the potential uses of funds (etail lending L, wholesale lending L w, financial maket assets B) to its souces of funds (equity E, etail deposits D, wholesale deposits D w, cental bank boowing CB and secuities issued S), L + L + B E + D + D + CB S (1) w w + The second constaint elates etail lending to a bank s etail funding (D ) and maket funding obtained by secuitization of etail loans (S sec ), L sec D + S (2) sec with S being pat of S. The constaint assumes that a bank funds its etail lending with etail savings L and/o secuitization to limit its liquidity isk. The LTD atio is pesented by. L and D ae the D steady state levels of loans and etail deposits, elated to equilibium LTD atio ( LTD ) at which the intemediation pocess functions nomally and the isk of a bad equilibium is low. At low levels of the LTD atio it is likely that L < L (and/o D > D, which is most likely a cyclical phenomenon, see Section 5). It can esult fom insufficient o impaied financial intemediation. Banks may hoad liquidity - and hold B instead of L - if they ae isk avese. Thee can also be stuctual easons why banks use etail deposits to finance othe assets than loans. Such potfolio choices can elate to the stuctue of the economy and/o domestic financial system and fo instance eflect a lack of pofitable lending oppotunities. At high levels of the LTD atio it is likely that D < D (and/o L > L, which is most likely a cyclical phenomenon, see Section 5). As a consequence D is insufficient to cove etail loans (L ). This may be compensated by the secuitization of loans (S sec ) as an altenative funding souce. Secuitization can be a elatively stable funding souce if it concens self-funding assets, such as motgages with low loan-to-value atios and annuity epayment. 5

8 4. Empiical methods In this section we investigate the empiical egulaities of the LTD atio. These ae useful ingedients fo the macopudential policy appoach, which we calibate on the stuctual and cyclical featues of the LTD atio and on the effects of its subcomponents, loans and deposits. 4.1 Tend and cycles The stuctual dimension is analyzed by the long-tem tend in the LTD atio. This is based on the onesided Hodick-Pescott (HP) filte with a high smoothing paamete (λ = 400,000). This captues longtem financial tends that ae diven by stuctual developments in the financial secto. Similaly the HP filte is used to detemine the tend of the cedit-to-gdp atio as macopudential instument fo setting countecyclical capital buffes (Dehmann et al., 2011). The cyclical dimension is analyzed by two methods. The fist method takes the deviation of the LTD atio fom the HP-filteed tend as the cycle. We take the deviation fom the HP-tend with λ = 400,000, which is the fouth powe of the λ that is commonly used in business cycle models. Hence ou method implies that financial cycles ae fou times longe than standad business cycles, which accoding to the liteatue seems appopiate (Dehmann et al., 2011). The second method uses a band-pass filte to isolate the cycle. The Chistiano-Fitzgeald filte captues the cycle that coesponds to a chosen fequency inteval. We set the lowe bound of the inteval at 5 yeas, which accoding to Dehmann et al. (2012) captues medium-tem financial cycles (the uppe bound is not fixed). The band-pass filte assumes a symmetic cycle with equally long upwad and downwad phases. 4.2 Aithmetical beak-down of effects The numeato (loans, L) and denominato (deposits, D) have a distinct effect on the LTD atio. These effects ae isolated by an aithmetical beak-down of the change of the atio. If numeato L inceases with l and denominato D with d, than: ( L + l) ( D + d) L D = ( Dl Ld) D( D + d) (3) The tem on the ight hand side of Equation 3 esults fom multiplying the fist tem on the left hand side by D, the second tem by (D+d) and some eaanging of the tems. The tem on the ight hand 6

9 side can be decomposed in a numeato effect by assuming d=0 and in a denominato effect by assuming l=0. l D Ld D( D + d), numeato effect (d=0), denominato effect (l=0) (4) (5) Subtacting the numeato and denominato effects fom the ight hand side of Equation 3 delives the inteaction effect, ld D( D + d), inteaction effect (6) The inteaction effect is a pue aithmetical effect. It may undeestimate the boade, economic inteaction between loans and deposits, as explained in the context of the financial flow model in Section 3 (see Annex 2 fo a futhe exploation of the boade inteaction effect). 4.3 Data The stuctual and cyclical dimensions, as well as the decomposition of the LTD dives ae analyzed with data of 11 EMU counties and the EMU total (constucted by aggegating loans and deposits of the 11 membe states). Fo each county the sample includes loans and deposits of banks outstanding to non-financial countepaties (households and fims) in the euo aea on a monthly basis in In pactice, definitions of the LTD atio diffe widely with egad to the type of assets and liabilities included and the juisdiction of loans and deposits (some definitions exclude foeign deposits). Avoiding egulatoy abitage could be a eason fo using a boad definition of loans and deposits, which fo instance includes deecognized secuitized loans in the numeato o debt secuities issued to etail customes in the denominato. Consolidated banking data have a boad coveage of loans and deposits, which is an advantage. Howeve fo seveal easons, consolidated statistics ae a less useful data souce fo the LTD atio. Fist, they do not have a detailed beak-down of loans and deposits to countepaties, i.e. households and fims. Second, long and compaable seies of consolidated data ae not available fo the counties we analyze. Thid, calculating the LTD atio with consolidated data implicitly neglects the isk that coss-bode deposits can be ing fenced in cises. Fo these easons we use data fom the monetay 7

