Research

Does a shift to ambitious climate policy increase financial fragility? By reducing the return on assets, carbon taxes can force the financial sector to de-leverage and sell assets at fire sale prices, which triggers a self-fulfilling run on the financial system. To characterize the probability of such a "Climate Minsky Moment" along the transition to net zero emissions, we propose a quantitative non-linear DSGE model with endogenous financial crises and obtain three results. First, carbon taxes are not detrimental to long run financial stability since a permanently lower asset return prevents the excessive buildup of financial sector leverage. Second, the net zero transition is initially characterized by a substantially elevated crisis probability since the financial sector might not be able to de-leverage fast enough. Third, neither accelerating or front-loading climate action reduces financial stability, but drastically reduces emissions in the medium run. Our analysis raises doubt on the notion of a trade-off between front-loading climate action and financial stability.

This paper proposes a quantitative multi-sector DSGE model with bank failure and firm default to study the interactions between bank regulation and climate policy. Households value the liquidity of deposits, which are protected by deposit insurance. Banks collect deposits and issue equity to extend defaultable loans to clean and fossil energy firms. Bank capital regulation affects liquidity provision to households, bank risk-taking, and loan supply across sectors. Using a calibrated version of the model, we obtain four results: first, fossil penalizing capital requirements can be discarded as climate policy instrument, since their effect on sector-specific investment is quantitatively negligible in general equilibrium. Second, Ramsey-optimal capital requirements in response to a tax-induced clean transition decline to counteract negative loan demand effects. Third, differentiated capital requirements are only necessary if banks are not perfectly diversified across sectors. Fourth, nominal rigidities induce a temporary tightening of capital requirements if the transition is inflationary and, thus, spurs a boom on the loan market.

We study optimal monetary policy in an analytically tractable New Keynesian DSGE-model with socially harmful emissions. Emissions are strongly pro-cyclical such that natural output in the competitive equilibrium under flexible prices overreacts to positive productivity shocks relative to the efficient allocation. When prices are sticky, actual output increases by less than natural output: the relationship between actual and efficient output depends on the emission externality and the degree of price stickiness. We show that it is not optimal to simultaneously stabilize inflation and close the natural output gap, even though this would be feasible. Divine coincidence is broken also in the presence of productivity shocks. For central banks with a dual mandate, we characterize the optimal monetary policy response and show that it places a larger weight on output stabilization. Optimal inflation volatility is larger than in the baseline New Keynesian model without an emission externality.

This paper shows how credit constraints at the firm level affect the conduct of climate policy. Using a large international panel of listed firms, this paper empirically demonstrates that firms with tighter credit constraints, measured by their distance-to-default, exhibit a smaller emission reduction after a carbon tax increase than their less constrained peers. We incorporate this channel into a quantitative E-DSGE model with credit frictions that depend on structural parameters and give rise to endogenous credit constraints. In the model, increasing the severity of credit frictions is associated with a tightening of credit constraints and an increase of the default probability. We show analytically that more severe credit frictions reduce the incentives to invest into emission abatement, since shareholders are less likely to receive the payoff from such an investment. In a calibrated of the model, we find that increasing the severity of credit frictions to such a degree that the default probability increases by 2 percentage points substantially impairs climate policy. In this case, carbon taxes have to be almost 8 dollars per tonne of carbon larger in order to remain consistent with net zero.

How does a shock to the liquidity of bank assets affect credit supply, cross-border lending, and real activity at the firm level? We exploit that, in 2007, the European Central Bank replaced national collateral frameworks by a single list. This collateral framework shock added loans to non-domestic euro area firms to the pool of eligible assets. Using loan level data, we show that banks holding a large share of newly eligible cross-border loans increase loan supply by 14% and reduce spreads by 16 basis points, compared to banks with smaller holdings of such loans. The additional credit is mainly extended to (previously eligible) domestic borrowers, suggesting only a limited cross-border effect of the collateral framework shock. However, the shock had real effects: firms highly exposed to affected banks increase their total debt, employment, and investment.

This paper demonstrates that repo markets play a crucial role in the manufacturing of safe assets. We overcome endogeneity concerns regarding repo market activity and the safety

and liquidity attributes of government bonds by exploiting a liquidity upgrade of Eurobonds in the Eurosystem collateral framework. Using transaction level data from the German repo

market, we document that repo rates for Eurobonds decline by around 50 basis points relative to Bund repo rates. This effect is robust to using agency bonds as control group, which did

not receive an upgrade, while Eurobond repo volumes increase significantly as well. The effect is most pronounced for short-term bonds and there is a considerable pass-through to

secondary market rates and bid-ask spreads. Exploiting the granularity of our dataset, we identify bond demand factors by cash lenders as the main driver of these effects, suggesting a

strong market segmentation between safe and quasi-safe assets. Our results suggests that a well-functioning repo market is one important prerequisite for the safety and liquidity status

of supranational government bonds.

How does convenience yield interact with sovereign risk and the supply of government bonds? To answer this question, this paper builds a quantitative model of sovereign debt and default, in which convenience yield arises because investors derive non-pecuniary benefits from holding risky government bonds, capturing the ability to use these bonds as collateral on financial markets. Convenience yield depends on the demand for and the supply of collateral as well as haircuts that increase in sovereign risk, reflecting mark-to-market practice on financial markets. Calibrated to Italian data, the model can replicate observed properties of financial market variables and public debt management. To understand convenience yield through the lenses of our model, we provide a decomposition of it into individual components. Counterfactual experiments suggest that the elasticity of a collateral valuation component and a haircut component with respect to government bond supply and default risk can have sizable effects on debt and default dynamics.

Abstract: This paper studies the effects of making corporate sector assets eligible as collateral for central bank borrowing. Banks are willing to pay collateral premia on assets if they become eligible as collateral. Collateral premia make debt financing cheaper for eligible firms, which respond by increasing their debt issuance. While this has a positive effect on collateral supply, firm responses also have a negative effect: higher debt issuance makes corporate bonds riskier in future periods, which in turn reduces aggregate collateral. We provide a novel analytical characterization of firm responses to eligibility requirements in a heterogeneous firm model with default risk and collateral premia paid on eligible bonds. Using a calibration of the model to euro area data, we study the impact of the ECB's collateral easing policy during the 2008 financial crisis and evaluate the quantitative relevance of firm responses. We find that firm responses substantially deteriorate collateral quality and dampen the total increase of collateral supply. Our analysis suggests that a covenant conditioning eligibility on leverage and current default risk is a potentially powerful instrument to mitigate the adverse impact of collateral premia on default risk and, thereby, to maintain a high level of collateral supply.

The European debt crisis of 2011 has been characterized by an unprecedented divergence in borrowing costs for euro area members. While 'peripheral' government bond yields increased to unprecedented levels, yields on German and other 'core' bonds strongly declined, even though German CDS-spreads reached an all-time high in 2011. To reconcile this flight-to-quality, I propose a model of a financially integrated monetary union in which heterogeneous sovereign borrowers issue bonds subject to default risk. Investors value the collateral service of government bonds, which decreases in haircuts that are specified by the central bank in its collateral framework. In a union-wide fiscal crisis, larger haircuts on all borrowers imply a contraction of aggregate collateral supply. This makes the collateral service of the safest available bonds more valuable to investors: yields on relatively safe bonds decline, even though their default risk increases. At the same time, the loss of collateral premia further increases the yields of riskier government bonds. Using the model, I show that a full backstop policy accepting all bonds during a fiscal crisis with zero haircuts reduces the dispersion of government bond spreads and reduces sovereign risk in the monetary union.