The European Central Bank released two working papers yesterday, each of which has something interesting to say about understanding financial markets. These papers add to the conversation of how regulators perceive risk and tend to arrive at interesting financial and economic policy conclusions.
The first paper, “Financial Stress and Economic Dynamics” by Kirstin Hubrich and Robert J. Tetlow, discusses a financial stress index. The index ideas that the authors review appear to have on/off switches – that is, everything looks fine until a stress event occurs, in which case things go haywire. The authors conclude that regulators must then intervene to set financial markets back on track. As the authors note, “Our results suggest that conventional monetary policy – both systematic and in terms of policy shocks – is not particularly effective in times of high financial stress; a much more powerful tool is to induce a switch from a high-stress state back to “normal times,” although how this could be achieved is outside the scope of the paper.”
The obvious difficulty in this conclusion is that financial stressors may come from any number of sources, both predictable and unpredictable. Regulators that rely on financial stress indices to chart an upcoming event may be sorely surprised when the unexpected becomes the reality. Can then regulators mandate away every sort of potential stressor? Well, unlikely; there are too many variables to capture everything at once. Instead, regulators can do their best to keep markets calm, use financial stress indices, and plan to react if and when markets and institutions get into trouble. It would be awfully interesting to find an indicator or multivariate model that would help predict the stressors however.
The second paper, “Flight to Liquidity and the Great Recession” by Sören Radde, takes on the macroeconomic effects of banks getting liquid and fast in the midst of a crisis. As we know, “Banks react to financial-sector specific shocks by shoring up their liquidity buffers, which acts as a powerful amplification mechanism leading to a sharp economic downturn.” Straight-forward stuff, but its gets more interesting when looking at the policy implications. The more that governments hinder themselves in acting against these macro moves, the more disruptive they are: Recessions triggered by collateral shocks “are stronger the less aggressively the monetary authority is able to cut its policy rate in order to offset the impact of inflation on real variables. This feature is relevant for central banks as it hints at a potentially important source of distortions introduced by the zero lower bound.” The implication is that very low interest rates are a double threat to economic growth: policy makers lose an important intervention mechanism just as a liquidity squeeze could occur (although arguably liquidity squeezes are less likely the more depressed an economic environment).
These papers are academic and model-driven, and hence won’t be read by most financial market practitioners. We see them as important building blocks in understanding financial policy however, and the potential decisions regulators might take.