10 statistics as published by the ECB to calculate the LTD atio, with loans adjusted fo sales and secuitization 2. While the monetay statistics do not include loans and deposits of banches and subsidiaies outside the euo aea, they do cove activities of foeign entities in the home maket. This fits with the ecipocity pinciple of the countecyclical capital buffe, implying that national authoities ae esponsible fo setting capital buffes to cedit exposues in thei juisdiction (BIS, 2010). 5. Outcomes 5.1 Stylized facts Table 1 shows a wide dispesion of LTD atio acoss EMU counties. While Italy, Ieland and Nethelands have an aveage atio above 140%, the mean atios of Belgium and Geece ae below 100%. The dispesion is also wide within counties (measues acoss time, not acoss banks), as shown by the lage diffeence between minimum and maximum LTD atio within counties. A high LTD atio could be associated with high volatility since a high funding gap makes the business of banks - of which the main pats ae captued by the LTD atio - moe sensitive to maket fluctuations. Table 1. Desciptive statistics LTD atios (monthly data, ) Measued acoss time, not acoss banks DE FR IT GR ES PT NL BE IR AT FN EMU Mean 100,3 116,4 157,3 86,2 118,6 132,6 145,5 76,7 153,1 108,3 129,9 117,3 Median 101,1 116,5 157,7 84,6 117,0 140,7 149,9 78,2 152,0 108,8 138,8 118,7 Stdev 9,9 7,4 18,8 32,6 9,7 20,4 11,5 5,4 22,6 3,0 18,1 5,2 Min 82,8 102,8 110,0 47,8 93,9 74,2 114,4 65,8 113,2 99,5 91,1 103,5 Max 114,9 131,3 201,3 174,9 134,0 153,2 165,7 85,6 200,6 114,3 153,4 125,5 5.2 Tend and cycle The long-tem (HP filteed) tend of the EMU aveage LTD atio inceased fom the end of the 90s until 2005 and deceased aftewads (Figue 1.a). This eflects the inceased access of banks to wholesale funding in the un up to the cisis on the back of financial innovations like secuitization. The cisis uged banks to change thei funding mix towads moe stable souces of funding, which 2 Adjustments fo sales and secuitization ae not available fo loans to non-financial companies and households in ou time sample. The ECB Statistical Data Waehouse (SDW) publishes gowth ates of total loans to non-financial institutions excluding govenments, adjusted fo sales and secuitization. We apply this coection facto (based on gowth ates) to loans of companies and households. 8

11 shows up in an incease of the denominato and decline of the LTD atio. Most counties fit the euo aea wide tend, although the tuning point to a downwad tend diffes acoss counties (Figues 1.bc). The tends in the LTD atios of Geece, Belgium and Austia show an obvious diffeent patten. Figue 1.a. Tend of LTD atio EMU LTD atio in pecentage points (times 100) Figue 1.b-c. Tends (HP filte) of LTD atios EMU counties AT BE DE FN FR NL ES GR IR IT PT LTD atio HP tend LTD atio Figue 2.a shows the cycle of the EMU LTD atio, based on the tend deviation and band-pass filte. The peaks and toughs of the cycle, as detemined by both methods, match closely. Measued as deviations fom tend, upwad phases of LTD atios in the county sample span 32 months on aveage and downwad phases 38 months. In this espect the LTD atio diffes fom financial cycles in geneal, which have shote contactions elative to expansions (Dehmann, 2012). One eason fo the diffeent cyclical patten is that it concens a atio of two financial vaiables. Figue 2.a. Cycle of LTD atio EMU Figue 2.b-c Cycles (band-pass filte) LTD atios EMU counties Cycle of LTD atio in pecentage points (times 100) Deviation HP filte Band-pass filte AT BE DE FN FR NL ES GR IR IT PT Figues 2.b-c suggest that the LTD cycles ae quite synchonized acoss EMU counties. The Dutch and Geece LTD atios ae most out of synch, which is confimed by the fomal measue of synchonicity φ pesented in Table 2 (the cycles ae completely synchonous to the euo aea efeence cycle if φ = 1, see Annex 1 and Mink et al., 2012). Gaphical inspection suggests that the LTD cycles of most counties also have simila amplitudes. We fomally measue co-movement by vaiable γ, which expesses the total distance between the cycle of a county and the efeence cycle (thee is 9

