Research Programme 2012/2013

Contents

Introductory Remarks Research Group: Research Group: Research Group: Research Group: Research Group: Research Group: Research Group: Research Group: Monetary Transmission and Monetary Strategy Corporate Finance, Household Finance, Monetary Policy and Financial Stability Public finances: Interactions with the overall economy and sustainability International Integration, international shocks and external imbalances Forecasting, Early Warning and Monetary Policy Financial Stability Banking Regulation and Supervision Banking Structure

3 4 12 20 26 34 40 46 59

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Introductory Remarks The research programme for 2012/2013 attempts to provide an overview of the ongoing and planned research for the coming 2 years. As in the past it is organized according to several informal research groups. Compared to last year's programme a new group on Banking structure has been established. It is a kind of spin off as in former programmes topics which are collected in this group have been included in other groups, in particular in the groups on financial stability and on banking regulation. We think that understanding the banking structure and its consequences for monetary policy, the financial stability and the real economy is important enough to have such a group. Furthermore it is planned to establish an international research network on international banking and this group should also be a platform for related projects. On the other hand we have no longer an explicit DSGE model group in our programme. The research centre was successfull to convince departments that DSGEmodels are a useful analytical tool. There exists now a core DSGE model in the Bundesbank and several extensions are underway which should be useful in the day to day business (see the appendix for a description where we stand in this respect). Against this backdrop it seemed sensible to integrate research work which uses DSGE models under the roof of those research groups which seemed most appropriate (like monetary policy or public finance). Also inside the exising research groups the focus has been changed in some cases. For example in the international integration group external imbalances and competitivness issues became more prominent. A second new element of our research programme is the idea to identify a few topics, which are of specific interest for policy makers and researchers. Chosen topics will be handled by a few economists who do related research projects over the horizon of the research programme. Our aim is that the outcome are on the one hand papers of an academic nature. On the other hand the outcome could be the basis for seminars with board members. In fact such board seminars have been installed recently. Proposals for such topics can be found in the Annex.

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Research group Monetary Transmission and Monetary Strategy JEL Codes: Members: 1 C2, C3, E2, E3, E4, E5 Petra Adolf, Nicole Binder, Barno Bls*, Julia von Borstel, Ulrike Busch, Sandra Eickmeier*, Christina Gerberding*, Felix Geiger, Rafael Gerke*, Felix Hammermann* (coordinator), Melanie Klein*, Bjrn Kraaz, Michael Krause*, Jeong-Ryeol Kurz-Kim, Martin Mandler*, Nobert Metiu*, Ansgar Rannenberg*, Stefan Ried*, Manuel Rupprecht, Michael Scharnagl*, Markus A. Schmidt, Jan Scheithauer, Christian Schumacher, Heiko Sopp, Jelena Stapf*, Jrn Tenhofen*, Ute Volz, Andreas Worms, Lilli Zimmermann*

Advisors/visitors: Jana Gieck (Goethe University Frankfurt), Vivien Lewis (Ghent University), Manfred J. M. Neumann (Rheinische Friedrich-Wilhelms-University Bonn) General Interest and Policy Relevance Understanding monetary transmission and defining monetary strategy, the two workstreams of the research group, are at the heart of a central banks tasks. The financial crisis has not only raised important questions for transmission, implementation and conduct of monetary policy but also challenged the conventional wisdom that a monetary regime achieving price stability guarantees by itself financial stability. It has become obvious that a better understanding of the interaction of the financial sector with monetary policy on the one hand and the macroeconomy on the other is crucial. Furthermore, the financial crisis evolving into a sovereign debt crisis has revived interest in the interaction between monetary policy and fiscal policy. Against this backdrop the first workstream (monetary transmission) concentrates on the following research questions: Has the monetary transmission process changed during the crisis? In particular, how has lending supply and risk-taking behaviour of banks changed? How should central banks react in an environment of interest rates close to the zero lower bound? How do conventional and unconventional monetary policy measures affect other interest rates and financial prices? How to measure financial conditions in the crisis? The second workstream (monetary strategy) aims to contribute to the following issues: Should central banks modify their targets under the specific conditions of the crisis, for example, aim for higher inflation rates? How should central banks take financial stability into account? Should central banks coordinate with fiscal policy respectively, fiscal policies in a monetary union and if so how? How does monetary policy influence inflation expectations under the specific conditions of the current crisis? Monetary Transmission Recent Research Arne Halberstadt and Jelena Stapf (2012) analyse in An affine multifactor model with macro factors for the German term structure: Changing results during the recent crisis the dynamics of German bond yields and risk premia for the period 1999 to 2010. They
1

A * indicates that this member plans to contribute a paper over the coming two years.

