Bank of England Working Papers -
Abstracts 2006 (no. 286 - 317)
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The following are brief abstracts of working papers. Those papers that are out of print are marked as such (oop). For details of how to obtain copies of working papers, both in and out of print, see the Working Papers main page.
You can also view the full text of working papers 23 and 24 (from 1994) and working papers since 1997 as PDF files, readable with the latest version of Adobe Acrobat (this is available free from Adobe's Website ). The working papers are listed with the most recent papers first
Working
Paper No 317
Corporate debt and financial balance sheet adjustment: a comparison of the United States, the United Kingdom, France and Germany
Peter Gibbard and Ibrahim Stevens
(254k)
The level of UK corporate debt directly affects financial stability in the United Kingdom because a significant amount of the exposure of the UK financial system is to UK corporates. Our paper provides a comparison of the determinants of corporate debt in the United States, the United Kingdom, France and Germany. The comparison serves to benchmark our findings about the determinants of UK corporate debt. In addition, the UK financial sector is significantly exposed to the corporate sectors in the United States, Germany and France. The model assesses the contribution of investment, acquisitions, cash flows and market-to-book values to the determination of debt, and also the tendency of debt to revert to its optimum level. Debt was found to be positively related to the financing needs of the firm, and the optimum level of debt to be negatively related to the market-to-book ratio. This casts some light on the procyclicality of debt. It suggests the growth of debt in a boom is explained by the increase in financing needs; and this more than offsets the fall in the optimum level of debt associated with the rising market-to-book value. In addition, we found that it may be expected that, in a boom, German and US debt will rise above the optimum level by more than in the United Kingdom and France - responding to the higher levels of investment and acquisitions. And in a slowdown, when adjusting back down to the optimum, German and US debt tends to be paid down more slowly.
Working
Paper No 316
Financial infrastructure and corporate governance
Helen Allen, Grigoria Christodoulou and Stephen Millard
(167k)
An essential part of the financial system is its infrastructure: for example, payment systems, securities settlement systems, central counterparties and messaging services. These enable transactions ranging from retail payments through to business in domestic and international wholesale financial markets. Given this, were any such system to fail, this could affect the whole economy. This threat to financial stability largely explains why central banks seek to ensure - via their 'oversight' role - that financial infrastructures take sufficient measures to mitigate risk. This paper explores the role of governance of infrastructures in the management of systemic risk. We do this by considering the case of a generic infrastructure provider operating under different forms of ownership. We show that, in the presence of consumption externalities, the level of risk mitigation chosen by the infrastructure provider is less than socially optimal. We then show that governance may have a role in adapting a provider's decision-making process to take due account of their risk externalities and, hence, provide a more socially optimal level of risk mitigation. Specifically, we suggest a feasible adaptation could be for infrastructures to appoint external stakeholder representatives to their boards with a specific remit to act in the wider public interest.
Working
Paper No 315
Do announcements of bank acquisitions in emerging markets create value?
Farouk Soussa and Tracy Wheeler
(186k)
The latter half of the 1990s saw a sharp rise in entry of banks from developed countries into emerging market financial systems. This was motivated by, among other things, the belief that expansion into underdeveloped financial markets would result in diversification and efficiency gains, and thus prove to be value creating. This paper uses a standard event-study methodology to determine the reaction of the acquirer's stock price to announcements of acquisitions in emerging financial markets (EFMs). Under the assumption of efficient markets, a positive reaction is interpreted as supporting the hypothesis that expansion into EFMs is value creating. However, in line with the literature on cross-border banking acquisitions in developed countries, announcements are found to be associated with negative abnormal returns for the acquirer, suggesting that potential downsides, such as operational risk, legal and social barriers, and political risk, are judged by markets to outweigh the potential benefits. Moreover, the value destruction from an acquisition was found to be bigger in all regions in the 18 months following the Asian crisis.