12 completely co-movement with the efeence cycle if γ = 0, see Annex 1). Table 2 shows that comovement is low fo Italy, Geece and Ieland in paticula. Table 2. Measues of cycle similaity (monthly data, ) DE FR IT GR ES PT NL BE IR AT FN Synchonicity (ϕ ) 0,86 0,81 0,93 0,38 0,74 0,75 0,33 0,74 0,72 0,90 0,83 Co-movement (γ ) -0,36-0,88-1,23-1,83-0,57-0,77-1,08-0,59-1,59-0,26-0,27 Note: measues fo synchonicity and co-movement as defined by Mink et al, The LTD cycle of the euo aea aveage is used as efeence cycle. 5.3 Decomposition Figue 3 decomposes the numeato and denominato effects of the LTD atio fo the euo aea. It shows that loan gowth (numeato effect) is diving the cyclical upswing and dominates the change of deposits. This is confimed by the outcomes in Table 3, which show that the diffeence between the aveage numeato effect in upwad and downwad phases is significantly positive in most counties, indicating that loan gowth is stonge in an upswing. The significant negative diffeence between the aveage denominato effects in upwad and downwad phases in most counties confims that the change of deposits is stonge in downwad phases of the LTD cycle. These esults suggest that an expansion of loans is patly financed by non-deposit funding, which aises the LTD atio. In downtuns the denominato effect becomes moe dominant, suggesting that the decline of the LTD atio is pimaily diven by inceasing deposits. One explanation fo this is that the funding side can moe easily be adjusted than the loan book, which has a longe matuity on aveage. This makes the loan book quite sticky, in paticula in downtuns. Figue 3. Numeato, denominato effect EMU Figue 4. Inteaction effect EMU Numeato and denominato effects as pecentage Cycle of LTD atio in pecentage points (times 100) (12 months moving aveages) (12 months moving aveages) Numeato effect (loans) Denominato effect (deposits) Cycle LTD atio (band-pass, h-axis) Inteaction effect Cycle LTD atio (band-pass, h-axis) 10

13 Table 3. Diffeence between numeato and denominato effects (effects in tems of 12 months moving aveages, times 100) DE FR IT GR ES PT NL BE IR AT FN EMU Numeato effect upwad 0,22 0,78 1,14 0,84 1,15 1,34 0,99 0,54 2,02 0,54 0,96 0,68 downwad 0,12 0,46 1,10 0,91 1,18 0,57 1,13 0,21 0,32 0,41 1,03 0,55 Diffeence (up - down) 0,10*** 0,32*** 0,04*** -0,06* -0,03** 0,77*** -0,15*** 0,33*** 1,71*** 0,13*** -0,08* 0,12*** Denominato effect upwad 0,29 0,51 0,68-0,25 0,89 0,77 0,61 0,42 1,49 0,41 0,64 0,52 downwad 0,35 0,63 1,20 0,60 1,22 0,60 1,08 0,33 0,45 0,49 0,76 0,65 Diffeence (up - down) -0,06** -0,13*** -0,52*** -0,85*** -0,33*** 0,17*** -0,48*** 0,08*** 1,03*** -0,08** -0,12** -0,14*** Note: means of effects times 100. T-test fo mean diffeences in upwad vs downwad phases, ***, **, * denoting significance at 1%, 5%, 10% confidence level. The inteaction effect is stonge in upwad phases (Figue 4). This indicates that the mutually einfocing effect between loans and deposits tends to dive the LTD atio up. Howeve, the low level of the effect suggests that the inteaction between loans and deposits is not an impotant dive behind the LTD atio (it concens the pue algebaic effect as deived in Equation 3; the wide inteaction effect is exploed in Annex 2). 6. Macopudential policy ules 6.1 Stuctual policy Macopudential policies can influence the tend level of the LTD atio by stuctual measues. The policymake can define an uppe and lowe bound of the LTD atio, which eflect maket failues (bad equilibia) that should be pevented. An uppe bound of the LTD atio (with D < D and/o L L > ) can be associated with unsustainable business models of banks that excessively ely on maket funding. A lowe bound of the LTD atio can be associated with impaied intemediation by banks, due to liquidity hoading and deleveaging ( L < L and/o D > D ). The boundaies ae efeence points fo policy measues. It is had to pinpoint paticula values fo the boundaies, since they may vay by county (depending on the stuctue of the local financial system) and by bank (depending on the business model). Moeove the values of the boundaies depend on the definition of the LTD atio. Thee is some histoical evidence on citical boundaies. A multiple county analysis, based on a boad definition of loans and deposits, suggests that an LTD atio ove 120% ae pesumptive indicato fo a banking cisis and LTD atios of 80% ae associated with impaied financial intemediation (ECB, 2012). The taget (o equilibium) level of the LTD atio ( LTD ) between the boundaies could be based on 11

