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Brexit (Probability) and Effects on Financial Market Stability

Thomas Krause, Felix Noth, Lena Tonzer
IWH Online, No. 5, 2016
Abstract
On 23 June 2016, there will be a referendum in the United Kingdom (UK) on the stay of the country in the European Union (EU). Based on recent poll data, the share of supporters and opponents of an exit varies around 50%. Opponents of the UK breaking up with Brussels („Brexit“) refer to high costs in terms of stagnating economic growth if the UK leaves the EU. The risk of reduced trade, declining foreign direct investment, and a lower degree of financial market integration is high following an exit of the “single market”.
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EFN Report Spring 2016: Economic Outlook for the Euro Area in 2016 and 2017

EFN Reports, No. 2, 2016
Abstract
Global growth will stay rather moderate this year. The peak of the upswing in the US appears to be over. For Japan, after three years of “Abenomics”, a prolonged upswing is still elusive. In China low profitability and high debt levels of many government-owned industrial firms continue to drag growth down. The low prices for commodities heighten uncertainty and volatility on financial markets since they increase the risks of financial crises in economies that are dependent on commodity exports. In the euro area, chances for the recovery to continue are good, as this year, like in 2015, oil prices will probably be markedly lower than they were a year ago, supporting real income of private households and lowering production costs of firms. In this context, our forecast is that euro area GDP will expand by 1.6% in 2016 and by 1.7% in 2017. These rates are higher than the rate of potential growth, but they are arguably low given the expansive monetary policy and the strong stimulus from decreased commodity prices. We do not expect an increase in euro area inflation during 2016, but prices will grow by around 1% in 2017, because the dampening effects of decreasing energy prices slowly fade off and the euro remains rather weak. However, risks for this cautiously optimistic forecast are substantial. New shadows on the financial sector, the uncertainty about whether or not the British will vote in favour of membership in the European Union and the lack of a viable political solution for the refugee crisis are some of the main uncertainties behind these forecasts.
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Did TARP Distort Competition Among Sound Unsupported Banks?

Michael Koetter, Felix Noth
Economic Inquiry, No. 2, 2016
Abstract
This study investigates if the Troubled Asset Relief Program (TARP) distorted price competition in U.S. banking. Political indicators reveal bailout expectations after 2009, manifested as beliefs about the predicted probability of receiving equity support relative to failing during the TARP disbursement period. In addition, the TARP affected the competitive conduct of unsupported banks after the program stopped in the fourth quarter of 2009. Loan rates were higher, and the risk premium required by depositors was lower for banks with higher bailout expectations. The interest margins of unsupported banks increased in the immediate aftermath of the TARP disbursement but not after 2010. No effects emerged for loan or deposit growth, which suggests that protected banks did not increase their market shares at the expense of less protected banks.
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EFN Report Winter 2015/16: Economic Outlook for the Euro Area in 2016 and 2017

EFN Reports, No. 1, 2016
Abstract
At present, growth in manufacturing and investment activity are weak, particularly in China but, to a lesser extent, in advanced economies as well. World activity in many service sectors, however, proves resilient. Worldwide demand is primarily backed by low interest rates and low prices for energy and commodities. However, the latter also cause serious risks for the stability of economies that are dependent on commodity export revenues. Since the sovereign debt crisis began to recede during 2013, fiscal policies have become ever less restrictive in most member states of the currency union. In 2016, fiscal policy in the euro area will even become a bit expansive. However, we expect only a moderate acceleration of the recovery in the euro area, because foreign demand will not expand by much due to the weakness of emerging market economies, and internal demand will still be dragged down by high debt levels of firms and households in many member countries. In particular, according to our forecasts, the euro area GDP will grow by 1.8% in 2016 and 2017, and this will be accompanied by a decline in the unemployment rate below 10%. Our inflation forecast for 2016 is 1.1%. For 2017, we expect inflation to increase up to 1.5% as during next year the dampening effects of decreasing energy prices will slowly fade off.
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EFN Report Summer 2015: Economic Outlook for the Euro Area in 2015 and 2016

EFN Reports, No. 3, 2015
Abstract
External conditions for the euro area economy are still favourable, albeit somewhat less so than at the beginning of the year. Oil prices are by more than a third lower than they were on average in 2014, but about 10 USD higher than in January. Long term interest rates are still very low, but by half a percentage point higher than in January. Worldwide growth in production and trade has disappointed in the first quarter of 2015, and recent leading indicators point to no more than a slightly faster expansion of world production for the rest of the year. The risks of contagion from the Greek crisis to the partner countries appear limited, because financial exposure to the Greek banking sector has been very much reduced. The EU nowadays has instruments with considerable power to fight losses of confidence, and the other countries that received financial assistance in the euro crisis appear politically much more stable, and their economies (including that of Cyprus in the first quarter of this year) have started growing at quite satisfactory rates. According to our forecasts, the euro area GDP will grow by 1.6% in 2015 and by 2.1% in 2016, as negative factors slowly become less important. Both private consumption and investment will expand at a good pace, and the unemployment rate will diminish, but still remain above 10% by the end of 2016. The main risk is that the Greek crisis has a more negative effect on confidence than initially expected. Our inflation forecast for 2015 is 0.2%, with the possibility of a mild deflation not excluded. During the first quarter of 2015 rising oil prices were the main contributors to the ascending inflation expectations, while during the second quarter upward surprises over expected inflation have come from manufactured goods and services. For 2016, we expect that inflation will increase up to 1.2%, still below the 2% ECB’s target.
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EFN Report Summer 2014: Economic Outlook for the Euro Area in 2014 and 2015