Working
Paper No 314
Consumer credit conditions in the United Kingdom
Emilio Fernandez-Corugedo and John Muellbauer
(420k)
It is widely perceived that credit supply conditions faced by UK consumers, particularly in the mortgage market, have been liberalised since the late 1970s, with implications for the housing market and consumer spending. This paper examines quarterly microdata from the Survey of Mortgage Lenders to learn about changes in credit conditions from loan to value ratios (LVRs) and loan to income ratios (LIRs) of first-time buyers (classified by region and age). It combines data on the proportions of high LVR and high LIR loans with aggregate information on UK consumer credit and mortgage debt to give ten quarterly series for 1975-2001. These are modelled in a ten-equation system. A comprehensive set of economic and demographic influences on the demand and supply of credit, applying relevant sign restrictions, are controlled for. A single time-varying index of credit conditions captures the common variation in the ten credit indicators which cannot be explained by the economic and demographic controls. The broad coverage of credit market indicators and thorough investigation of economic forces driving the credit market should make the resulting credit conditions index more robust than previous estimates. The index increases in the 1980s, peaking towards the end of the decade. It retraces part of this rise in the early 1990s, before increasing again to levels, for one of the two measures, exceeding the previous peak. The index is useful in modelling consumption and the housing market, and in interpreting current monetary conditions. An important by-product of the paper is the model for consumer credit and mortgage debt developed here.
Working
Paper No 313
Bank capital channels in the monetary transmission mechanism
Bojan Markovic
(314k)
Recent empirical evidence based on microdata panels indicates the importance of banks' balance sheets for the monetary transmission mechanism. This paper builds a dynamic general equilibrium model to analyse the macroeconomic consequences of changes in the cost of bank capital, and thus the cost of bank credit. The model includes the interaction between the supply side (banking sector) and the demand side (corporate sector) of the credit market. The analysis suggests that bank capital channels may be an important part of the monetary transmission mechanism, particularly when there are large, direct shocks to banks' balance sheets. Such shocks could occur when there are structural changes that affect the banking system. The impulse responses are likely to be magnified due to the interaction between the supply and the demand sides of the credit market.
Working
Paper No 312
Exchange rate pass-through into UK import prices
Haroon Mumtaz, Özlem Oomen and Jian Wang
(355k)
In this paper we estimate the rate of exchange rate pass-through (ERPT) into UK import prices using disaggregate data at the SITC-2 and SITC-3 digit level. Consistent with earlier studies, we find evidence for significant heterogeneity among the estimated industry-specific pass-through rates. In an environment where cross-sectional heterogeneity is significant the use of aggregate data can be misleading since aggregation may lead to heavily biased ERPT estimates at the economy-wide level. We demonstrate that the aggregation bias caused by this heterogeneity is not negligible for the UK data. Further, we investigate the source of the cross-sectional variation in the estimated industry-specific pass-through rates. For our sample, we find the industry-specific average inflation rates to be significant in explaining this variation. Furthermore, we find evidence for short-run and long-run partial pass-through into food and manufacturing sectors. As for the economy-wide ERPT the conclusion stands, possibly reflecting the relatively large weight of manufacturing goods in UK imports. Finally, we find a significant reduction in estimated ERPT rates since 1995 caused by increased stability of the UK economy over the past decade.
Working
Paper No 311
The yen real exchange rate may be stationary after all: evidence from non-linear unit root tests
Georgios Chortareas and George Kapetanios
(204k)
The empirical literature that tests for purchasing power parity (PPP) by focusing on the stationarity of real exchange rates has so far provided, at best, mixed results. The behaviour of the yen real exchange rate has most stubbornly challenged the PPP hypothesis and deepened this puzzle. This paper contributes to this discussion by providing new evidence on the stationarity of bilateral yen real exchange rates. We employ a non-linear version of the Augmented Dickey-Fuller test, based on an exponentially smooth-transition autoregressive model (ESTAR) that enhances the power of the tests against mean-reverting non-linear alternative hypotheses. Our results suggest that the bilateral yen real exchange rates against the other G7 and Asian currencies were mean reverting during the post-Bretton Woods era. Thus, the real yen behaviour may not be so different after all but simply perceived to be so due to the use of a restrictive alternative hypothesis in previous tests.