14 the isk toleance of the macopudential authoity and the volatility of maket funding, which will depend on the stuctue of the financial system. This appoach assumes that the LTD atio is maintained within the lowe and uppe bounds by calibating LTD on the available maket funding (S), its volatility (σ S ) and pobability (P) that the LTD atio cosses the lowe o uppe bound. The macopudential authoity sets LTD to bing P in line with his isk toleance. To keep the LTD atio below the uppe bound at pobability P, the taget level fo LTD should be loweed popotional to σ S (vice vesa LTD should be aised popotional to σ S to keep the atio above the lowe bound). Figue 5 shows a ange of simulated LTD atios that meet these conditions, at hypothetical values of S=100, σ S =10%, P=5%, uppe bound=120 and lowe bound=80. The macopudential authoity chooses LTD within this ange, given LTD = LTD + σ S. 3 It assumes that changes in the LTD atio ae entiely diven by fluctuations in maket funding, which go in tandem with ising loans in an uptun and ising etail deposits in a downtun. In the theoetical situation that σ S =0 the equilibium level could be set at the uppe o lowe bound. A ational choice will be LTD =100, which gives most leeway to contol both an upswing and downswing of the LTD atio. Howeve the authoity could pefe an altenative LTD level within the ange, if the possibilities to influence the LTD atio in an uptun and downtun ae not simila. At a cetain high volatility level σ S, the authoity has no flexibility to choose between equilibium LTD levels (this is the point whee LTD associated with the uppe and lowe bounds meet at 100%, see Figue 5). This could be solved by lifting the isk toleance, i.e. accepting a highe pobability that the LTD atio cosses the uppe o lowe bounds. Figue 5 shows that at P=10%, the ange of equilibium levels LTD that keep the LTD atio below the uppe bound (above the lowe bound) is wide. Figue 5. Equilibium LTD atio vs. volatility maket funding LTD σ S 80 12,5% 10,0% 7,5% 5,0% 2,5% 0,0% 0,0% Eq LTD LTD up bnd, P=5% Eq LTD LTD low bnd, P=5% Eq LTD LTD up bnd, P=10% Eq LTD LTD low bnd, P=10% 3 LTD is simulated by taking 10,000 andom daws fo σ S fom a nomal distibution. 12

15 As an illustation, Figue 6 compaes the HP filteed tend of the actual LTD atio of the euo aea to a hypothetical equilibium value of 100% (assuming L, D = 100), an uppe bound of 120% and a lowe bound of 80%. It shows that the LTD tend atio has stayed within the boundaies duing the sample peiod. Afte hitting the uppe bound in 2006, the tend LTD atio has declined theeafte. In 2012 half of the euo aea counties still had a tend atio of moe than 120% (Finland, Geece, Ieland, Italy, Nethelands, Potugal, see Figues 1.b-c). While citical levels of lowe and uppe bounds may vay by county, depending on the stuctue of the local financial system, vey low o high levels may not be sustainable in the long un. A vey low LTD atio may eflect an insufficient level of financial development, while a vey high LTD level may eflect an oveextended financial secto. Figue 6. Boundaies LTD atio EMU LTD atio in pecentage points (times 100) 1,60 1,40 1,20 1,00 0,80 0, HP filteed tend LTD atio Uppe bound Lowe bound The tend of the LTD atio could be kept within the bounded aea by wide anging stuctual measues that affect loans (L ), deposits (D ) and the intemediation pocess in geneal. i) Guidance o incentives in micopudential supevision to change banks business models towads moe taditional, deposit based lending. An example of such an incentive is the supevisoy assessment of the sustainability of banks financing model, as egulaly conducted by DNB. ii) Changes in egulation that influence funding and lending (e.g. by mico and macopudential measues that estict lending, o foste the use of stable funding souces). iii) Repaiing monetay tansmission by stuctual efoms of ill-functioning banks (efoms should aim at witing-off and/o disposal of bad loans and ecapitalization to suppot the flow of cedit). iv) Influencing maket stuctues by efoms that aim at paticula maket segments, fo instance the etail savings maket. Policy measues like tax changes can influence the distibution of savings between pension funds, insuance companies and banks. 13

