A flow of funds perspective on the financial crisis volume II macroeconomic imbalances and risks to financial stability (repo

Against this background, the Directorate General Economics andDirectorate General Financial Stability of the European Central BankECB jointly hosted a workshop on ‘A flow-of-funds perspec

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A Flow-of-Funds Perspective on the Financial Crisis, Volume I: Money, Credit and Sectoral Balance Sheets

Bernhard Winkler, Ad van Riet and Peter Bull (editors)

A Flow-of-Funds Perspective on the Financial Crisis, Volume II: Macroeconomic Imbalances and Risks to Financial Stability

Bernhard Winkler, Ad van Riet and Peter Bull (editors)

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V´ıtor Constˆancio

Bernhard Winkler, Ad van Riet and Peter Bull

Part I Flow of Funds and Macrofinancial Analysis

John Duca and John Muellbauer

Richard Barwell and Oliver Burrows

Shuji Kobayakawa and Ryoichi Okuma

Philippe de Rougemont and Bernhard Winkler

Carlos Cuerpo and Alexandr Hobza

v

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vi Contents

Christophe Van Nieuwenhuyze

Part III Flow of Funds and Financial Stability

Nuno Silva, Nuno Ribeiro, Ant´onio Antunes

Virgilijus Rutkauskas

Financial Sector in Austria against the Background of the

Michael Andreasch

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Figures and Diagrams

Figures

and net liquid assets/income to the consumption/

income/income and illiquid financial assets/income to

of unsecured debt and excluding pension assets) across

vii

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viii List of Figures and Diagrams

value of a variable: report item ‘loans, excluding

with the double-entry treatment of business events via

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6.3 Euro area gross capital formation 162

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x List of Figures and Diagrams

assumption of 10 per cent of NPL by households granted

Diagrams

capital formation or between transactions in financial

11A.1 From-whom-to-whom table of the financial accounts in

xii

The biggest financial crisis in a lifetime has shown how important it

is to have a deep understanding of the financial balance sheets of themain sectors of the economy and the financial flows that take placebetween them This type of information is essential for a proper under-standing of the transmission of monetary and financial shocks throughthe economy

Against this background, the Directorate General Economics andDirectorate General Financial Stability of the European Central Bank(ECB) jointly hosted a workshop on ‘A flow-of-funds perspective onthe financial crisis: lessons for macrofinancial analysis’ in Frankfurt amMain, Germany, on 28–29 November 2011 This publication of theworkshop proceedings, complemented by a few invited contributions,provides a comprehensive overview of a broad range of uses of the flow

of funds within the central bank community as well as in the academicfield The flow-of-funds perspective on the financial crisis is presented

in two volumes The first volume on ‘Money, credit and sectoral balancesheets’ focuses on the role of flow-of-funds analysis in complementingtraditional monetary analysis centred on bank balance sheets and exam-ines the portfolio and financing behaviour of non-financial sectors Thesecond, companion volume on ‘Macroeconomic imbalances and risks tofinancial stability’ explores the use of flow of funds for macrofinancialanalysis

Flow-of-funds analysis, with its focus on financial flows, financialintermediation and sectoral balance sheets, has had a good crisis, ifpolicy pertinence is the key criterion, unlike most of conventionalmacroeconomics While not a model, the flow of funds provides acoherent framework to map out the successive and interrelated stages

of the banking, private debt, sovereign debt ‘stock’ and the associated

‘flow’ rebalancing crisis that policy-makers have been confronting sincethe turn of the credit cycle in 2007 A cross-sectoral perspective, a keyrole for financial intermediation, sectoral balance sheets and financialquantities, had been notably absent from the dominant macroeco-nomic paradigm pursuing intertemporal optimisation in the allocation

of savings and investment by a representative agent in the presence

of complete and efficient markets Such a stylised world is obviouslynot very relevant for the challenges we are confronting in repairing

xiii

The use of financial accounts in the context of balance sheet ment and sectoral rebalancing in the European context is taken up inPart II on ‘Flow of Funds and Macroeconomic Imbalances in Europe’.This part reflects on the use of financial accounts data for diagnosingthe evolution of the financial balance sheet and macroeconomic rebal-ancing in the euro area, in particular, based on euro area aggregate data

adjust-as well adjust-as cross-country evidence Part III, entitled ‘Flow of Funds andFinancial Stability’, brings together contributions on the use of finan-cial accounts for financial stability purposes They focus on how to tracecross-sectoral linkages that underpin the analysis of systemic risks.What inspiration can policy-makers draw from flow-of-funds analy-sis? Can it provide some useful pointers on the challenges we havebeen confronting during the evolution of the crisis in its successivephases, with respect to crisis prevention, crisis management and cri-sis resolution? The flow-of-funds data, first of all, provide importantinsights into the origins of the crisis, the building up of financial imbal-ances and vulnerabilities both globally and inside the euro area Theyalso provide a rough map on evolving financial structures and chang-ing patterns in financial intermediation For crisis management – andidentification of financial stability risks, in particular – they further pro-vide insights into cross-sectoral interdependence, which is relevant forcontagion and the propagation of shocks across different sectors of theeconomy, via balance sheet interlinkages and risk transfer along inter-mediation chains (ECB, 2009) On crisis resolution, the flow-of-fundsmap of assets and liabilities helps us think about orderly restructuring

of balance sheets and sustainable stock–flow dynamics of debt and ings flows They also support reflections on burden sharing betweencreditors and debtors, rebalancing between surplus and deficit sectors,and risk transfer between private and public sectors These are difficultquestions of the type that policy-makers have to confront every day

sav-The contributions in this volume (and those in the companion ume I) may not necessarily answer such questions in a clear-cut way.However, the flow of funds at least offers a framework in which askingsuch questions is possible and meaningful It is useful to recall the sem-inal work 80 years ago by economist-statistician Irving Fisher (1933) ondebt dynamics, based on a careful and systematic tabulation of balancesheet data, as an early antecedent and complement to Copeland’s (1952)

vol-‘moneyflows’ as the precursor to comprehensive flow-of-funds accounts.Such ‘bottom-up’ economics would seem to provide a healthy antidote

to the self-referential ‘top-down’ modelling that has been prevalent inrecent decades

V´ıtor Constˆancio European Central Bank

References

Constˆancio, V (2012) Completing and repairing EMU, Speech at the Hyman

P Minsky Conference, Berlin, 26 November.