Working
Paper No 310
Returns to equity, investment and Q: evidence from the United Kingdom
Simon Price and Christoph Schleicher
(289k)
Conventional wisdom has it that Tobin's Q cannot help explain aggregate investment. This is puzzling, as recent evidence suggests the closely related user cost approach can do so. We do not attempt to explain this puzzle. Instead, we take an entirely different approach, not using the first-order conditions from the firm's maximisation problem but instead exploiting the present-value expression for the firm's value. The standard linearised present-value asset price decomposition suggests that Q should be able to predict other variables, such as stock returns. Using UK data we find that it has strong long-horizon predictive power for debt accumulation, stock returns and UK business investment. The correctly signed results on both returns and investment appear to be robust, and are supported by the commonly used and bootstrapped standard error corrections, as well as recently developed asymptotic corrections.
Working
Paper No 309
Fundamental inflation uncertainty
Charlotta Groth, Jarkko Jääskelä and Paolo Surico
(225k)
We develop a method of quantifying the uncertainty surrounding the estimates of the fundamental inflation implied by the New Keynesian Phillips Curve (NKPC). The uncertainty is represented as a band around the fundamental inflation, and encompasses the sampling uncertainty of both the estimates of the structural parameters and the estimates of the VAR used to form a projection of real marginal costs. An empirical application on UK and US data confirms that fundamental inflation tracks actual inflation reasonably well in both countries. For the United Kingdom the confidence band is sufficiently narrow, relative to the sample variance of inflation, to identify a number of periods where the predictions of the NKPC do not fully capture movements in actual inflation. In contrast, considerable uncertainty surrounds the estimates of fundamental inflation for the United States.
Working
Paper No 308
Optimal emerging market fiscal policy when trend output growth is unobserved
Gregory Thwaites
(220k)
This paper is concerned with how fiscal policy in emerging markets should respond to economic fluctuations. We model the behaviour of a fiscal authority in an emerging market country who can use external borrowing to smooth the effects of exogenous output shocks on domestic agents' private consumption. We focus on the policy implications of the facts that (1) the GDP process in emerging markets is characterised by a relatively volatile trend growth rate, and (2) that policymakers cannot directly observe the output gap or the trend GDP growth rate. We have two key findings. First, we find that risk-averse policymakers who face EME-style output processes (ie processes dominated by shocks to the trend growth rate) should run tighter fiscal policies, with lower average debt-GDP ratios, than those in industrialised countries, who face different output processes. Second, our baseline parameterisation suggests that EME policymakers should run countercyclical fiscal policies. This result contrasts with other papers which have used optimising frameworks and the features of EME output processes to rationalise the observed procyclicality of EME fiscal policies or external balances. Simulations suggest that the welfare costs of naively running a fiscal policy that would be appropriate for an industrialised country are around 1% of certainty-equivalent consumption, but this result is sensitive to parameterisation. We find that a simple rule-of-thumb policy that stabilises the debt-GDP ratio in every period entails much smaller welfare losses.
Working
Paper No 307
Fiscal rules for debt sustainability in emerging markets: the impact of volatility and default risk
Adrian Penalver and Gregory Thwaites
(167k)
The determinants of public debt dynamics - real interest rates, the real exchange rate, output growth and the primary fiscal balance - are typically more volatile in emerging market economies than in industrialised countries. Capital markets also typically demand higher interest rates from emerging markets when their debt dynamics deteriorate. This paper considers how these characteristics affect the choice of fiscal policy rules in emerging markets. We estimate an econometric model of the determinants of public debt dynamics on Brazilian data and use this model to simulate the effect of different fiscal policy rules for future paths of debt. We then derive the set of fiscal policy rules which stabilise public debt dynamics. We find that macroeconomic forecast uncertainty and feedback among the endogenous variables (principally from the debt-GDP ratio to interest rates) force the policy rule to be significantly more responsive to changes in public debt. Rules that would stabilise debt in a fully known world may not do so when the policymaker is faced with a realistic pattern of shocks. The method we employ may be a useful addition to the toolkit of domestic and international policymakers when assessing fiscal rules and debt sustainability.