16 6.2 Countecyclical policy Macopudential policy can influence the cycle of the LTD atio between the uppe and lowe bounds. The stylized facts in the pevious section show that loan gowth is dominant in an uptun, aising the LTD atio to the uppe bound. In a downtun deposit gowth is dominant, educing the LTD atio to the lowe bound. These egulaities can be used to apply countecyclical measues (see Figue 7). Fist, the LTD atio can be used as indicato fo othe macopudential instuments. Fo instance, if the LTD atio ises in an uptun, the countecyclical capital buffe can be inceased and loan-to-value atios esticted, while those measues may be elaxed in a downtun. Second, macopudential policy can be infeed fom the LTD atio itself. We popose two ules fo influencing the LTD-cycle by countecyclical funding estictions. Figue 7. Stylized LTD cycle funding estictions Uppe bound LTD Equilibium LTD funding estictions Lowe bound LTD switch on ule 1 switch on ule 2 switch off ule 1 switch off ule 2 The fist ule is applied when the system neas the uppe bound. This is typically associated with cedit gowth financed by wholesale funding, which is abundantly available in cyclical upswings. The ule equies banks to fund new lending ( L ) with an inceasing shae of stable deposits ( D ) and is designed as a function of the LTD atio and taget atio LTD, D = (1 α) D + α ( L LTD 1 LTD ( 1 t 1 + ) log ( λ ) ) 100 (7) x, t, t, t t whee D, is the autonomous gowth of etail deposits (independent of policy measues), t stands fo x t time and α and λ ae adjustment paametes. The ule is designed like solvency ules in macoeconomic models fo public debt (see Johnson, 2001 fo an oveview). A caveat fo applying such ules to banks is that they do not take into account altenative eactions by banks. They may take othe actions to close thei funding gap than assumed by the ule. The ceteis paibus condition is nonetheless applied to illustate the effects of funding estictions on a maco level. 14

17 The macopudential authoity sets the paametes of the ule ( LTD and the adjustment paametes), dependent on its isk assessment. If it wants to keep the LTD atio futhe away fom the uppe bound, it can apply a highe α. If it wants banks to adjust moe apidly towads the taget LTD atio it can aise paamete λ. These decisions can be based on the volatility of maket funding σ S. The funding equiement is switched off when the LTD atio eaches LTD. Figue 8 shows how the ule woks, x when the LTD atio is simulated ove time, assuming LTD = 100, α = 0.5, λ = 0.4, D 1 and L = 5 (the latte two ae constant gowth tems). It assumes that the ule is switched on at the stat of an upwad phase of the LTD cycle (this condition is imposed in Equation 7, by setting t=0 each time the ule is switched on). The ule is switched off when the LTD atio etuns to 100%, as shown by the dop in D at t = 30., t = Figue 8. Anti-cyclical ule in upwad phase LTD atio in pecentage points The policy ule can be a ecommendation to the micopudential supeviso. He could chage fees to banks that do not issue etail deposits in line with loan gowth, o impose funding estictions aimed at the taget LTD atio. Since loans tend to ceate deposits by themselves - as explained in Section 3 - the ule has an inheent logic. Howeve, it could have advese side-effects. Inceased competition fo etail funding can sti up saving ates and affect othe sectos that also ely on etail savings. This will be less an issue in an uptun than in a downtun, when banks moe likely scamble fo stable funding. A ise of inteest ates could even be suppotive to monetay and macopudential policy in an uptun. Advese side-effects should be taken into account when applying the instument, eithe by adjusting its design (possibly by avoiding a had limit o defining long enough adjustment peiods when the uppe bound is not hit yet) o by applying it in conjunction with othe instuments, fo instance the countecyclical capital buffe to estains loan gowth in an uptun. 15