Copeland, M (1952) A Study of Moneyflows in the United States (New York: NBER) European Central Bank (2009) Financial Stability Review, Special feature C on ‘Bal-

ance sheet contagion and the transmission of risks in the euro area financial system’, Frankfurt am Main, June.

Fisher, I (1933) ‘The debt deflation theory of great depressions’, Econometrica, 1,

337–57.

Notes on the Editors

Bernhard Winkler worked at the Deutsche Bundesbank before

join-ing the European Central Bank (ECB) in July 1998 as Economist in theDirectorate-General Research Subsequently he held positions as SeniorEconomist in the Monetary Policy Strategy Division and in the Coun-sel to the Executive Board as Adviser to Prof Otmar Issing Since May

2005 he is Senior Adviser in the Directorate Monetary Policy responsible,

inter alia, for flow-of-funds analysis at the ECB and the co-ordination of

financial projections as part of the quarterly macroeconomic projectionsexercises He has published on issues related to monetary and fiscal pol-icy in a monetary union, on monetary policy communication and onthe Stability and Growth Pact as well as on cross-checking and the flow

of funds

Ad van Riet joined De Nederlandsche Bank as Economist in 1987

and took up a (Senior) Economist position at the European MonetaryInstitute in 1994 He joined the European Central Bank as PrincipalEconomist when it was established in 1998 and was then in charge

of the Monetary Policy Stance Unit He became Head of the EU tries Division in 2000 and Head of the Fiscal Policies Division in 2007.Since September 2011 he is Senior Adviser in the Directorate GeneralEconomics and Secretary of the ECB Occasional Paper Series He haspublished on European money demand, fiscal policy and structuralreforms

Coun-Peter Bull joined the Bank of England in 1964 After some years in

the economics, international and foreign exchange areas, he moved tostatistics, latterly as Head of the Statistics Department in 1987–94 In

1994 he joined the European Monetary Institute in Frankfurt as Head

of Statistics, and remained as Director General Statistics when the pean Central Bank was established in 1998 After retirement in autumn

Euro-2002 he has continued to work on related matters in the ECB and where His more recent publications are in the field of national accountsand statistics

else-xvi

Notes on the Contributors

Michael Andreasch is Senior Expert working at the Oesterreichische

Nationalbank since 1981 Initially he worked in the area of balance

of payments statistics, focusing on the cross-border financial ties of the Austrian economy, and since 2000 in the area of financialaccounts His main research interests are the financial interlinkage ofeconomic sectors and their relationship to the real economy, as well asthe integration of micro-data in macroeconomic aggregates mainly forhouseholds

activi-Ant ´ onio Antunes holds a BSc in Electrical Engineering from Instituto

Superior T´ecnico, Lisbon, and a PhD in Economics from UniversidadeNova de Lisboa At Banco de Portugal, he first worked in the FinancialStability Division, where he developed econometric models for predict-ing default rates in the corporate sector He is currently Head of theMonetary Policy Division He has done research in macroeconomics andempirical economics

Richard Barwell is Senior European Economist for Royal Bank of

Scotland He has published a book on macroprudential policy with grave Macmillan Before joining RBS he worked for the Bank of Englandfor the best part of a decade in both the Monetary Analysis and Finan-cial Stability Directorates Richard has a PhD in Labour Economics fromthe London School of Economics

Pal-Oliver Burrows is Senior Manager in the Financial Stability Directorate

of the Bank of England, where he has spent nine years in two arate spells He works on assessing risks to UK financial stability forthe Bank’s Financial Policy Committee, with a particular focus on risksrelated to the non-financial company and household sectors and to theflow of funds within the UK financial system He has previously worked

sep-at a London-based macroeconomic hedge fund Oliver has an MSc inEconomics from University College London

Carlos Cuerpo joined the Spanish Corps of State Economists in 2008

and worked for a three-year period as Economic Analyst in the SpanishMinistry of Economy and Competitiveness In 2011 he started a sec-ondment at the European Commission as a National Expert within theDirectorate General of Economic and Financial Affairs, carrying out

xvii

xviii Notes on the Contributors

responsibilities related to the Macroeconomic Imbalances Procedure,notably, the analysis of real estate markets and private sector balancesheets He holds a MSc in Economic Analysis from the London School ofEconomics He has also worked as a lecturer, teaching courses at under-graduate and postgraduate levels in various institutions, including LSEand the George Washington University, among others

Philippe de Rougemont is an economist on secondment from the

Banque de France to the Directorate General Economics of the pean Central Bank with specialisation in sectoral accounts, conjunc-tural analysis (notably inventory movements) and corporate behaviour.Previously, he was seconded to Eurostat (fiscal accounts) and the Inter-national Monetary Fund, and before that to the Directorate GeneralStatistics of the ECB He started his career at the Banque de France inthe Business Survey Department, and was then in the Flow-of-FundsUnit

Euro-John Duca is Associate Director of Research at the Federal Reserve Bank

of Dallas, where he supervises and conducts research in nomics and finance Earlier, he was Economist at the Federal ReserveBoard from 1986 to 1991 and was a part-time Lecturer at the University

macroeco-of Maryland He currently teaches Money and Banking as an AdjunctProfessor at Southern Methodist University He received a PhD in Eco-nomics from Princeton and has published articles on macroeconomics,money, credit, housing and financial crises

Janez Fabijan is Vice Governor–Deputy Governor of the Bank of

Slovenia He was educated as Economist and Advisor in Accounting andholds a master’s degree in Informatics–Decision Support Systems Hehas a career in central banking in Slovenia, running projects in areassuch as implementing ERP systems, payment system reform, and reform

of the statistical reporting system for financial institutions His mainresearch areas include financial accounts, monetary policy transmission,decision support systems for supervisory functions, and banking riskmanagement

Alexandr Hobza is an economist in the Directorate General for

Eco-nomic and Financial Affairs of the European Commission Prior tojoining the European Commission, he worked as a Research Fellow

at the Centre for European Policy Studies in Brussels He receivedhis PhD from the University of Economics in Prague and he has amaster’s degree in Quantitative Economics from the Universit´e Libre

de Bruxelles His research interests are macroeconomic imbalances,

international financial flows, impact and political economy of structuralreforms, and coordination of economic policies in the EU.