, 2014
Abstract
World growth disappointed at the beginning of the year, when in the US extremely cold weather caused production to contract, the recovery in the euro area stumbled and the slowdown of the Chinese economy continued. At present, however, confidence indicators and order books point to a moderate pickup of growth in most regions. Prices on markets for energy, real and financial assets have reacted little to recent bad news about rising geopolitical risks in the Middle East and Eastern Europe up to now. A sudden increase of risk aversion or a change of believes among investors could trigger a swift deterioration of financial conditions for the world economy. In the euro area, strong stimuli from abroad are not to be expected and private households continue to keep their real spending about constant. Investment has been expanding since summer 2013, but at a very moderate rate. In this context, our forecast for GDP growth is 1.1% in 2014 and 1.6% in 2015. For 2014 and 2015, we do not see any significant reduction of the unemployment rate, because employment dynamics will stay weak due to subdued growth and the still rising participation rate in the euro area. Our inflation forecast for 2014 is 0.6%. In 2015 inflation will also remain subdued, at about 1.0%. In this context of very low price dynamics, monetary policy keeps the recovery alive: official interest rates around zero and the search for yields on financial markets have depressed yields for government bonds; the fall in financing costs allows euro area governments to conduct fiscal policies that are much less restrictive than in the years before, with tax cuts in Italy, France, and Spain starting this year. Nonfinancial firms benefit from a shrinking burden of interest payments, and the availability of bank loans for small and medium enterprises has improved since 2012 in most countries.
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Note on the Hidden Risk of Inflation

Makram El-Shagi, Sebastian Giesen
Journal of Economic Policy Reform, No. 1, 2014
Abstract
The continued expansionary policy of the Federal Reserve gives rise to speculation whether the Fed will be able to maintain price stability in the coming decades. Most of the scientific work relating money to prices relies on broad monetary aggregates (i.e. M2 for the United States). In our paper, we argue that this view falls short. The historically unique monetary expansion has not yet fully reached M2. Using a cointegration approach, we aim to show the hidden risks for the future development of M2 and correspondingly prices. In a simulation analysis we show that even if the multiplier remains substantially below its pre-crisis level, M2 will exceed its current growth path with a probability of 95%.
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EFN Report Winter 2013/14: Economic Outlook for the Euro Area in 2014 and 2015

, 2013
Abstract
During 2013, the world economy has recovered from a soft spot that had started in summer 2012, and chances are good that the speed of expansion in world production observed in the second half of 2013 will be kept up in 2014. Growth of world trade, however, is markedly lower than it should be if correlations of the past 20 years were still valid. The uncertain prospects for trade are a serious risk factor, in particular for export oriented economies, in 2014 and beyond.
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Macroeconomic Factors and Micro-Level Bank Risk

Claudia M. Buch
Bundesbank Discussion Paper 20/2010, 2010
Abstract
The interplay between banks and the macroeconomy is of key importance for financial and economic stability. We analyze this link using a factor-augmented vector autoregressive model (FAVAR) which extends a standard VAR for the U.S. macroeconomy. The model includes GDP growth, inflation, the Federal Funds rate, house price inflation, and a set of factors summarizing conditions in the banking sector. We use data of more than 1,500 commercial banks from the U.S. call reports to address the following questions. How are macroeconomic shocks transmitted to bank risk and other banking variables? What are the sources of bank heterogeneity, and what explains differences in individual banks’ responses to macroeconomic shocks? Our paper has two main findings: (i) Average bank risk declines, and average bank lending increases following expansionary shocks. (ii) The heterogeneity of banks is characterized by idiosyncratic shocks and the asymmetric transmission of common shocks. Risk of about 1/3 of all banks rises in response to a monetary loosening. The lending response of small, illiquid, and domestic banks is relatively large, and risk of banks with a low degree of capitalization and a high exposure to real estate loans decreases relatively strongly after expansionary monetary policy shocks. Also, lending of larger banks increases less while risk of riskier and domestic banks reacts more in response to house price shocks.
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EFN Report Summer 2013: Economic Outlook for the Euro Area in 2013 and 2014

, 2013
Abstract
The structural problems in emerging economies, the still mild recovery in the USA and the on-going crisis in the euro area will probably keep world economic growth subdued at least for the rest of 2013. Current and expected future monetary policy in Japan and, in particular, in the USA have heightened volatility in global bond and stock markets, including those of the euro area, though much less than during the crisis episodes. The process of consolidation of public finance in many euro area countries has become slightly less ambitious but it will continue to weigh on the economy in 2013, though less than in 2012. For this reason and for the lower expected global growth, we have revised downward our GDP forecasts for 2013 from previous reports. Now, we expect GDP to be -0.5 per cent lower in 2013 than in 2012, with considerable risks of an even stronger contraction. In 2014, when fiscal policy might be close to neutral, and if reforms continue to be, by and large, successfully implemented, the euro area economy should start to close its wide output gap with an expected GDP growth of about 1.2%, again subject to downwards risks. Moreover, this will not be sufficient to lower the unemployment rate, which actually could further increase to about 12.5%. The interest rates cut in May 2013 shows the will of the ECB to keep monetary policy expansive, but credit conditions and lending rates remain quite heterogeneous across the member countries. Despite the interest rate cut, euro area inflation is still very likely to remain significantly below the ECB target throughout our forecasting period. Our inflation expectations for 2013 have moderated to a y-o-y rate of 1.5%, and they remain subdued also in 2014, at about 1.4%.
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