Working
Paper No 306
Consumption excess sensitivity, liquidity constraints and the collateral role of housing
Andrew Benito and Haroon Mumtaz
(348k)
Using a switching regression technique we provide unique evidence on three questions concerning the consumption behaviour of UK households. First, what percentage of households display excess sensitivity to income? Second, what affects the likelihood of being in that group? Third, is there a collateral channel from house prices to consumption? We find 20%-40% of households display excess sensitivity. These households may be liquidity constrained or saving for other precautionary reasons. This is found to be more likely for those without liquid assets, with negative home equity, the young, unmarried, non-white and the degree-educated. According to the 'collateral channel', house prices influence consumption by allowing households that would otherwise be liquidity constrained to borrow on more attractive terms. A key implication of that view is that capital gains on housing should influence the consumption of the liquidity constrained/precautionary saving households, but not other households. We test that implication for the first time and find direct evidence in support.
Working
Paper No 305
Bank capital, asset prices and monetary policy
David Aikman and Matthias Paustian
(501k)
We study a general equilibrium model in which informational frictions impede entrepreneurs' ability to borrow and banks' ability to intermediate funds. These financial market frictions are embedded in an otherwise-standard dynamic New Keynesian model. We find that exogenous shocks have an amplified and more persistent effect on output and investment, relative to the case of perfect capital markets. The chief contribution of the paper is to analyse how these financial sector imperfections - in particular, those relating to the banking sector - modify our understanding of optimal monetary policy. Our main finding is that optimal monetary policy tolerates only a very small amount of inflation volatility. Given that similar results have been reported for models that abstract from banks, we conclude that assigning a non-trivial role for banks need not materially affect the properties of optimal monetary policy.
Working
Paper No 304
Procyclicality, collateral values and financial stability
Prasanna Gai, Peter Kondor and Nicholas Vause
(254k)
This paper analyses how the risk-sharing capacity of the financial system varies over the business cycle, leading to procyclical fragility. We show how financial imperfections contribute to underinsurance by entrepreneurs, generating an externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs due to financial frictions and the volatility costs due to amplification, are also illustrated.
Working
Paper No 303
The danger of inflating expectations of macroeconomic stability: heuristic switching in an overlapping generations monetary model
Alex Brazier, Richard Harrison, Mervyn King and Tony Yates
(339k)
The volatility of inflation and output has fallen in most advanced economies in the 1990s and 2000s. We use a monetary overlapping generations model to discuss the cause and durability of this macroeconomic change. In that model, agents' decision rules require them to make forecasts of future inflation, which, because of shocks to productivity, is uncertain. Agents make forecasts of inflation using two rules of thumb or 'heuristics'. One is based on lagged inflation, the other on an inflation target announced by the central bank. They switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each. Movements in that proportion generate fluctuations in small sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilises the economy but does not prevent agents switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.
Working
Paper No 302
International and intranational consumption risk sharing: the evidence for the United Kingdom and OECD
Vincent Labhard and Michael Sawicki
(262k)
'Consumption risk sharing' refers to the ability of agents to insure or protect their consumption against shocks to their income, for example, by borrowing and lending or holding claims on foreign equity. So measuring the extent of risk sharing informs us about how consumption is likely to respond to country or region-specific shocks to income. This paper presents the evidence for consumption risk sharing by UK consumers, both across regions of the United Kingdom (intranationally) and between the United Kingdom and other countries (internationally). The main motivation for collecting this evidence is to establish to what extent UK consumers insure against income risks, and whether they do so to the same extent intranationally and internationally. Such evidence can tell us whether risk sharing functions effectively as an absorber of country or region-specific shocks in the United Kingdom. We find that there is more risk sharing across the UK regions than between the United Kingdom and other OECD countries. To test the robustness of our conclusions, we document the evidence for risk sharing using recent econometric techniques, which allow explicitly for country or region-specific factors impacting on consumption and output, including measurement errors in the data. We find that our results remain robust when we account for the possible impact of measurement error and preference shocks, and are consistent with results reported in the existing literature. Additionally, our paper also makes a separate contribution to the literature by illustrating the role of the choice of deflators in estimating the true extent of risk sharing for the United Kingdom and OECD. In terms of the channels through which risk sharing occurs, we find that the main mechanism of regional risk sharing operates via cross-regional asset holdings. Internationally, the main source of income smoothing comes from international borrowing and lending.