Shuji Kobayakawa is Associate Director-General of the Monetary Affairs

Department, which plans and formulates monetary policy at the Bank ofJapan After having worked for the OECD as Economist covering struc-tural policy analysis and country analysis, he became a Chief Editor ofthe Bank of Japan’s Financial System Report He then headed the Bank’sStatistics Division He has a DPhil in Economics from the University ofOxford

John Muellbauer is Senior Research Fellow of Nuffield College,

Profes-sor of Economics and Senior Fellow of the Institute for New EconomicThinking at the Oxford Martin School, Oxford University He is a fel-low of the British Academy, of the Econometric Society and of theEuropean Economic Association and a CEPR Research Fellow Beforecoming to Nuffield College in 1981, he was Professor of Economics

at Birkbeck College, London, and Lecturer at Warwick University Heobtained his doctorate from the University of California Recent workincludes interactions between finance and the real economy focused

on the household sector, inflation forecasting and exchange rate through, mortgage arrears and possessions in the UK, the role of housing

pass-in the financial crisis, drivers of US house prices, and the implications

of the long-term shift in US credit market architecture

Ryoichi Okuma is an economist at the Research and Statistics

Depart-ment of the Bank of Japan After having engaged in the compilation andimprovement of Japan’s flow-of-funds accounts in the Statistics Divi-sion, he is now responsible for the assessment and projection of theJapanese economy in the Research Division

Nuno Ribeiro has been working in the Economic Research

Depart-ment of the Banco de Portugal on capital markets, financial system andfinancial stability issues for the last 18 years He has been involved ininternational organisations’ working groups and task forces, as well as

in policy discussions, concerning a variety of aspects of the financial tor He has been the Head of the Financial Stability Division since 2003

sec-He graduated in Economics from the Faculty of Economics of dade Nova de Lisboa and completed academic requirements for a PhD

Universi-in the same faculty

Virgilijus Rutkauskas first worked in insurance and consultancy

com-panies, before joining the Financial Stability Division at the Bank of

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xx Notes on the Contributors

Lithuania in late 2007 His main areas of interest are the interactionbetween economy and finance, assessment and analysis of the financialsector, households, corporates and other economic agents, estimation ofcredit and deposit dynamics and their interest rates, and measurement

of economic power

Nuno Silva is an economist at the Economic Research Department of

Banco de Portugal since 2009, working in the Monetary Policy Division.Previously, he worked in the Financial Stability Division, where he wasinvolved in stress test exercises on the Portuguese banking system andcredit risk monitoring He has a Licenciatura in Economics from Univer-sidade Nova de Lisboa and a MSc in Operational Research and Financefrom the University of Southampton His research focuses on theapplication of contingent claim analysis to systemic risk measurement

Christophe Van Nieuwenhuyze is an economist at the Research

Department of the National Bank of Belgium since 2002 At the NBB,

he started his career as a member of the Business Cycle and ForecastingUnit, with a deep interest in the quantitative modelling of short-termGDP growth Since 2010 he has been active in the Financial AccountsTeam, where his research interests cover the domain of the flow of fundsand balance of payments, with particular attention to assessing finan-cial positions, international financial integration, European MonetaryUnion and macroprudential policy

Bernhard Winkler, Ad van Riet and Peter Bull

1.1 Introduction

Flow-of-funds accounts are a component of the national accountssystem reporting the financial transactions and balance sheets of theeconomy, classified by sectors and financial instruments As described

by Winkler (2010), the financial accounts track funds as they move fromsectors, such as households, that serve as sources of funds (net lenders),through intermediaries (financial corporations) or financial markets tosectors that use the funds to acquire physical and financial assets (non-financial corporations, government, rest of the world) These flows,together with valuation changes, result in changes to sectoral (net) assetpositions and the composition of the corresponding balance sheets.The financial crisis has driven home the importance of financial flowsand balance sheets for an understanding of real–financial linkages, and

it has spurred a renewed academic and policy interest in flow-of-fundsanalysis During the crisis, policy-makers could rely neither on receivedwisdom and assumptions on liquid and efficient markets underlying thefunctioning of the financial system, nor on standard macroeconomicworkhorse models to give ready answers on the origins, transmissionchannels and policy implications of the financial crisis In such circum-stances flow-of-funds data could be seen, at least, to provide a promisingframework to articulate relevant questions to be asked when confrontingnew challenges for monetary policy and financial stability, such asrelated to debt and asset market dynamics, leverage cycles, financial

∗  The authors on behalf of the European Central Bank (ECB) This chapter shouldcnot be reported as representing the views of the ECB The views expressed are those of the authors and do not necessarily reflect those of the ECB.

1

flow-of-on financial accounts data have become an important element in theenhanced surveillance of macroeconomic imbalances (in both the EUand the G20 context) Moreover, flow-of-funds approaches can be usedfor macroprudential risk analysis.

Central banks have traditionally taken a close interest in the working

of the financial system and have for a long time invested in compilingfinancial accounts, most notably at the US Federal Reserve, but also atthe Bank of Japan and at many European national central banks For acomprehensive compilation of key academic papers and applications seeDawson (ed.) (1996) The set of studies included in De Bonis and Pozzolo(eds) (2012) is also highly recommended Flow-of-funds analysis for theeuro area is a relatively recent endeavour For the European Central Bank

it offers a natural platform for cross-checking and ‘bridging’ analysisunder the economic and monetary ‘pillars’, that are a key feature of itsmonetary policy strategy (see Winkler, 2010)

The remainder of this introduction and overview summarises the tributions to the workshop proceedings collected in the present volume,sub-divided into three thematic parts, each covering a specific field ofinterest

con-1.2 Part I: Flow of funds and macrofinancial

analysis

As pointed out by Winkler (2010), the flow-of-funds accounts, by selves, are not informative about the underlying drivers of financial pro-cesses, nor can they be used to forecast the implications of flow-of-funds

them-developments for economic dynamics and vice versa To this end,

empir-ical tools for flow-of-funds analysis have to be developed The most monly adopted modelling approach for flow-of-funds analysis involves

com-the use of empirical macroeconomic portfolio balance models in com-thespirit of James Tobin (1969) Several contributions in Part I, entitled