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estimate two model specifications, one with only latent factors, and another one with a Taylor-type rule comprising a price and a real activity factor drawn from a large macro variable data set as additional driving forces. Macro factors, notably the real activity factor, help to improve the fit of the model and enhance forecasts of future yields. Looking at the impact of the recent subprime, financial and sovereign debt crisis' they conclude that risk aversion of market participants captured in the market price of risk changed most dramatically for the real activity and the price factor. Offsetting safe haven flows affecting especially shorter maturities explain why yield risk premia increase less at the short end as compared to longer maturities in times of crisis. A liquidity stress factor included into the macro model mirrors this slope influencing effect and leads to smoother forward rates for yield risk premia. Ulrike Busch (2012) investigates in Credit Cycles and Business Cycles in Germany: A Comovement Analysis stylised facts of the cyclical nature of four German loan aggregates and of their co-movement with GDP growth. For loans to non-financial corporations strong cycles are identified and a strong co-movement with GDP is estimated. Furthermore, these loans lag GDP significantly. In contrast, loans to the private sector, loans to private households and housing loans show no significant lead/lag relationship against GDP. The empirical evidence presented in the paper illustrates the financial instability hypothesis. In the project Bank-related loan supply factors during the crisis: an analysis based on the German bank lending survey Barno Bls (2011) analyses the role of bank-related constraints in explaining the sharp slowdown in bank lending to non-financial corporations in Germany during the recent financial crisis. She uses a panel approach based on a unique data set which matches the individual responses of the banks participating in the Eurosystems Bank Lending Survey with the corresponding micro data on loan quantities and prices. The main finding is that bank-related supply and demand-side indicators were both important in explaining the slowdown of bank lending during the crisis years. Claudia M. Buch, Sandra Eickmeier and Esteban Prieto (2010) investigate in Macroeconomic factors and micro-level bank risk the importance of the interplay between banks and the macroeconomy for financial and economic stability. They analyse this link using a factor-augmented vector autoregressive model (FAVAR) which extends a standard VAR for the U.S. macroeconomy by a set of factors summarising conditions in the banking sector based on data of more than 1,500 commercial banks from the U.S. call reports. The main findings are: (i) Average bank risk declines, and average bank lending increases following expansionary shocks. (ii) The heterogeneity of banks is characterised by idiosyncratic shocks and the asymmetric transmission of common shocks. In the project In search for yield? Survey-based evidence on bank risk taking Claudia M. Buch, Sandra Eickmeier and Esteban Prieto (2011) analyse the risk-taking behaviour of banks based on a FAVAR for the U.S. for the period 1997-2008. They include standard macroeconomic indicators and factors summarising information provided in the Federal Reserves Survey of Terms of Business Lending. These data allow modelling the reactions of banks new lending volumes and prices as well as the riskiness of new loans. They find that small domestic banks increase their exposure to risk, foreign banks lower risk, and large domestic banks do not change their risk exposure after expansionary monetary and house price shocks. In Monetary Policy Implementation and Overnight Rate Persistence Dieter Nautz and Jan Scheithauer (2011) use fractional integration techniques to explore how the operational framework of four major central banks affects the persistence of overnight rates. The results suggest that a well-communicated and transparent interest rate target of the central bank is a particularly important condition for a low degree of overnight rate persistence. Further relevant papers described in more detail under research group International Integration: How Do Credit Supply Shocks Propagate Internationally? A GVAR Approach by