Working
Paper No 301
The welfare benefits of stable and efficient payment systems
Stephen Millard and Matthew Willison
(167k)
The Bank of England's second core purpose is to maintain the stability of the financial system. Payment systems, by supporting transactions, are a key aspect of this. In this paper, we examine the importance of smoothly functioning payment systems to the economy by extending a recently developed theoretical model of banks. In the model the risk of theft implies a cost to using cash. This risk can be avoided by depositing cash in banks and transferring money through an interbank payment system. However, agents are then exposed to the risk that the payment system is unreliable. Agents will use a payment system (rather than cash) to make transactions if the system is sufficiently cheap to use and/or it is sufficiently reliable. We show that the introduction of a payment system that buyers and producers choose to use unambiguously increases social welfare if it expands the number of trades occurring in the economy. This is more likely the more reliable is the payment system. When the introduction of a payment system does not increase the number of trades, social welfare may increase or decrease depending on the trade-off between the risk of using cash and the risk that the payment system is unreliable. We again show that the more reliable is the payment system, the more likely welfare is increased by its introduction and we illustrate how this benefit might be quantified.
Working
Paper No 300
Elasticities, markups and technical progress: evidence from a state-space approach
Colin Ellis
(386k)
Conventional techniques for estimating the elasticity of substitution between capital and labour in the production process typically focus on factor-demand equations. An implicit assumption in this approach is normally that the markup is stationary. But that may not be true. This paper considers a new approach that models the markup as an unobserved variable. Using the factor-demand equations for capital and labour, technical progress can also be estimated as a stochastic process, rather than just imposing a time trend. The resulting estimates of the whole-economy markup for the UK economy suggest that it has fallen over the past 30 years, and this result appears to withstand a variety of robustness checks. The estimated elasticity is somewhat lower than most previous estimates. This implies that conventional techniques may be misleading.
Working
Paper No 299
Optimal discretionary policy in rational expectations models with regime switching
Richhild Moessner
(266k)
The existence of and uncertainty about structural change in the economy are important features facing policymakers. This paper considers the implications for policy design of uncertainty about structural change, modelling the time variation in parameters of forward-looking models as Markov processes. We extend an algorithm of Backus and Driffill for optimal discretionary policy in rational expectations models to the case with Markov switching in model parameters. As an illustration, we apply our method to determine the optimal monetary policy solution in the presence of structural changes in intrinsic output persistence, within a hybrid New Keynesian model estimated for the euro area. We find that the coefficients of the optimal policy rule are state-dependent, and depend non-linearly on the transition probabilities between states with different values of intrinsic output persistence.
Working
Paper No 298
Optimal monetary policy in Markov-switching models with rational expectations agents
Andrew P Blake and Fabrizio Zampolli
(373k)
In this paper we consider the optimal control problem of models with Markov regime shifts and forward-looking agents. These models are very general and flexible tools for modelling model uncertainty. An algorithm is devised to compute the solution of a linear rational expectations model with random parameters or regime shifts. This algorithm can also be applied in the optimisation of any arbitrary instrument rule. A second algorithm computes the time-consistent policy and the resulting Nash-Stackelberg equilibrium. Similar methods can be easily employed to compute the optimal policy under commitment. Furthermore, the algorithms can also handle the case in which the policymaker and the private sector hold different beliefs. We apply these methods to compute the optimal (non-linear) monetary policy in a small open economy subject to random structural breaks in some of its key parameters.