‘Flow of Funds and Macrofinancial Analysis’, also identify a continuedneed to develop modelling tools based on the flow-of-funds framework

This is highlighted in particular in the contribution by John Duca eral Reserve Bank of Dallas and Southern Methodist University) and John Muellbauer (Nuffield College and Institute for New Economic Thinking

(Fed-at the Oxford Martin School) They explicitly go back to the portfoliobalance view of Tobin and his Yale colleagues, in which portfolio choiceacross a wider range of assets matters for saving behaviour and real–financial linkages The authors illustrate the relevance of flow-of-fundsbalance sheet variables for household behaviour by examining the cru-cial role of credit market liberalization for consumption outcomes inthe case of the United States For this purpose, they augment a life-cycleconsumption function with credit constraints and disaggregated wealtheffects that can vary over time depending on financial innovations Akey element in this respect is the introduction of shifts in credit avail-ability, both in unsecured household credit and in mortgage credit, andthe consequent induced behavioural shifts They then introduce thisconsumption function into a larger system which endogenises key port-folio choices made by households, such as changes in mortgage debt,mortgage refinancing, housing equity withdrawal or the acquisition ofresidential housing The authors conclude with a plea to strategicallyintegrate flow-of-funds accounts into tractable macroeconometric mod-els that better incorporate real and financial sector linkages and areuseful for assessing financial stability

Richard Barwell (Bank of England at the time of writing) and Oliver Burrows (Bank of England) construct a flow-of-funds framework for the

United Kingdom to analyse financial flows, balance sheets and assetprices and the building up of financial fragilities during the ‘Great Mod-eration’ Their analysis of the DotCom bubble around the turn of themillennium and of the great credit expansion shows that there weremany linkages between the balance sheet developments that led tofinancial instability The rapid expansion of household debt during thecredit and housing boom found its counterpart in increasingly stretchedbank balance sheets The non-financial corporate sector realised bal-ance sheet growth considerably in excess of income growth by rapidborrowing from banks The rise in corporate debt was used to financeacquisitions of commercial property and to increase the return onequity The UK banking sector became highly exposed to the value ofthe assets and income streams of households and corporates, while also

4 Winkler et al.

expanding its non-UK activities The authors conclude that the flow

of funds offers a useful framework to spot the build-up of financialfragilities in an economy

Shuji Kobayakawa and Ryoichi Okuma (both Bank of Japan) start

from the observation that the financial systems in Japan and the euroarea have much in common, both being bank-based, in contrast tothe United States, where banking assets are much smaller as a ratio

to GDP An important difference is, however, that Japanese itory corporations raise funds primarily through deposits by house-holds (through retail funding),while their counterparts in the euro areadepend largely on deposits from each other (through wholesale fund-ing) The authors also analyse the network of lending and borrowingrelationships between different sectors using the detailed flow-of-fundsaccounts for Japan This shows that the funds raised by the gen-eral government have increased with each sector contributing Loansfrom depository corporations to private non-financial corporations andhouseholds are the principal channels of funding for the private sec-tor The authors conclude with an overview of the further developmentand enhancement of the flow-of-funds accounts for Japan, also stressingtheir importance for assessing the stability of the financial system

depos-Janez Fabijan (Banka Slovenije) calls for developing a comprehensive

and consistent statistical information system of quarterly financial andbroader sectoral accounts in each euro-area country He refers to Slove-nia’s experience with building up such a coherent statistical informationand decision support system for policy purposes Given the natural role

of the financial sector as an intermediator of funds, granular data forthis core sector are of vital importance The availability of such moregranular data in Slovenia allowed a closer analysis of bank deleveragingafter 2008 The core of the concept used in Slovenia is a matrix reportingsystem for financial intermediaries, which also forces them to redesigntheir information systems for stronger risk management in the future

1.3 Part II: Flow of funds and macroeconomic

imbalances in Europe

The second part of this volume, entitled ‘Flow of funds and nomic imbalances in Europe’, brings together work on sectoral balancesheets and rebalancing in the wake of the crisis for the euro area as well

macroeco-as individual European Union (EU) economies

Philippe De Rougemont and Bernhard Winkler (both European

Cen-tral Bank) offer an overview of ECB analysis on selected features ofthe financial crisis in the euro area, in part drawing on ECB (2011)

They emphasise the theme of ‘sector rotation’ as evident in sectoralnet lending and also balance sheet developments during various stages

of the crisis, for example with the non-financial corporate sector as

it quickly cut outlays and increased savings, abruptly turning into

a net lender to the rest of the economy after the Lehman Brothersshock, reversing the previous expansionary net borrowing positions.The authors note that governments took on a similar ‘intermediationrole’ by taking over impaired assets and leverage from bank balancesheets post-Lehman Brothers, while additions to financial sector bal-ance sheets sharply retrenched from their boom levels They also payattention to other changes in intermediation patterns during the crisis,such as the substitution of bank finance with market funding and thebuffering role of trade credit and inter-company loans Furthermore,they look into the evolution of intra-euro area imbalances throughthe lens of the sector accounts, by showing the evolution of sectoralnet lending for two country groupings (current account surplus anddeficit countries), in particular highlighting the associated divergence

in non-financial corporations’ profit measures and wages across the twogroups

Carlos Cuerpo and Alexandr Hobza (both European Commission)

pro-vide an overview of the new EU surveillance framework for conomic imbalances through the lens of various indicators built fromthe flow-of-funds data The emphasis in the analytical framework is onearly warning and sustainability of macroeconomic trends, the adjust-ment capacity and potential spillovers They underline that a properassessment of the nature and origin of excessive imbalances is essential

macroe-in order to target the policy responses on the underlymacroe-ing root causes.Against this background, the authors try to identify which euro-areacountries face a debt overhang and what are the prospects for balancesheet repair in financial corporations, other firms and households Inaddition, they examine how private sector deleveraging pressures areaffected by the savings–investment balances of the public sector and

of the economy as a whole Looking ahead, they conclude that holds and firms in a number of euro-area countries will face a protractedausterity period and considerably lower levels of credit than in the past

house-Christophe Van Nieuwenhuyze (Belgian National Bank) conducts an

aggregate analysis of the debt positions of the euro-area countries, ering both public and private debt, because a country’s solvency is alsodetermined by the financial position of the private sector He also takesaccount of the financial assets of the various sectors to arrive at their netdebt positions As it turns out, euro-area countries differ a lot in terms oftheir total net (external) financial assets The experience of the financial

cov-6 Winkler et al.

