Does Prolonged Monetary Policy Easing Increase Financial Vulnerability

Using firm-level data for approximately 1,000 bank and nonbank financial institutions in 22 countries over the past 15 years we study the impact of prolonged monetary policy easing on risk-taking behavior. We find that the leverage ratio, as well as other measures of firm-level vulnerability, increases for banks and nonbanks as domestic monetary policy easing persists. Cross-border effects are also notable. We find effects of roughly similar magnitude on foreign financial sector firms when the U.S. eases policy. Results appear robust to a variety of specifications, and to be non-linear, with risk-taking behavior rising most quickly at the onset of monetary policy easing.

There is growing recognition that prolonged monetary policy easing of major economies can have extraterritorial spillovers, driving up financial system leverage in other countries. When faced with such a rise of threats to financial stability, what can countries do? Specifically, is there a role for macroprudential tools, capital controls or foreign exchange intervention in safeguarding financial stability from risks arising externally? We examine the efficacy of these policy interventions by exploring whether preemptive or reactive policy interventions can mitigate such risks. Using a sample of 950 bank and nonbank financial firms across 28 non-U.S. economies over the past two decades, we show that if policymakers are able to implement policies prior to an additional consecutive decline in U.S. interest rates, financial institutions do not increase their leverage by as much as they otherwise would. By contrast, it is more difficult to counter the spillovers with reactive policy interventions. In practice, however, policymakers need to remain cautious about the timing of preventative tightening, especially when their economies face large negative shocks such as a pandemic.

Extended periods of ultra-easy monetary policy in advanced economies have rekindled debates about the zombification of weak companies and its impact on resource allocation, economic growth, inflation, and financial stability. Using both firm-level and macroeconomic data, we find that recessions are a critical factor in the rapid increase in the number of zombie firms. Expansionary monetary policy can help reduce zombification when interest rates are at the zero lower bound (ZBL), but a too-accommodative monetary policy for extended periods is associated with a higher probability of zombification. Small and medium enterprises are more likely to become zombie firms. This raises concerns about the sustainability of too-easy monetary policy implementation, especially in countries where growth is lackluster. Our findings imply a tradeoff between conducting a countercyclical monetary policy, which also helps contain the increase in the number of zombie firms in cyclical downturns, and using an expansionary monetary policy for long periods, which may lead to a combination of low interest rates, low growth, and high financial vulnerability. Such a tradeoff is not a concern currently when most countries are tightening their monetary policy stance, but policymakers should be mindful of it during future recessions.

The October 2019 Global Financial Stability Report (GFSR) identifies the current key vulnerabilities in the global financial system as the rise in corporate debt burdens, increasing holdings of riskier and more illiquid assets by institutional investors, and growing reliance on external borrowing by emerging and frontier market economies. The report proposes that policymakers mitigate these risks through stricter supervisory and macroprudential oversight of firms, strengthened oversight and disclosure for institutional investors, and the implementation of prudent sovereign debt management practices and frameworks for emerging and frontier market economies.

Extraordinary policy measures have eased financial conditions and supported the economy, helping to contain financial stability risks. Chapter 1 warns that there is a pressing need to act to avoid a legacy of vulnerabilities while avoiding a broad tightening of financial conditions. Actions taken during the pandemic may have unintended consequences such as stretched valuations and rising financial vulnerabilities. The recovery is also expected to be asynchronous and divergent between advanced and emerging market economies. Given large external financing needs, several emerging markets face challenges, especially if a persistent rise in US rates brings about a repricing of risk and tighter financial conditions. The corporate sector in many countries is emerging from the pandemic overindebted, with notable differences depending on firm size and sector. Concerns about the credit quality of hard-hit borrowers and profitability are likely to weigh on the risk appetite of banks. Chapter 2 studies leverage in the nonfinancial private sector before and during the COVID-19 crisis, pointing out that policymakers face a trade-off between boosting growth in the short term by facilitating an easing of financial conditions and containing future downside risks. This trade-off may be amplified by the existing high and rapidly building leverage, increasing downside risks to future growth. The appropriate timing for deployment of macroprudential tools should be country-specific, depending on the pace of recovery, vulnerabilities, and policy tools available. Chapter 3 turns to the impact of the COVID-19 crisis on the commercial real estate sector. While there is little evidence of large price misalignments at the onset of the pandemic, signs of overvaluation have now emerged in some economies. Misalignments in commercial real estate prices, especially if they interact with other vulnerabilities, increase downside risks to future growth due to the possibility of sharp price corrections.

This paper updates the database on systemic banking crises presented in Laeven and Valencia (2008, 2013). Drawing on 151 systemic banking crises episodes around the globe during 1970-2017, the database includes information on crisis dates, policy responses to resolve banking crises, and the fiscal and output costs of crises. We provide new evidence that crises in high-income countries tend to last longer and be associated with higher output losses, lower fiscal costs, and more extensive use of bank guarantees and expansionary macro policies than crises in low- and middle-income countries. We complement the banking crises dates with sovereign debt and currency crises dates to find that sovereign debt and currency crises tend to coincide or follow banking crises.

Provides an in-depth overview of the Federal Reserve System, including information about monetary policy and the economy, the Federal Reserve in the international sphere, supervision and regulation, consumer and community affairs and services offered by Reserve Banks. Contains several appendixes, including a brief explanation of Federal Reserve regulations, a glossary of terms, and a list of additional publications.