In our yesterdays session, we discussed another paper of Mister Shin, this time a piece he published with Mister Adrian:
Adrian, T. and Shin, H.S. (2011), "Financial Intermediaries and Monetary Economics", Handbook of Monetary Economics, edition 1, volume 3, pp. 601-650.
Here are some key findings:
It seems to be a stylized fact that shifts in the (short-term) policy rate translate directly into shifts in the slope of the yield curve. For this to hold, longer rates must be somewhat stickier than short rates. This is empirically proven by Figure 1 (p.604, see below), which states an almost 1:1 negative relation between changes in the fed fund rate and the term spread.
A higher term spread has important implications for the banking business because it increases its profitability. Hence, the future risk-taking capacity of the banking industry is fostered and thereby credit supply increases. That is, procyclicality in loan supply is explained by the variation of the slope of the yield curve. The risk-taking channel of financial intermediaries - effective also because the banking system is financed increasingly short-term and market-based - entails the policy implication that the short-rate is an important price variable on its own. This stays in contrast to the widely held view of monetary policy that short-rates are simply an instrument to steer longer rates, ultimately the ones that are relevant for consumption and investement decisions. Incremental variations in short-rates can have detrimental effects on a wide range of transactions made by market-based institutions. As the authors argue, for SIV a difference of a quarter percent in funding costs may make all the difference between a profitable venture and a loss-making one (p.605).
It remains a puzzle why financial intermediaries haven't realized those potential funding risks prior to the crisis. It also poses the question if monetary policy was aware of the amplification mechanism that arise because of bank's active balance sheet management. I assume, it was not. Nevertheless, the FED became increasingly tighter in the run-up to the crisis - argueably practiced some sort of "leaning against the wind policy", at least from 2004-2006.
Sadly enough, this tightening did not wind up risky short-term funding or made the financial system any safer. I guess, there is more to come...