crisis has shown that the financing of persistent current account deficitswithin the euro area cannot be taken for granted Therefore, policiesshould concentrate on reducing the substantial differences between theeuro-area members in terms of their total net financial assets (rebalanc-ing) This implies that the deficit countries (countries with a negativenet financial asset position or an aggregate net debt) should increasetheir net savings, preferably by improving their competitiveness VanNieuwenhuyze emphasises that the surplus countries (countries withnet financial assets) can contribute to the rebalancing by correctingrigidities in their domestic markets He therefore welcomes the EU’s newmacroeconomic imbalances procedure, which also monitors the exter-nal position of a country, for example by means of the net internationalinvestment position

1.4 Part III: Flow of funds and financial stability

The final Part III, entitled ‘Flow of Funds and Financial Stability’, looks

at the use of tools based on flow of funds for financial stability purposes,such as network analysis of interconnectedness and systemic risks

Nuno Silva, Nuno Ribeiro and Ant´onio Antunes (all Banco de Portugal)

develop a new systemic risk indicator based on contingent claims sis by combining balance sheet information from the financial accountswith assumptions on the volatility of asset returns They based thisindicator on first estimating all sets of shocks in the system of sectoralbalance sheets that would deplete the equity base of at least one sec-tor, and then deriving the probability of such shocks happening Theauthors apply the methodology to the case of Portugal for the period2002–10, considering shocks to equity for four sectors as well as shocks

analy-to liabilities for non-financial corporations and households, paying arate attention to household mortgages The resulting systemic riskindicators for Portugal point to an elevated level of systemic risk sincethe end of 2007

sep-Against the background of the need to improve financial stability

analyses, Virgilijus Rutkauskas (Bank of Lithuania) provides insights into

the use of flow of funds in financial stability assessments undertaken atthe Bank of Lithuania In the case of Lithuania, unlike for many othercountries, the complete matrix of holding sectors is also known Thisallows taking into account the interconnectedness between separate sec-tors and the characteristics of financial instruments when assessing thepotential impact of systemic shocks and how they could affect the finan-cial system and the economy, including possible second-round effects

Rutkauskas notes that this macro approach could be complementedwith a micro approach, thus further enriching the analysis of financialstability He finishes with a word of caution: a lot of future work will beneeded to identify all the risks and mismatches in the financial system,

to evaluate how they could trigger losses and to conduct system-widestress-tests with second-round effects

Michael Andreasch (Oesterreichische Nationalbank) undertakes an

analysis of the sectoral financial interlinkages of the financial sector inAustria He first presents selected results based on the ‘from-whom-to-whom’ relationship between the sub-sectors and sectors of the Austrianeconomy and their relationship with foreign creditors and debtors Tak-ing a macroeconomic viewpoint, he then compares the developments

in Austria with those in other European countries in terms of the size offinancial positions and their relevance for the value added of the finan-cial sector Andreasch also explores the usefulness of financial accountsfor financial stability purposes He uses, in particular, the concept ofnetwork exposure to conduct a simulated transmission of balance sheetshocks, assuming a 10 per cent loss on banks’ portfolio of loans granted

to households Finally, he studies the role of short-term wholesale bankfunding in Austria against the background of the financial crisis

As stressed in many contributions to this publication, the financial sis has underlined the usefulness of flow of funds for macrofinancialanalysis and financial stability issues The flow of funds supports ourunderstanding of the origins and the successive evolution of the finan-cial crisis globally as well as in the euro area in a number of dimensions.This relates, in particular, to the need to:

interconnectedness of private, government and financial sectors;

interest rates, when assessing financial conditions;

in the context of assessing deleveraging needs and balance sheetrepair from the perspective of stock-flow adjustment;

debt is another sector’s asset;

understand the dynamics of real–financial linkages

We hope and expect that the contributions in this book, and those inthe companion volume, will stimulate additional analysis and research

8 Winkler et al.

to further deepen our understanding of stock-flow adjustments from across-sectoral perspective as well as on the role of the financial systemand its interaction with the real economy

References

Dawson, J (ed.) (1996) Flow of Funds Analysis – A Handbook for Practitioners

(Armonk, NY and London: M.E Sharpe).

De Bonis, R and A.F Pozzolo (eds) (2012) The Financial System of Industrial Countries – Evidence from Financial Accounts (Heidelberg: Springer).

European Central Bank (2011) ‘The financial crisis in the light of the euro area

accounts: a flow-of-funds perspective’, Monthly Bulletin, October, 99–120.

European Central Bank (2012) ‘Comparing the recent financial crisis in the United States and the euro area with the experience of Japan in the 1990s’,

Monthly Bulletin, May, 95–112.

Tobin, J (1969) ‘A general equilibrium approach to monetary theory’, Journal of Money, Credit and Banking, 1, 15–29.

Winkler, B (2010) ‘Cross-checking and the flow of funds’ in L Papademos

and J Stark (eds), Enhancing Monetary Analysis (Frankfurt am Main: European

Central Bank), 355–80.

Part I

Flow of Funds and

Macrofinancial Analysis

1968 stylised paper on pitfalls in financial modelling included three tors (governments, private sector and banks) and a set of seven financialassets, and focused on investment (rather than consumption) as the keyinteraction between the financial sector and the real economy In thelate 1970s, the Yale school brought households and therefore consump-tion into the frame with a complete systems approach to household

sec-∗Revised version of Muellbauer’s keynote address at the ECB conference: ‘A of-funds perspective on the financial crisis: lessons for macrofinancial analysis,’ 28 November 2011 The views expressed are those of the authors and are not necessarily those of the Federal Reserve Bank of Dallas or the Federal Reserve System Comments from Adrian Pagan and the editors are gratefully acknowledged.

flow-11

flow-of-funds analysis; see, for example, the important paper by Backusand Purvis (1980).

