Mirko Wiederholt, Goethe University
"Inflation Expectations, Monetary Policy, and the Zero Lower Bound"

After the GDP contracted sharply in 2008 the zero lower bound became binding in the United States. As a consequence, the Federal Reserve started using announcements about the future path of monetary policy, the so-called forward guidance. Within this framework, households' inflation expectation play a crucial role. So long as the nominal interest rate is at zero, the only variable that remains are inflation expectations. In his presentation at the IMFS Working Lunch, Mirko Wiederholt, Chair of Macroeconomics at Goethe University Frankfurt explained the relationship between "Inflation Expectations, Monetary Policy, and the Zero Lower Bound".

According to his paper, most of the propagation of shocks at the zero lower bound comes from movements in inflation expectation. Monetary and fiscal policy mainly act on consumption by changing inflation expectations. Therefore, Wiederholt modelled inflation expectations in a way that they were consistent with survey data on inflation expectations with households having heterogeneous expectations and responding sluggishly to shocks to future inflation. Based on the revised theory, Wiederholt comes to the conclusion that the deflationary spiral takes off more slowly in bad times and the government spending multiplier is smaller. Besides, forward guidance is less effective and can even have negative effects whereas uncertainty shocks can have first-order effects.

Sean J. Griffith, Fordham University
"How to Make a Global Market in Derivatives Regulation"

In the year seven after the outbreak of the global financial crisis, regulators all over the world are still struggling how to avert another crisis of this dimension. Since derivatives involve a high credit risk their default could make a crisis spread across the financial system. In his presentation in the series IMFS Working Lunch on September 18, Sean J. Griffith, Professor of Law at Fordham Law School, New York, analyzed the possibilities to regulate derivatives, while trying to avoid spillover effects that lead to a systemic risk.

Based on the G20 plan of the Pittsburgh summit 2009, all standardized OTC derivative contracts should be traded on exchanges or trading platforms and cleared through central counterparties. But “is mandatory clearing really such a good idea?” Griffith asked. In bilateral trading, parties to a contract are directly and indirectly exposed to each other, while in a centralized world a single counterparty acts as counterparty to all counterparties. Consequently, as Griffith pointed out, all risks “accumulate in the middle”. Besides, the clearinghouses themselves become “a dangerous entity that is too big to fail”, the professor of business law warned. According to Griffith, clearinghouses even increase the systemic risk by fragmenting netting, especially if different asset classes have different clearinghouses or if different jurisdictions demand their own clearinghouses. Thus, clearinghouses “merely shift the risk, they do not eliminate it”.

As a possible alternative, Griffith cited Manmohan Singh. The economist and former Indian Prime Minister proposed to introduce a punitive tax on the residual derivative liabilities of systemically important financial institutions. Another approach comes up with an entity licensed by regulators to collect variation margin collateral across all derivative products on a netted basis. However, as Griffith indicated, “you cannot evaluate these approaches because of the single mandatory clearing principle”. Since uniformity in regulation created risk, “we should allow for alternatives”, Griffith appealed. He proposed an U.S. review committee to allow for “substituted compliance” with foreign regulatory regimes that are at least as effective at containing systemic risk as U.S. regulation. Thus, “the importance of U.S. financial markets can give the U.S. a leading role in regulation”, Griffith concluded.

  • The presentation can be downloaded here (578 KB).
  • The paper "Substituted Compliance and Systemic Risk: How to make a Global Market in Derivatives Regulation" is also available for download (PDF, 600 KB).
  • To the photo gallery of the presentation
Vikrant Vig, IMFS
"The Limits of Model-Based Regulation"

In his talk at the IMFS Working Lunch Prof. Vikrant Vig investigated the ways large banks make use of capital regulation, demonstrating the danger of complex requirements. Instead of enhancing financial stability, model-based capital regulation can harm financial stability.

The 45 top European banks command about more than half of the market share. In a paper with Markus Behn and Rainer Haselmann, Prof. Vikrant Vig investigated how large banks exploited the introduction of model-based capital regulation.

Under the Basel 2 guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating the regulatory capital. However, this refers only to banks meeting certain minimum conditions and disclosure requirements in estimating capital for various exposures. All of the large banks opted for introducing the new approach based on internal-ratings (IRB approach) instead of sticking to the traditional approach. Since the national supervisors only authorized them to shift to this approach gradually, a whole set of data was created.

By analyzing loans and balance sheets of German banks between 2004 and 2012, Prof. Vig found out that the internal risk estimates systematically underpredicted the actual default rates. Furthermore, he concluded that the banks that used the internal ratings approach increased lending in the aftermath of the financial crisis of 2007. "The 45 big banks could afford a complex regulation and could benefit from it," Prof. Vig pointed out. Their expansion took place at the expense of the smaller banks which implemented the traditional approach.

“The model-based regulation is a regulation that subsidizes size,” Prof. Vig said, criticizing the trend for more and more requirements. According to his study, however, not only the big banks come out of this as winners but also the regulators who create lots of new jobs, building themselves an empire. The ones who finally suffer from financial instability are the tax payers, he summarized.

Joachim Englisch, University of Münster
"Finanztransaktionsteuer – völker- und unionsrechtliche Bedenken"

On February 12, 2014, Professor Joachim Englisch, Managing Director of the Department of Tax Law at the University of Münster, talked about the worries and concerns regarding the financial transaction tax, seen from the perspective of public international law. The presentation was held in German and can be downloaded here.