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Sandra Eickmeier and Tim Ng (2011) and The changing international transmission of financial shocks: Evidence from a classical time-varying FAVAR by Sandra Eickmeier, Wolfgang Lemke and Massimiliano Marcellino. Planned and Ongoing Research Projects The planned and ongoing projects broadly related to the monetary transmission mechanism can be subdivided into two groups, where the first addresses implementation of monetary policy and monetary transmission more generally, whereas the second group concentrates more specifically on the behaviour of financial institutions and on bank lending in particular. Monetary policy implementation and monetary transmission Stefan Ried investigates monetary policy implementation in DSGE models (new). Major central banks have made every endeavour to enhance their set of instruments, from asset purchases to changes in allotment procedures, collateral requirements, eligible counterparties and the interest rate corridor. In this paper, the existing DSGE literature on monetary policy implementation is reviewed and first attempts are made to find out where and how a standard New Keynesian DSGE model can be enriched for some of the elements used for monetary policy implementation these days. Jana Gieck examines the effects of unconventional monetary policy measures in an open economy (new). In particular, she investigates the different transmission channels of unconventional measures such as liquidity injections (quantitative easing) and the repurchase of debt and securities (qualitative easing) in a two-country DSGE model with a banking sector. Martin Mandler uses in Threshold effects in European inflation dynamics: The role of money (new) threshold models to study nonlinearities in the inflation process related to monetary dynamics both in individual EU member countries before the introduction of the Euro and for the Euro area. He extends the existing analysis of Amisano and Fagan (2010) in two directions: (i) Using a threshold model in place of the Markov-switching framework allows for a richer description of inflation dynamics. (ii) Monetary dynamics are allowed to have a direct impact on inflationary developments instead of only triggering switches between regimes. Rafael Gerke, Felix Hammermann and Jrn Tenhofen analyse changes in the monetary transmission mechanism (new). Gerke, Hammermann, Tenhofen and Gerba (2011) have estimated a time-varying parameter VAR model (TVP-VAR), where the parameters are allowed to change in every quarter. Based on a TVP-VAR featuring stochastic volatility to model time-variation in the standard deviations of the shocks, they document the relative stability of the monetary transmission mechanism in the euro area over time. It is intended to, first, extend the prior specification in the sense of discarding the draws which lead to unstable processes and, second, to move to a more elaborate identification approaches like sign restrictions. Wenjuan Chen, Norbert Metiu and Anton Velinov combine statistical information with economic theory in Interactions between monetary policy and the stock market: Evidence from Markov-switching structural vector autoregressions (new) to achieve identification of monetary policy shocks to the stock market. A Markov-switching structural vector autoregression is formulated, which exploits a heteroskedasticity feature of the reduced form error covariances to identify empirically plausible structural innovations. The validity of various conventional identification schemes which are just-identifying in this framework is tested in a small monetary system for the United States. Monetary transmission with a focus on the financial sector

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Barno Bls, Christina Gerberding and Michael Scharnagl use in Transmission of system monetary policy decisions in the German economy (ongoing) a Bayesian VAR model based on a large data set to obtain detailed information on reactions of the most important German financial variables (e.g. credit aggregates) and real activity variables to monetary shocks. In Identifying the macroeconomic effects of loan supply shocks in the euro area (new) Barno Bls and Michael Scharnagl contribute to the resurgent debate about a possible credit crunch by investigating the effects of financial market shocks on loans and real activity for selected euro area countries. Using the unique information related to the loan supply determinants from the national Bank Lending Survey data the authors conduct their analysis on the basis of two alternative identification schemes (standard Cholesky vs. identification via sign restrictions) within a VAR. Lilli Zimmermann investigates the effects of monetary policy shocks on the financing behaviour of non-financial corporations (new). By applying different specifications of a VAR model for a panel of selected euro area countries the study analyses how non-financial corporations respond to a monetary policy shock focusing particularly on their financing behaviour. The study is based on quarterly financial accounts data and provides not only valuable insights on the monetary transmission mechanism but is also essential for macroprudential analyses. The project on the Interest rate channel in Germany (ongoing) by Melanie Klein aims at investigating the pass-through of monetary policy measures on various banks funding costs (deposit rates, money market and capital market rates) for Germany and the EMU. While most former studies focused on the pass-through from market rates to bank lending rates, this first step of the interest rate channel has been widely neglected in research so far. The financial and sovereign debt crisis, however, has shown the importance of this first part for the transmission of monetary policy. Using monthly data, inter alia, provided by the Bundesbank MFI interest rate and capital market statistics, also determinants of the passthrough like rigidity of funding costs and the financial structure will play a crucial role in the analysis. The related project Retail deposits and funding stability by Roman Inderst and Tobias Waldenmaier analysing the interest-rate elasticity of deposits in Germany and other projects on the interest rate pass-through are part of the research group Banking Structure. Melanie Klein enquires about empirical evidence of the risk-taking channel in Germany (ongoing). The empirical analysis will focus on the link between monetary policy and the risk-taking behaviour of German banks on the basis of banking group data (macro panel) from the prudential database. The analysis will cover in particular to which extent changes in the monetary policy rate impact on the degree of risk in the banks portfolio. Estimates are conducted on the basis of static panel models and of a standard VAR. Michael Scharnagl and Falko Fecht examine loans and banking variables (new). Based on a variety of mechanisms through which financial markets can affect the real economy the analysis uses wavelet methods to investigate the effects of variables describing banking behaviour on the evolution of loans in Germany. A potential explanatory variable may be bank earnings as an indicator of the performance of bankers maximising their reputation. Other variables to be taken into account are the ratio of equity to bank assets and liquidity transformation. Wavelet analysis seems to be an appropriate tool to identify cycles of various frequencies in time series. The relative importance of short-term and long-term effects may change over time. Michael Scharnagl conducts a wavelet analysis of loans (new). ECB (2009) analyses the lead/lag relationship between changes in real GDP and real loans to households as well as