However, in the 1970s and throughout much of the 1980s, tarism, by focusing on the link between the money supply and inflation,offered a simpler and deceptively elegant view which crowded out themore complex portfolio balance view of Tobin, Brainard, Backus andPurvis The former view had the simplicity of a reduced-form approach,while the latter required a more structural approach, as it entailedmodelling portfolio choices across a wider range of assets relevant forsavings behaviour and real–financial linkages The subsequent fad ofreal business cycle theory, including its New-Keynesian incarnations in

mone-‘micro-founded’ dynamic stochastic general equilibrium (DSGE) els, eclipsed any substantive role for money and credit and essentiallyassumed a ‘passive’ financial sector

mod-The financial accelerator was introduced into this DSGE framework

by Bernanke et al (1999) However, the financial friction on which thismodel is based has a simple one-period form and applies only to firmsthrough costly monitoring carried out by banks Roles for households,housing and mortgage markets, as well as feedbacks via the asset baseand potential solvency of the banking sector, were missing in this initialversion of the financial accelerator Iacoviello (2005) introduced housingand a new financial friction, a maximum loan-to-value ratio at whichpatient households are willing to lend to impatient households How-ever, the model lacks a banking sector, mortgage default, the possibility

of house prices overshooting as well as of housing equity withdrawalbeing positive in aggregate It therefore cannot capture the US sub-primecrisis which triggered the global financial crisis

Figure 2.1 presents some of the mechanisms and feedbacks whichoperated in this crisis From left to right, it illustrates the linkagesvia construction, whose collapse amounted to about three percentagepoints of GDP cumulated over three years (see Duca et al., 2010), and,second, via consumption, as collateral values dropped and credit con-tracted The third and fourth channels track the negative feedback loopsvia credit markets and the banking sector more generally, through creditcontraction triggered by rising bad loan books, risks of bank insolven-cies and risk spreads In turn, the decline in economic activity feeds backnegatively on home values, amplifying the initial shocks

As consumption accounts for around 70 per cent of US GDP, this ond channel played a central role in the crisis Indeed, in the GreatRecession, the saving rate rose by four percentage points, as consump-tion fell 4 per cent more than income, in sharp contrast to a relativelyflat saving rate in prior US recessions Consumption also plays a key role

sec-Tobin LIVES 13

Lower Demand

for Housing

Slower GDP Growth

↓Home Prices &

Wealth, Slower Consumption

Mortgage and Housing Crisis

Less Home

Construction

Lower Capital of Financial Firms

↑ Counter-Party Risk, Money &

Bond Mkts Hit

Credit Standards Tightened

on All Loans

Figure 2.1 The financial accelerator operating in the US sub-prime crisis

in economic upswings of the business cycle, where negative feedbacksbecome positive feedbacks As noted in our related paper (Duca et al.,2012b), the post-2009 recovery in US consumption has been unchar-acteristically weak This unusual behaviour can be accounted for in

a credit-augmented life-cycle consumption function, generalising thework of Ando and Modigliani (1963), Friedman (1957, 1963) and Tobinand Dolde (1971) The combination of wealth and credit effects, inconjunction with accounting for how financial innovation has shiftedkey financial–real linkages, is necessary to understand the behaviour ofconsumption

Such a consumption function conditions consumption on householdincome, portfolios of assets and debt held at the end of the previousperiod, credit availability, and asset prices and interest rates In a gen-eral equilibrium setting, these all have to be endogenised However,since households make consumption and housing purchase decisionsjointly with portfolio decisions, there is much to be gained in modelling

a household sub-system of equations for such data, as was the intent ofBackus and Purvis (1980) Doing so seriously means facing the challenge

of handling major evolutionary structural change in econometric elling – namely, the evolving credit architecture facing households Aby-product of this is improving our understanding of the secular decline

mod-in the US savmod-ing rate Moreover, the models discussed below offer new

ways of interpreting data on credit, money and asset prices, which arecrucial for central banks.

The chapter is structured as follows Section 2.2 discusses the tribution of the Yale school to understanding financial–real economylinkages and the role of money It suggests some additional pitfalls infinancial modelling, particularly dealing with financial innovation andconsequences of deregulation, as well as with expectations, in addition

con-to those highlighted by Tobin and Brainard Section 2.3 discusses keychanges in the US credit market architecture

Section 2.4 summarises the background and motivation for our augmented life-cycle consumption function A key element is theintroduction of shifts in credit availability, in both unsecured householdcredit and mortgage credit, and the consequent induced behaviouralshifts The credit channel is incorporated via variations in down-payment constraints and home equity withdrawal As an implication

credit-of the model, the impact credit-of rising house prices on consumption is likely

to be negative in countries with less active mortgage markets (as in Italyand other continental European housing finance systems) where sav-ing would have to increase to satisfy the down-payment constraint Theopposite holds for countries like the United States, the United Kingdom

or Australia, where easy availability of home equity loans made housinginto a more liquid asset and higher housing collateral values boostedspending

Section 2.5 introduces this consumption function into a larger systemwhich endogenises key portfolio choices made by households, such aschanges in mortgage debt, mortgage refinancing, housing equity with-drawal or its counterpart, given changes in the mortgage stock, theacquisition of residential housing The demand for housing as a stock isjointly determined with non-housing consumption Given the existingstock of the previous period, this can then be used to derive an equationfor house prices as an inverted demand equation, which can be incorpo-rated as part of the equation system Since shifts in the ability of homeowners to borrow against accumulated housing equity are not observ-able directly, we introduce a latent variable to represent such shifts.This has consequences throughout the equation system and potentiallyenters both as an intercept shift and in interaction with key variablessuch as housing wealth This is why the acronym ‘latent interactivevariable equation system’ (LIVES) describes such an equation system

To illustrate the outcome of such a modelling effort, we summarisesome of our recent work on the US which well explains booms and busts

in consumption, mortgage refinancing, housing equity withdrawal and

Tobin LIVES 15

house prices, as well as long-run changes in the household saving rate.Section 2.7 concludes and discusses how the Flow-of-Funds Accountscan be strategically integrated into tractable macroeconometric modelsthat better incorporate real and financial sector linkages and are usefulfor assessing financial stability

