PhD thesis defence by Pablo Herrero Marco
This thesis studies the effects macro-prudential policies and its optimal design. The models developed across the different chapters share two key features: macro-finance linkages and non-linear dynamics. Macro-finance linkages accurately quantify the welfare effects of macroprudential policies by accounting for the two-way dynamic feedback between asset prices and real economic activity. Non-linear dynamics regulate the strength of macro-finance interactions: they are weak during good times, but strong during times of financial crises.
In Chapter 1, titled 'Assessing Options for Deposit Insurance Reform: An Infinite-Horizon Approach', I develop a model of deposit insurance designed to capture key features of the recent US banking turmoil. In March 2023, unusually fast depositor withdrawals led to the failure of several US banks. In response, the government provided an implicit temporary increase in deposit insurance by covering 100 % of the ex-ante uninsured depositors. These events have reignited a debate on deposit insurance reform. This paper contributes to this discussion by developing a dynamic general equilibrium model that incorporates: (a) idiosyncratic bank failures, (b) contagion from failing banks to solvent banks and the broader economy, and (c) state-contingent deposit insurance. I calibrate the model to US data and use it to assess several options for deposit insurance reform. First, I show that, under fast government response, state-contingent deposit insurance is the optimal policy. Second, if the government’s response is delayed, fixed deposit insurance is preferred to the state-contingent policy. Third, delayed government response does not justify full deposit insurance at all times: the optimal fixed deposit insurance policy covers around 65 % of total deposits.
In Chapter 2, titled 'The Foreign Liability Channel of Bank Capital Requirements', and coauthored with Luigi Falasconi, Caterina Mendicino, and Dominik Supera, we examine the effects of tighter capital requirements in a quantitative model of risky financial intermediaries partly funded with foreign currency debt. Setting bank capital requirements at appropriately high levels is crucial to enhance the resilience of banks against sudden losses and the risk of insolvency. As bank default risk declines, the cost of foreign funding decreases, encouraging greater reliance on foreign liabilities. This reveals a novel trade-off in bank capital regulation. On the one hand, higher capital requirements strengthen the resilience of both banks and the broader economy against shocks originating from the banking sector. On the other hand, they increase banks’ exposure to potential disruptions in foreign funding. Our findings suggest that in the presence of bank solvency risk, foreign prudential tools, such as capital flow management taxes or foreign exchange rate interventions, are complementary to bank capital requirements in mitigating financial vulnerabilities. Empirical evidence on Peru’s transition to higher capital requirements lend support to the foreign liability channel of bank capital requirements.
In Chapter 3, titled 'The Aggregate Demand Channel of Loan-to-Value Shocks', and co-authored with Caterina Mendicino and Christopher Schang, we explore the aggregate and distributional effects of loan-to-value (LTV) tightening shocks, and their interaction with monetary policy, using a Heterogeneous-Agent New Keynesian (HANK) model. Households in the model face income risk, housing decisions, and collateral constraints. Stricter LTV limits affect the economy through aggregate demand effects, triggering a decline in aggregate consumption, house prices and inflation. Our results suggest that general equilibrium channels amplify the impact of LTV tightening, disproportionately affecting highly leveraged borrowers. Stronger monetary policy accommodation mitigates these effects, limiting the aggregate costs of stricter LTV regulations and their unequal burden across households. These findings highlight the importance of coordinated macroprudential and monetary policies.