Working
Paper No 297
Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics
Fabrizio Zampolli
(752k)
This paper examines the trade-offs that a central bank faces when the exchange rate can experience sustained deviations from fundamentals and occasionally collapse. The economy is modelled as switching randomly between different regimes according to time-invariant transition probabilities. We compute both the optimal regime-switching control rule for this economy and optimised linear Taylor rules, in the two cases where the transition probabilities are known with certainty and where they are uncertain. The simple algorithms used in the computation are also of independent interest as tools for the study of monetary policy under general forms of (asymmetric) additive and multiplicative uncertainty. An interesting finding is that policies based on robust (minmax) values of the transition probabilities are usually more conservative.
Working
Paper No 296
Sterling implications of a US current account reversal
Morten Spange and Pawel Zabczyk
(344k)
This paper investigates the potential implications for sterling of the US current account returning to balance. The analysis is conducted using a three-country model comprising the United Kingdom, the United States and a block that is meant to represent the rest of the world. The main conclusion from our analysis is that the potential implications for sterling of a US current account reversal are highly uncertain - one can derive a wide range of estimates for the potential changes. Estimates of the sterling adjustments are smaller than the implied movements in the dollar and depend heavily on (a) the cause of the US current account adjustment; (b) the assumptions one makes about the associated adjustment of the UK current account deficit; and (c) assumptions about key model parameters.
Working
Paper No 295
Productivity growth, adjustment costs and variable factor utilisation: the UK case
Charlotta Groth, Soledad Nuñez and Sylaja Srinivasan
(305k)
This paper constructs estimates of total factor productivity (TFP) growth for the United Kingdom for the period 1970-2000, using an industry data set that spans the whole economy. The estimates are obtained by controlling for variable utilisation of capital and labour, and costs of adjusting these factors. The analysis is focused on the 1990s. This was a period when the growth rate of the standard measure of TFP growth for the United Kingdom, the Solow residual, did not match the sharp rise in US productivity, even though the macroeconomic environment in both countries was similar. The paper delivers two main results. First, the aggregate Solow residual underestimates TFP growth throughout the 1990s, since it does not account for falling utilisation rates and high capital adjustment costs. Second, the impact of non-technological factors on the Solow residual is similar in the first and the second half of the 1990s. This means that the broad movement in the Solow residual during the 1990s is similar to that of the estimated TFP growth. Potential reasons behind these results are discussed using disaggregated data.
Working
Paper No 294
How does the down-payment constraint affect the UK housing
market?
Andrew Benito
(489k)
A house purchase typically requires a deposit (or down-payment) and so a significant amount of cash. This paper considers the empirical implications of this borrowing constraint for the housing market. It shows that, at the aggregate level, models of the housing market that incorporate the constraint are consistent with the following stylised facts: i) a positive correlation between house price inflation and transactions; ii) greater volatility of former owner-occupiers’ house price inflation than for first-time buyers; iii) the presence of first-time buyers in the market falls with the rate of change of house prices; and iv) house prices are more sensitive to the incomes of the young.
The paper then exploits variation across local housing markets
in the rate of change in house prices and considers how leverage
affects the response of the rate of change of house prices to
shocks. The evidence, based on data for 147 district-level housing
markets for the period 1993-2002, suggests that a large incidence
of households with high levels of leverage (loan to value ratios)
raises the sensitivity of house prices to a shock. This is also
consistent with the down-payment constraint model of the housing
market.
Working
Paper No 293
Resolving banking crises - an analysis of policy options
Misa Tanaka and Glenn Hoggarth
(415k)
This paper develops a dynamic model to examine the ex-ante
and ex-post implications of five policy options for resolving
bank failures when the authorities cannot observe the level
of non-performing loans (NPLs) held by individual banks. Under
asymmetric information, we show that the first-best outcome
is achievable when the authorities can close all banks that
fail to raise a minimum level of new capital. But when the authorities
cannot close banks and must rely on financial incentives to
induce banks to liquidate their NPLs, recapitalisation using
equity (Tier 1 capital) would be the second-best policy, whereas
recapitalisation using subordinated debt (Tier 2 capital) is
suboptimal. If the authorities do not wish to hold an equity
stake in a bank, they should subsidise the liquidation of non-performing
loans rather than inject subordinated debt. We also show that
the cost of this subsidy can be reduced if it is offered in
a menu that includes equity injection.