2.2 The Yale school and the flow of funds

To analyse interactions between the financial system and the real omy, Brainard and Tobin proposed a system-wide general equilibriumapproach In their famous 1968 paper on ‘pitfalls in financial modelbuilding’ they set out, for a closed economy, the sectoral balance sheetsand propose a stylised system of equations for modelling them In theirframework there are three sectors (government, commercial banks andthe private sector) and seven endogenous assets The private sector holdsdemand deposits, time deposits, treasury bonds, loans and equities Oneequation is specified for each asset, as a function of four interest rates,current income and total wealth Banks hold net free reserves, loans andtreasury bonds, each holding a function of demand and time depositsand interest rates It is assumed that the short-run dynamics of assetholdings are governed by partial adjustment

econ-Some interest rates are market-determined; others are policy variables.Tobin’s q is part of the model providing a role for equity yields Thekey interaction between the financial sector and the real economy inBrainard and Tobin’s stylised model occurs via business investment.Consumption implicitly is just a function of after-tax income Thus, theyield on equities is a key component of the vector of four endogenousinterest rates The equity yield, or the stock market price, depends onthe economy’s portfolio composition, policy instruments, productivityshocks and so on in a reduced form relationship with (presumably) quitecomplex dynamics

Brainard and Tobin emphasise the accounting consistency for theholdings by banks with the private sector, given overall balance sheetconstraints They argue that the main pitfall in financial modelling atthe time was the widespread failure to impose explicitly the financialidentities in model building, so missing the complex interdependencies

of the whole system Tobin (1969) contrasts somewhat more tarist’ special cases, with money and equities as the only assets, with

‘mone-a multiple ‘mone-asset model In the re‘mone-al world, where c‘mone-apit‘mone-al is neous, and asset demands depend on expectations, attitudes to riskand estimates of risk, Tobin concludes: ‘there is no reason to think that

heteroge-the impact (of monetary policies or oheteroge-ther financial events) will be tured in any single exogenous or intermediate variables, whether it is amonetary stock or a market interest rate’.

cap-In Tobin (1981), he expands on this theme in assessing the monetaristcounterrevolution, and also the then new classical economics Solow(1983) elegantly summarised the Tobin view as follows:

in a world with a complex set of portfolio preferences, financialinstitutions, and paper assets (some with fixed and some with market-determined yields), monetary theory and monetary policy are notwell represented by a model in which an undifferentiated ‘M’ isexogenously varied by means of helicopter drops, and idealized heli-copter drops at that Instead, money supplies actually change inthe course of transactions between the Treasury and the public, orbetween banks and the non-bank public, in which at least one otherasset besides money must change hands in such a world, with con-sumers having finite lifetimes and finite horizons, and inter-temporalmarkets less than perfectly transparent, financial policies will havereal effects in as long a run as actually matters

The effects of quantity constraints had long been on Tobin’s mind Inearlier work, Tobin and Brainard (1963) had discussed the effects ofinterest rate ceilings and reserve requirements on the bank lending orcredit channel of monetary transmission, in some ways anticipatingBernanke and Blinder (1988) and Bernanke and Gertler (1989) Inter-estingly, credit constraints were central to Tobin’s return to integratingconsumption behaviour into his multi-sector view of the economy Inthe same year as Modigliani (1971) had emphasised the importance

of wealth effects on consumption for monetary transmission, Tobinand Dolde (1971) analysed monetary transmission and wealth effects

on consumption when some households either cannot borrow or face

an external finance premium (interest rates on loans exceed those onassets) However, there is still no housing market or mortgage debt inthis model Their micro-simulation model, with much heterogeneity,implied that a single wealth budget constraint in estimated systems

of household behaviour (for example, Saito, 1977; Blake, 2004), wasinappropriate

Building on the work of Tobin and his co-authors, Backus and Purvis(1980) integrated consumer expenditure with portfolio decisions Theyanalysed quarterly US household Flow-of-Funds data in a completesystems approach with partial adjustment of asset stocks to long-runequilibrium levels, but did not make the mistake of assuming a single

Tobin LIVES 17

wealth budget constraint One of their key points, a highlight of Purvis(1978), is that disaggregated assets, not just net worth, are needed tomodel consumption, and this is strongly supported by their empirical

there are hints of interesting findings For example, estimated marginalpropensities to consume (m.p.c.s) out of liquid assets and (minus) con-sumer credit are far larger than those out of stock market wealth or,indeed, out of housing

While Backus and Purvis emphasise pitfalls from not taking an grated approach to portfolio and consumption determination, threefurther pitfalls in financial modelling are even more serious These arisefrom neglecting structural changes in the financial system, particularlyassociated with changes in credit availability to households, uncertaintyand the treatment of expectations The last two issues and the endogene-ity of asset prices were tackled in the quite different approach of Breeden(1979) in the consumption framework of the capital asset pricing model(CAPM), but at the cost of assuming efficient and complete asset mar-kets (and so, for example, no credit constraints), rational expectations,and the existence of a representative consumer This approach fits nat-urally with DSGE models that treat finance as a ‘passive’ adjunct to thereal economy However, there is a developing literature of asset pricingmodels with time-varying risk premia (see Campbell et al., 2012), whichpotentially might be able to capture at least some aspects of interactionsbetween finance and the real economy

inte-After the early 1980s, the literature analysing Flow-of-Funds systems

is fairly limited Blake (2004) is a rare exception He focuses on thesystem properties of the Deaton–Muellbauer ‘almost ideal demand sys-tem’ using a common net worth constraint (ignoring the Backus andPurvis insight), but partially accounting for credit market innovation,

as measured by a debt/income proxy

Most empirical macro studies over the past few decades, however,have tended to ignore the importance of financial architecture for macromodelling For example, the large and predominant vector autoregres-sive (VAR)-based literature on empirical links between money, creditand business cycles tends to find unstable relationships This instabilityarises because these frameworks do not distinguish demand influencesfrom the impulse and propagation effects of financial innovation on thesupply of credit Recognising this shortcoming, the profession is now re-examining how Flow-of-Funds data can be incorporated into models ofthe macroeconomy and financial stability, partly to make sense of thesevere recession associated with the housing and financial crisis