18 The second countecyclical ule is applied when the system neas the lowe bound, due to impaied intemediation of deposits into loans. To avoid such a bad equilibium, banks ae given an incentive to match an inceasing faction of new deposits with loanable funds (L ). This is defined as bank funding that is available fo lending, i.e. new cedit supply. The ule fo the downtun is a function of t the funding gap ( LTD LTD 1 ) and adjustment paametes α and λ. The ule stimulates that the incease of demand deposits ( D ) is inceasingly matched with supply of new loans ( L ). The ule is witten as, x LTD LTD t 1 L, t (1 α) L, t α ( D, t 1 ( 1 = + + ) log ( λt ) ) 100 (8) whee L, is the autonomous gowth of loanable funds (independent of policy measues). The ule is x t illustated in Figue 9, whee the LTD atio is simulated ove time, assuming LTD = 100, α = 0.5, λ = x 0.4, L 1 and D = 5 (the latte two ae constant gowth tems). It assumes that the ule is, t = switched on when the LTD atio falls below 100%, at the stat of each downwad phase of the LTD cycle (this condition is imposed in Equation 8, by setting t = 0 each time the ule is switched on). The ule is switched off when the LTD atio etuns to 100%, as shown by the dop in L at t = 25. Figue 9. Anti-cyclical ule in downwad phase LTD atio in pecentage points The supeviso can foste the supply of loanable funds by uging banks to epai thei balance sheets, ecapitalize and issue moe stable funding (tem funding o secued funding). This could equie a sufficiently long adjustment peiod to limit advese pice effects in those makets. If the decline of the 16

19 LTD atio would have detimental economic effects and banks ae not able to obtain stable funding, thee is a case fo the cental bank and/o govenment to step in. They can take vaious measues aimed at bank s funding, to foste cedit supply. The cental bank has a natual ole to suppot the monetay tansmission. Depending on the situation it can take unconventional monetay policy measues, fo instance by poviding long-tem epo funding to banks and/o widen the collateal famewok by accepting cedit claims. A funding fo lending scheme, which povides long-tem funding at favoable tems, is paticulaly tagetted at new lending. The govenment may contibute to that by guaanteeing long tem bank debt (as was done in by many Euopean counties). Such measues can enhance the supply of loanable funds and suppot banks lending. In pactice, an uppe bound might be sufficient to pevent bad equilibia. A lowe bound would pobably not be needed since impaied intemediation usually follows fom a coection of excessive liquidity isks which the uppe bound may pevent. The countecyclical capital buffe could also contibute to that, although it pimaily aims at cedit and not at liquidity isk. Moeove, fom a liquidity isk pespective it is less woisome that banks appoach the lowe than the uppe bound, paticulaly if a declining LTD atio owing to stong deposit inflows is not associated with falling lending. This undescoes that judgement - based on analysis of the loan and deposit components - emains an impotant element in macopudential decisions with egad to the LTD atio. 6.3 Stability popeties The stability popeties of the macopudential ules ae illustated by seveal sensitivity tests. We apply diffeent values fo α, λ, L x D, t in the ule fo the upwad phase in the LTD atio (Equation 7; the conclusions ae simila fo the ule fomulated fo the downwad phase). Figues show that the stability of the ule is quite obust to changing the paamete values. At diffeent values of α, λ, L x D, t the LTD atio conveges to LTD in the long un. This is due to the condition that the ule is switched off at an LTD atio of 100. Figue 10 shows that a highe α educes the maximum value of the LTD atio (and also educes the adjustment peiod), while Figue 11 shows that a lowe λ polongs the adjustment peiod (and as a consequence also aises the maximum value). The LTD atio is also sensitive to changes in the autonomous incease of lending ( L in Figue 12) and etail deposits ( x D, t in Figue 13). The stability popeties of the ule also hold if vaious paametes ae changed simultaneously. Only when vey low values of α, λ, x D, t and high values of L ae implied simultaneously the LTD atio keeps on ising and does not convege to LTD. The macopudential authoity can pevent this by contolling the adjustment paametes α and λ. 17

20 Figue 10. Sensitivity fo alpha LTD atio in pecentage points Figue 11. Sensitivity fo lamda LTD atio in pecentage points Figue 12. Sensitivity fo L LTD atio in pecentage points Figue 13. Sensitivity fo D LTD atio in pecentage points 18