Working
Paper No 292
Switching costs in the market for personal current accounts:
some evidence for the United Kingdom
by Céline Gondat-Larralde and Erlend Nier
(363k)
This paper provides an analysis of the competitive process
in the market for personal current accounts in the United Kingdom.
Using survey data, we first describe some stylised developments
in this market over our sample period (1996-2001). We find a
gradual change in the distribution of market shares over time.
This contrasts with a marked dispersion in price, which appears
to persist through time. Analysing the evolution of market shares,
we address two key questions: (i) are bank market shares responding
to price differentials?; (ii) if not, which type of imperfect
competition best fits the data? Our conclusions point to the
existence of customer switching costs as a key determinant of
the nature of competition in the market for personal current
accounts. The results of this study are therefore broadly supportive
of a number of recent initiatives to facilitate switching bank
accounts in the United Kingdom.
Working
Paper No 291
Affine term structure models for the foreign exchange
risk premium
by Luca Benati
(592k)
This paper uses two affine term structure models from the Duffie-Kan
class—a three-factor Cox-Ingersoll-Ross model, and a three-factor
model in the spirit of Longstaff and Schwartz—to extract
historical estimates of foreign exchange risk premia for the
pound with respect to the US dollar. The term structures of
interest rates for the two countries are estimated jointly,
together with the dynamics of the nominal exchange rates between
them, via maximum likelihood. The likelihood function is computed
via the Kalman filter, and is maximised numerically with respect
to unknown parameters. Particular attention is paid to the robustness
of the results across models; to the overall (filter plus parameter)
econometric uncertainty associated with risk premia estimates;
and to the ability of estimated structures to replicate Fama’s
‘forward discount anomaly’. The paper’s main
results may be summarised as follows. First, risk premia estimates
are not consistent across the two models. Second, both models
fail to replicate the forward discount anomaly, with theoretical
values of ß in the Fama regressions implied by estimated
structures being consistently positive at all horizons from
1 to 12 months.
Working
Paper No 290
UK monetary regimes and macroeconomic stylised facts
by Luca Benati
(1mb)
We exploit the marked changes in UK monetary arrangements
since the metallic standards era to investigate continuity and
changes across monetary regimes in key macroeconomic stylised
facts in the United Kingdom. We find that, historically, inflation
persistence has been the exception, rather than the rule, with
inflation estimated to have been highly persistent only during
the period between the floating of the pound, in June 1972,
and the introduction of inflation targeting, in October 1992.
As a corollary, our results clearly reject Mishkin’s explanation
for time variation in the extent of the Fisher effect, favouring
instead Barsky’s theory. We document a remarkable stability
across regimes in the correlation between inflation and the
rates of growth of both narrow and broad monetary aggregates
at the very low frequencies, thus countering the Whiteman-McCallum
criticism of Lucas. The post-1992 inflation-targeting regime
appears to have been characterised, to date, by the most stable
macroeconomic environment in recorded UK history, with the volatilities
of the business-cycle components of real GDP, national accounts
aggregates, and inflation measures having been, post-1992, systematically
lower than for any of the pre-1992 monetary regimes/historical
periods, often markedly so, as in the case of inflation and
real GDP. The Phillips correlation between inflation and unemployment
was flattest under the gold standard, steepest between 1972
and 1992. In line with Ball, Mankiw and Romer, evidence points
towards a positive correlation between mean inflation and the
steepness of the trade-off. We show how Keynes, in his dispute
with Dunlop and Tarshis on real wage cyclicality, was entirely
right: during the inter-war period, real wages were strikingly
countercyclical. By contrast, under inflation targeting they
have been, so far, strongly procyclical.