2.3 Addressing vast changes in US credit market

architecture since the mid-1960s

Before one can estimate the full impact of the crisis through the four

channels highlighted in Figure 2.1, a time series framework needs to

address the vast changes in US credit market architecture since the 1960s, otherwise estimates will be contaminated by mis-specificationbias Underlying declines in information costs, changes in regulation,and regulatory avoidance gave rise to four major shifts in householdcredit market structure: (1) a fourfold increase in credit card owner-ship rates from 15 per cent in 1970 to over 60 per cent by 1992; (2)the increased securitisation of mortgages by Government SponsoredEnterprises (GSEs, mainly Fannie Mae, Freddie Mac, and Ginnie Mae),which lowered the costs and stabilised access to prime mortgages; (3) anincreased ability to tap housing equity among homeowners; and (4) theboom and bust in sub-prime mortgages in the 2000s (Duca et al., 2011,2012a, 2012b)

mid-As will be reviewed later, the first development spawned a decline inthe precautionary need to save and an accompanying decline in thepersonal saving rate during the 1980s, while the second – coupled withthe deregulation of deposit interest rates – primarily had the effect ofeliminating Regulation Q-induced disintermediation, and thereby sta-bilised residential construction during much of the Great Moderationperiod The third development – the increased liquidity of housingwealth – mainly occurred in the late 1990s and early 2000s It hadthe effect of amplifying the impact of the boom and bust in US houseprices during the mid- and late 2000s, respectively, which stemmedfrom an unsustainable easing of credit standards for first-time homebuyers, most pronounced for sub-prime borrowers, followed by a greatretrenchment In this way, the shifts in household credit market archi-tecture had ramifications for aggregate consumption and thereby themacroeconomy

The changes in household finance were spawned by a mixture ofderegulation and technological advances Improved information tech-nology coupled with the deregulation of deposit rates allowed a largeincrease in the availability of consumer credit, particularly evident in alarge rise in credit card ownership rates during the 1980s and early 1990s(Duca et al., 2012b) During the late 1990s, falling transaction costsfor refinancing mortgages, coupled with tax reform favouring mortgageover consumer debt and moderate house price appreciation, fostered

a boom in mortgage equity withdrawal Much of this was through

Tobin LIVES 19

‘cash-out’ mortgage refinancings, in which households replaced higherinterest rate old mortgages with new mortgages having higher prin-cipal balances Along with the advent of home equity lines of creditencouraged by the tax reform in 1986, this set the stage for consump-tion to be boosted and then battered by the recent boom and bust in

US house prices Duca et al (2011, 2012a) show how the bubble in

US housing was driven by swings in mortgage credit standards ated with the sub-prime mortgage boom and bust This type of financesurged owing to improvements in the ability to sort non-prime borrow-ers using credit scoring and the rise of private-label mortgage-backedsecurities The latter were the predominant means of funding non-prime mortgages deemed too risky to be held in portfolio by banks or

associ-to be packaged inassoci-to standard mortgage-backed securities (MBS) whoseinvestors are insured against default on underlying prime mortgages byFannie Mae or Freddie Mac

The funding of sub-prime mortgages via private-label MBS reflectedthe rise of structured finance in the early to mid-2000s, which stemmedfrom the confluence of several regulatory and financial product devel-opments On the surface, private-label mortgage-backed securitiesprovided protection against default risk to investors through eitherbeing packaged into collateralised debt obligations (CDOs) and/or beingenhanced with derivatives such as credit default swaps (CDS) Thedemand for the former was bolstered by (1) capital inflows from foreign-ers who bought investment grade-rated private-label MBS; (2) increaseddemand from Fannie Mae and Freddie Mac under greater Congressionalmandates to buy these securities to bolster home ownership rates; (3)increased demand from commercial banks due to favourable capitalrequirement treatment of investment grade MBS under Basel II; (4)increased demand from the rise of structured investment vehicles andother capital requirement avoidance vehicles; and (5) the US Securi-ties and Exchange Commission (SEC) increasing the maximum leverageratio ceilings on the brokerage units of investment banks The increaseduse of derivatives like CDS was due in part to key changes in derivativeslaws As argued by Roe (2011) and Stout (2011), the Commodity FuturesModernization Act of 2000 induced a major expansion of derivatives bynot only deregulating the derivatives market, but also making deriva-tive contracts enforceable and giving derivatives contracts prior claims

on collateral enforceable before a court decided which claims to honour

in the event of a business bankruptcy

The coalescing of these factors allowed more sub-prime and Alt-A(another type of non-prime) mortgages to be originated in the early

2000s, which lowered the down-payment constraints and other creditstandards facing first-time home buyers Duca et al (2011, 2012b) showthat the average down-payment for first-time home buyers fell fromabout 12 per cent in the mid- to late 1990s to about 6 per cent at theheight of the sub-prime boom By increasing the share of potential first-time buyers who can qualify for a mortgage, this change increased theoverall effective demand for owner-occupied housing As stressed in anoverview of the housing and financial crisis (Duca et al., 2010), thiscan create substantial excess demand for existing homes because hous-ing markets are thinly traded – the annual turnover rate for homes isusually 5–6 per cent versus around 100 per cent for stock traded onthe NYSE As a result, an easing of credit standards spawns increases inhouse prices This, in turn, increases expected house price appreciation,which has a bubble-builder effect of lowering the real user cost of mort-gage credit and thereby amplifying the initial price increases induced by

The increases in housing wealth, amplified by a higher liquidity ofhousing, induced greater consumer spending The resulting increase

in house prices also raised the relative price of existing to new homes(increasing Tobin’s q for real estate capital), spurring a constructionboom In this way, innovations lowering the credit barriers to homepurchases by potential first-time home buyers and to mortgage equitywithdrawals by established home owners triggered the housing and con-sumption boom of the early to mid-2000s The underlying innovationswere, however, not sustainable

The increases in house prices induced by the easing of mortgagecredit standards initially disguised the high risks to investors of hold-ing sub-prime MBSs If a sub-prime borrower encountered difficulty inmeeting mortgage payments, higher house prices enabled them to eithersell their home (and pay off the mortgage) or obtain larger mortgagesagainst the more highly valued collateral But, when US house pricesstopped rising, newer sub-prime borrowers were no longer bailed out by

losses led investors to realise the high risk of private-label MBSs, and thesubsequent lack of demand led to a collapse in non-prime originations,

a tightening of mortgage credit standards and ensuing falls in housingdemand and house prices (Duca et al., 2010) These, in turn, triggeredreversals in housing construction and consumption, the latter of whichare discussed in more detail in Section 2.4

Before turning to consumption, there are some important tions among the types of assets securitised that have relevance for