21 7. Conclusion Building on eseach that investigates the indicato popeties of the Loan-to-Deposit atio fo liquidity isk, ou pape links the empiical egulaities of the atio to macopudential policy. Decomposition analysis of the numeato and denominato of the LTD atios in 11 EMU counties shows that loan gowth is dominant in an uptun, aising the LTD atio to the uppe bound. In a downtun deposit gowth is dominant, educing the LTD atio to the lowe bound. The inteaction effect between loans and deposits is statistically significant and is stonge in upwad phases of the LTD cycle. Based on these findings, the macopudential authoity may want to influence the cycle of the LTD atio between an uppe and lowe bound. The boundaies eflect maket failues (bad equilibia) which should be pevented. Destabilizing cycles of the LTD atio between the uppe and lowe bounds can be countebalanced by macopudential ules. We fomulate a ule which stimulates banks to issue etail deposits in an uptun and a ule that povides incentives to ceate loanable funds in a downtun. The fist ule discouages banks to use maket funding when it likely is easily available. To some extent it is in line with the financial flow model, which says that loans tend to ceate deposits by themselves. The second ule deals with situations in which banks have abundant etail savings owing to a flight to quality. The ule encouages banks to lend thei deposits to households and non-financial fims. Besides the cycle of the LTD atio, the tend level of the LTD atio can be influenced by stuctual policy measues, which influence maket stuctues o the financial intemediation pocess moe fundamentally. The policy ules focus on the denominato of the LTD atio (i.e. the funding side of the balance sheet), since the numeato is influenced by othe macopudential instuments, like the countecyclical capital buffe and limits to the loan-to-value atio. While measues taken at the funding side of banks have added value to mitigate systemic liquidity isk, coodination issues could aise when multiple macopudential instuments ae applied. This is an impotant subject fo futue eseach. 19

22 Refeences Adian, T. and H.S. Shin (2008), Liquidity supply, Monetay Policy, and Financial Cycles, Fedeal Reseve Bank of New Yok Economic Policy Review, 14(1), 1-7. Beg, S.A. (2012), The declining deposit to loan atio - What can the banks do?, Staff memo 28/2012, Noges Bank. Betz, F., S. Opică, T. A. Peltonen and P. Salin (fothcoming), Pedicting Distess in Euopean Banks, Woking Pape. BIS (2010), Guidance fo national authoities opeating the countecyclical capital buffe. Chadha, J. S. and L. Coado (2012), Maco-pudential policy on liquidity: What does a DSGE model tell us?, Jounal of Economics and Business, 64. Bunnemeie, M. K. and L.H. Pedesen (2009), Maket Liquidity and Funding Liquidity, Review of Financial Studies 22(6), Cecchetti, S.G., M.R. King and J. Yetman (2011), Weatheing the financial cisis: good policy o good luck?, BIS Woking Papes, 351. Chystal, K.A. and P. D. Mizen (2001), Goodhat s Law: Its Oigins, Meaning and Implications fo Monetay Policy, Pape pepaed fo the Festschift in honou of Chales Goodhat to be held on Novembe 2001 at the Bank of England. DNB (2012), Oveview of Financial Stability in the Nethelands, 15, Mach Dehmann, M., C. Boio and K. Tsatsaonis (2011), Anchoing Countecyclical Capital Buffes: The ole of Cedit Aggegates," Intenational Jounal of Cental Banking, 7(4), Dehmann, M., C. Boio and K. Tsatsaonis (2012), Chaacteising the financial cycle: don't lose sight of the medium tem!, BIS Woking Papes 380. ECB (2012), Financial Stability Review, June Fedeal Reseve Boad (2012), Banking Agencies Issue Host State Loan-to-Deposit Ratios, Pess elease, June 29, Goodhat, C.A.E., A.K. Kashyap, D.P. Tsomocos and A. Vadoulakis (2013), An Integated Famewok fo Analyzing Multiple Financial Regulations, Intenational Jounal of Cental Banking, 9(1). Jobst, A.A. (2012), Measuing Systemic Risk-Adjusted Liquidity (SRL), A Model Appoach, IMF Woking pape 12/209. Johnson, R (2001), Fiscal eaction ules in numeical maco models, Fedeal Reseve Bank of Kansas City. Kashyap, A.K., R. Rajan, and J.C. Stein (2002), Banks as Liquidity Povides: An Explanation fo the Coexistence of Lending and Deposit- Taking, The Jounal of Finance 57(1). Le Leslé, L. (2012), Bank Debt in Euope: Ae Funding Models Boken?, IMF Woking Pape 12/299. Mink, M., Jacobs, J. P.A.M. and J. de Haan (2012), Measuing coheence of output gaps with an application to the euo aea, Oxfod Economic Papes, 64(2), Van den End, J.W. and M. Kuidhof (fothcoming), Modelling the liquidity atio as macopudential instument, Jounal of Banking Regulation. 20

