Abstract
Following the financial crisis of 2009 there was an emergence of macroprudential policy tools, as well as a need to model the macroeconomy and the financial sector in a coherent framework. This paper develops and calibrates a small open economy DSGE model for Lithuania to shed some light on the interactions between the macroeconomy and the banking sector, regulated by macroprudential policy. The model features housing market, and endogenous credit risk a la de Walque et al. (2010), whereby the household can default on mortgage repayments, what leads to housing collateral seizure. Foreign-owned banks, that are subject to risk-sensitive macroprudential capital requirements, take into account not only the mortgage default rate but also the cap on loan to value (LTV) ratio when making lending decisions. Using this mechanism, we show that while a more stringent LTV constraint reduced credit demand, it can also lead to an expansion in credit supply via lower credit risk. Therefore, a tightening of LTV requirement should result in only a slight reduction in mortgage lending, coupled with lower interest rate margins. The article compares the impact of the tightening of three macroprudential tools, namely, bank capital requirements, mortgage risk weights and LTV limit. We find that broad-based capital requirements, such as the counter-cyclical capital buffer, are less efficient in leaning against the housing credit cycle, because of a relatively large cost incurred on the firm sector.
Highlights
Over the recent decades loose monetary policy, financial deregulation and advances in finance greatly contributed to increasing financial leverage across the globe, fuelling asset prices in an unsustainable manner
This toolset is oriented towards banks and contains measures such as bank capital requirements and borrower-based measures, e.g. loan-to-value (LTV) ratio caps for mortgage lending, debt service to income (DSTI) and debt to income (DTI) ratio caps
After the financial crisis of 2009 macroprudential policy arose as a new systemic approach to mitigate risks and enhance the resilience of the financial sector
Summary
Over the recent decades loose monetary policy, financial deregulation and advances in finance greatly contributed to increasing financial leverage across the globe, fuelling asset prices in an unsustainable manner. The post-crisis period saw an emergence of macroprudential policy tools that address the systemic approach and are designed to decrease the formation of systemic risk and increase the resilience of markets, institutions and the general economy This toolset is oriented towards banks and contains measures such as bank capital requirements and borrower-based measures, e.g. loan-to-value (LTV) ratio caps for mortgage lending, debt service to income (DSTI) and debt to income (DTI) ratio caps. This paper builds and calibrates a general equilibrium banking model for the economy of Lithuania, as the country experienced almost a textbook-type boom and bust cycle in the 2000’s, as well as had macroprudential regulation introduced in 2011, with measures such as DSTI cap of 40% and LTV cap 85% for mortgages, bank capital buffer requirements. We proceed as follows: the Section 2 describes the model we use for simulations, under the calibration from Section 3, Section 4 provides the analytical results and Section 5 concludes
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