Comments on Shin and Shin Bank of Korea Research Conference May 31- June 1, 2010 Mark M. Spiegel Vice President, Economic Research Director, Center for Pacific Basin Studies Comments are my own and not those of the Federal Reserve

Paper examines information in money aggregates for macro-prudential policy Ratios of credit to money likely to be positively correlated with financial leverage – Such aggregates may therefore provide indications of financial vulnerabilities – Typically characterize assets as being more “money like” on basis of ease of settlement However, this criterion not always useful for indentifying financial vulnerability Ex.: Overnight repos highly liquid, but can be source of systemic vulnerability

“Core” vs. “Non-core” liabilities Identity of claims holder is relevant Core liabilities: – Claims held by domestic household sector Non-core liabilities: – Repos and other claims held by banks and other financial sector firms – Foreign liabilities, particularly short-term and denominated in hard currencies

Korean non-core liabilities Demonstrates major buildups prior to 1997 Asian and 2008 Global Financial crises Also finds close correlations between measure of non-core liabilities and market-based measures of financial vulnerability Suggests evidence lends support to argument for tax on non-core liabilities

Gross positions and maturities matter Inflation of bank balance sheets positively related to financial vulnerability Collapses (e.g. Northern Rock) typically preceded by substantial buildup of non-core liabilities Also finds buildup of short-term liabilities immediately preceding collapse

Extension to open economy Adrian, Etula, Shin (2009) – Repos and outstanding CP of U.S. banks suggest increased global appetite for risk – Reduces currency premium on foreign holdings – Implies reduced appreciation of foreign currency This paper tests hypothesis for won/dollar – Confirms that non-core liabilities growth negatively correlated with won valuation – Argues consistent with “risk appetite” theory

Comments

Four questions Do we want to limit buildup of gross liabilities and interbank lending in financial system? Do we want to limit foreign liabilities? Is it desirable to use a tax policy to achieve these goals? Questions concerning parametric results

I. Interbank liabilities Source of systemic risk – Interbank liabilities can cause contagion, as difficulties weaken creditor bank balance sheets – Vehicle for excessive leverage growth CP/M2 grew in Korea during boom – Encouraged shorter-term liabilities to support complex financing chains Limits policy responses – Can prove difficult to unwind quickly in crises, limiting scope for intervention – Sometimes difficult to even know who is exposed

Do we know that inter-bank lending harmed crisis performances? Rose-Spiegel (2009) – Used “MIMIC” approach to gauge crisis performance of broad cross-section in 2008 – Compared to proposed causes measured in 2006 Financial conditions had some effect – One measure of leverage significant at 10% confidence level – Equally plausible other proxies insignificant Don’t directly measure inter-bank claims

Rose-Spiegel results for financial conditions

Bank Claim/Deposits at 10% Confidence

Bank Leverage Insignificant

Other concerns Moving assets “off grid” – Paper argues analysis should also apply to “… securities firms and other intermediaries” – Easier said than done – Stricter bank regulation could move assets “off-grid” to non-banks, reducing regulatory oversight Diversification – Used to talk about need to reduce exposure to specific areas (e.g. agriculture) – Now appreciate systemic component more, but idiosyncratic issues still there, notably for small banks

II. Limiting external borrowing Spillovers when constraints exist at country level Banks borrowing in hard currencies exposed to currency mismatches – Also lead to illiquidity, as in needs of banks to acquire dollar assets to reduce such mismatches – Led to Fed swap program Composition of external borrowing important – Paper: Korea suffered substantial reductions in bank FX liabilities during crisis – In contrast, initially had foreign equity inflows

Rose-Spiegel results for int’l imbalances

III. Is tax levy the desirable policy? While paper focuses on tax levies on non-core liabilities, it acknowledges alternatives – Time-varying capital requirements (Basel III) – Capital surcharges for large and complex financial institutions Claim that levies desirable as they are “priced” – Induces banks to take account of externality – But if banks are in heterogeneous financial conditions, willingness to pay tax may be greatest among weakest banks “gambling for resurrection” Could use all instruments in optimal combination

IV. Parametric results on exchange rate Non-core liabilities as indicator of “global risk appetite” – Mixes supply effect we are looking for with other Korea- specific demand side effects – Much cleaner to use U.S. data from Adrian, et al (2009) Expected monetary policy response – During inflation targeting period, would need to respond to capital inflows with policy tightening Affects interest rate conditions as well as exchange rate movements – Would want proxy for expected future spreads as well – Would expect serial correlation in current specification

BOK raised policy rate in response to financial inflows

Episode coincided with won appreciation

Credit spread results Paper claims that increased non-core liabilities should be associated with increased credit spreads – Explanation is that financial intermediaries would be willing to borrow at higher rates Seems contradictory with exchange rate story – That story stresses supply side, global appetite for risk – This story on demand side, based on bank risk appetites Need more structure for both specifications to deal with identification – U.S.-based proxy for “global risk appetite” could help

Conclusion Paper tells persuasive story that non-core liabilities create financial vulnerability – Korean data peaks over boom and then collapses Evidence from broader cross-section not so clear More structure in parametric specifications would help in identification – Expansion of U.S. financial intermediary balance sheets could provide plausibly-exogenous credit supply shocks