23 Annex 1. Measues of cycle similaity The measues of cycle similaity we use ae taken fom Mink et al. (2012). They define synchonicity between the business cycle (g i ) of an individual county i and the efeence cycle (g ) in peiod t as, ( t) i = gi ( t) g g ( t) g i ( t) ( t) ϕ (1.1) When aveaged ove a time inteval and tansfomed to a unifom scaling, φ shows the faction of time that the output gap of county i has the same sign as the output gap of the efeence cycle. Hence, measue φ anges between 1 and 0 (a value of 1 indicates complete similaity). The co-movement measue γ i expesses the distance between the cycle of a county and the efeence cycle, and scales this distance by the oveall sum of these output gaps, i ( t) n gi ( t) g ( t) = gi ( t) = n γ (1.2) i 1 The minus sign makes that the measues fo co-movement and similaity move in the same diection, i.e., an incease in the measue signals an incease in similaity. Measue φ anges between 0 and -n (a value of 0 indicates complete co-movement). 21

24 Annex 2. Simulation of inteaction effects with panel-var model To analyze this boad inteaction effect between loans and deposits, we estimate a small panel Vecto Autoegessive model (p-var). The model teats the vaiables in the system as endogenous and allows fo unobseved individual heteogeneity by including fixed effects. It eads as follows: Dit L it = Y it Dit Ai B L L + ( ) it + ε it (2.1) Y it whee D t is the annual gowth ate of deposits, L t the annual gowth ate of loans and Y t a vecto containing GDP gowth and the change in inteest ates (govenment bond yields, which usually ae the basis of loan and deposit ates) fo each county i and month t. Matix A i contains county-specific fixed effects, B(L) is a matix polynomial in the lag opeato whose ode is 2 andε it is the eo tem. The coefficients of the p-var model ae estimated by system Genealised Method of Moments (GMM). 4 The decomposition of the esiduals is conducted by Choleski decomposition. The identifying assumption is that vaiables that come ealie in the odeing affect the following vaiables contempoaneously, as well as with lags, while the vaiables that come late affect the pevious vaiables only with lags. We assume that deposits ae moe exogenous than loans and theefoe deposits appea fist in the odeing of the vaiables. Inteest ates ae included afte loans and GDP gowth afte inteest ates. To examine the inteaction between loans and deposits we use impulse-esponse functions that ae deived fom the p-var model. The impulse esponses of show a significant inteaction effect: both loans and deposits espond significantly positive to shocks in the othe vaiable (the effects ae significantly diffeent fom zeo, see Figue A, uppe panels). The esponse of loans to a shock in deposits is stonge than vice vesa, undelining the impotance of deposit funding fo loan supply. 5 We also find significant negative esponses of loans and deposits to a shock in inteest ates (middle panels Figue A). While it is obvious that loan demand falls if inteest ates ise, it is less obvious that deposits eact similaly. Risk motives appaently dominate pice incentives, with households and fims pefeing safe deposits, even if deposit ates ae deceasing. The esponse of loans and deposits to a shock in GDP is positive, but not significant. 4 Fo moe details we efe to Love and Zicchino (2006), whose Stata code we gatefully used fo the estimation. 5 The elative stength of the esponse of loans to a shock in deposits is undelined by simulations which include loans as fist vaiable in the panel VAR. Than the inteaction effect unning fom deposits to loans emains significant, which is not the case anymoe fo the esponse of deposits to a shock in loans. 22

25 23

26 Pevious DNB Woking Papes in 2013 No. 367 No. 368 No. 369 No. 370 No. 371 Andea Colciago and Loenza Rossi, Fim Enty, Endogenous Makups and the Dynamics of the Labo Shae of Income Dik Boedes, Paul Hilbes and David Rijsbegen, What dives pension indexation in tubulent times? An empiical examination of Dutch pension funds Luca Acieo, Ronald Heijmans, Richad Heuve, Maco Massaenti, Cistina Picillo and Fancesco Vacica, How to measue the unsecued money maket? The Euosystem s implementation and validation using TARGET2 data Stijn Claessens and Neeltje van Hoen, Impact of Foeign Banks Gabiele Galati, Fedeica Teppa and Rob Alessie, Heteogeneity in house pice dynamics

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