How to Stabilize the Economy in the Presence of a Pro-Cyclical Banking System?

by Yuemei Ji and Paul De Grauwe

Banks are at the core of the mechanisms that can produce instability in the economy. A number of pro-cyclical features in the behaviour of banks if left unchecked can destabilize the economy. In this research project, we focus on the feature that banks are money-creating institutions. When they extend a new loan at the same time they create a new deposit. As a result, bank loan supply is not constrained by the total saving of the economy. This adds an important pro-cyclical mechanism into the economy: during a boom, the assets of the banks increase in value. This in turn raises the equity ratios of the banks and leads them to expand the supply of loans. In doing so, they also create money (deposits) which further stimulates the economy. The opposite occurs during a recession.

We analyse this important feature using a behavioural macroeconomic model. This model assumes that agents have cognitive limitations preventing them from having rational expectations. Instead they use simple forecasting rules (heuristics) and are willing to switch rules depending on their relative performance. The advantage of such a model is it generates endogenous movements in optimism and pessimism (animal spirits) that drive the business cycle and are in turn influenced by it.

Using a calibrated version of this model, we find that the combination of the behavioural assumption and the money creation feature has generated very high volatility in a number of macroeconomics variables such as output gap. The volatility found in the behavioural model with banks is much higher than in a behavioural model without banks. Furthermore, there is a strong correlation between the output gap and the supply of bank loans (see Figure 1). The origin of this positive correlation is when optimism is on the rise, output is booming and asset prices increase.

This improves the equity position of banks holding their risky assets. This leads them to expand their loan supply, which in turn stimulates investment and hence aggregate demand increases. All this leads to an important business cycle amplification effect produced by banks.

Figure 1: Strong correlation between output gap and loan supply change

[Loan supply change and output gap]

What are the policy implications of these results? In general terms we find that the existence of banks with the strong pro-cyclical feature increases the need to stabilize the economy.

We have analysed a number of policy tools that can be used to stabilize the economy. The primary tool is the interest rate (through the Taylor rule). We find that in the presence of banks that amplify the business cycle the central bank has to apply more intense output stabilization to achieve the same degree of stability compared to a system without banks.

When the central bank finds it difficult to stabilize the business cycle through the standard interest rate instrument (as it is today when the interest rate is close to zero), we find that macroprudential control has to take over as the main instrument to stabilize the banking system and the economy at large. The way macroprudential control works in our model is through counter-cyclical capital requirement regulating the capacity banks have in varying their loan supply in response to changes in the value of their equity. As long as the equity position is below a pre-set value which is called ‘Cap’, banks are allowed to change bank loans linking with its equity positions. Once the equity position exceeds this value ‘Cap’, banks do not behave according to their equity positions. As a result, the pro-cyclical loan supply mechanism is aborted.

In Figure 2, we show the results of simulating our model under different level of macroprudential control measured by ‘Cap’. When Cap=0, the central bank imposes the most restrictive control so that banks are prevented from changing their loan supply. As Cap increases banks increase their autonomy to do so. We find that the standard deviation of the output gap is low when Cap = 0. It increases steadily as the loan supply controls are loosened. Thus macroprudential control is an important instrument in stabilizing the banking system and in doing so in stabilizing the business cycle.

Figure 2: Volatility and macroprudential control (cap)

[Standard deviation output gap and capital: x-axis: Cap; y-axis: standard deviation y]

To conclude, the banking sector is an important source of macroeconomic volatility, as it tends to amplify movements of optimism and pessimism and the business cycle. This runs the risk of creating intense booms and busts which in turn can greatly dislocate societies. It is important that the monetary authorities use their available policy tools to stabilize an otherwise unstable system.

For more insights see the related working paper here