Working
Paper No 289
Defined benefit company pensions and corporate valuations:
simulation and empirical evidence from the United Kingdom
by Kamakshya Trivedi and Garry Young
(475K)
This paper examines the role of defined benefit company pensions
in amplifying the effect of common shocks to companies’
stock market valuations. It identifies and evaluates the significance
of two channels of amplification: cross-holdings of equities
in pension schemes, and leverage induced by pension liabilities.
Econometric analysis of weekly stock market data for a sample
of FTSE 350 UK companies confirm that these effects are statistically
significant and robust to outlying observations.
Working
Paper No 288
The price puzzle: fact or artefact?
by Efrem Castelnuovo and Paolo Surico
(497K)
This paper re-examines the empirical evidence on the price
puzzle and proposes a new theoretical interpretation. Using
structural VARs and two different identification strategies
based on zero restrictions and sign restrictions, we find that
the positive response of prices to a monetary policy shock is
historically limited to the subsamples associated with a weak
central bank response to inflation. These subsamples correspond
to the pre-Volcker period for the United States and the period
prior to the introduction of the inflation targeting framework
for the United Kingdom. Using a micro-founded New Keynesian
monetary policy model for the US economy, we then show that
the structural VARs are capable of reproducing the price puzzle
from artificial data only when monetary policy is passive and
hence multiple equilibria arise. In contrast, this model never
generates on impact a positive inflation response to a policy
shock. The omission in the VARs of a variable capturing the
high persistence of expected inflation under indeterminacy is
found to account for the price puzzle observed in actual data.
Working
Paper No 287
Assessing central counterparty margin coverage on futures
contracts using GARCH models
by Raymond Knott and Marco Polenghi
(560K)
This study considers how the probability of exceeding central
counterparty (CCP) initial margin levels can be estimated, in
order to provide a timely and informative measure of risk coverage.
Previous studies of CCP margining have largely focused on the
unconditional distribution of returns, estimating margin coverage
on a long-term average basis. The present study extends previous
work by estimating conditional margin coverage using a GARCH
(1,1) model, so that variations in coverage can be tracked over
a much shorter time frame. The model is applied to estimating
non-coverage probabilities for two heavily traded derivatives
contracts, the Brent and FTSE 100 futures. To account for the
well-documented fat-tailed characteristics of distributions
of futures returns, several variants of the GARCH model are
estimated. These assume that innovations are distributed according
to either normal, Student t, extreme value or historical distributions.
Backtesting is used to select the best performing distribution.
During the sample period, margins are found to provide a coverage
level generally in excess of 99%, over a one-day time horizon.
It is noted, however, that the coverage probability implied
by the model is likely to fall under more volatile market conditions;
under these circumstances central counterparties will reset
initial margin more frequently and call for margin intraday.
Working
Paper No 286
Modelling the cross-border use of collateral in payment
systems
by Mark J Manning and Matthew Willison
(182K)
Banks often rely on collateralised intraday liquidity from the central bank in order to be able to effect payments in a real-time gross settlement (RTGS) payment system. If a bank is holding insufficient eligible collateral in a particular country, and therefore cannot obtain credit from the local central bank, it may have to delay payments. This constitutes a liquidity risk to the system. Furthermore, a bank operating in multiple systems may face a mismatch between the location of its collateral holdings and liquidity needs. In this paper, we examine the extent to which the liquidity risk arising from such a mismatch may be mitigated by allowing cross-border use of collateral. We develop a two-country, two-bank model in which risk-neutral banks minimise expected costs with respect to their collateral choice in each country. In our baseline model, in which each bank faces a liquidity need in only one country, we find that liquidity risk is indeed reduced by cross-border use of collateral. This result holds despite the fact that banks may find it optimal to economise on their total holdings of collateral. However, when we extend the model to allow for the possibility that a bank faces liquidity needs in both countries simultaneously, the total quantum of collateral held is important. Indeed, when a bank finds it optimal to reduce its total holdings, there may be an increase in liquidity risk in at least one country when simultaneous liquidity demands are realised.