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real loans to non-financial corporations from 1980 to 2009. There is evidence for a lead of GDP with respect to loans to non-financial corporations. Recursive analysis of the correlation and the lead of GDP gives some indication of time variation. Deutsche Bundesbank (2011) performs a similar analysis in the frequency domain for data for Germany from 1980 to 2010. As this type of analysis has no resolution over time, structural changes cannot be identified. The time-varying correlation is analysed using the concept of wavelet coherency, the lead/lag relationship over time by calculating the wavelet phase difference for various frequency bands. Arne Halberstadt and Jelena Stapf build an affine term structure model with inflation data for Germany (new). Affine multifactor term structure models cover bond yield movements over time and over the cross section. Including forward looking inflation data and a real pricing kernel would allow them to derive model-based long-term inflation expectations as well as inflation risk and real risk premia. Developments of long-term inflation expectations incorporated in break-even-inflation rates derived from a standard Svensson term structure estimation could be benchmarked against the model results and interpreted on a more granular basis. Monetary Strategy Recent Research Claudia Kurz and Jeong-Ryeol Kurz-Kim (2011) modify in A nonlinear Taylor rule: from an econometric point of view the Taylor regression, with the aim of providing an explanation of why the (standard) Taylor regression is spurious and, at the same time, a solution as to how central bank monetary policy can still be described by a more general Taylor rule. An empirical example using euro-area data confirms the compatibility of his modification with empirical data. In the project Existence of a nonlinearly stable European money demand function Jeong-Ryeol Kurz-Kim scrutinises whether a nonlinearly stable European money demand function exists that takes account of stock market uncertainty. It reveals that the stability of the long-run European money demand depends on the stock market uncertainty. Michael Krause and Stphane Moyen (2011) analyse in Public debt and changing inflation targets the extent to which an increase in the inflation target can help a government to reduce the real debt accumulated during the crisis. They use a standard New Keynesian model with long-run debt. The potential effect of surprise increases of inflation depends on the average maturity of debt. It turns out that the reduction in the real debt stock achievable after 10 years is at best 30 percent of the crisis-related debt. The same is true if agents only slowly perceive the inflationary intentions of the government. Planned and Ongoing Research Projects Central banks monetary policy strategy face with the financial crisis turning into a sovereign debt crisis new challenges on two frontiers: The first group of projects focuses on the interaction between monetary policy and the financial sector and the second group on the interaction with fiscal policy. Monetary strategy: interaction between monetary policy and the financial sector In asymmetric information in credit markets, bank leverage cycles and macroeconomic dynamics (new) Ansgar Rannenberg (2012) adds a moral hazard problem between banks and depositors as in Gertler and Karadi (2011) to a DSGE model with a costly state verification problem between entrepreneurs and banks as in Bernanke, Gertler and Gilchrist (1999) (BGG). This modification amplifies the response of the external finance pre-

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mium and the overall economy to monetary policy and productivity shocks. The amplification allows Rannenbergs model to match the volatility and correlation with output of the external finance premium, bank leverage, entrepreneurial leverage and important real variables in U.S. data better than a BGG-type model. A reasonably calibrated combination of balance sheet shocks produces a downturn of a magnitude similar to the Great Recession caused by the recent financial crisis. Rafael Gerke, Felix Hammermann and Jrn Tenhofen analyse potential interactions between monetary and macroprudential policy (ongoing). The starting point of the analysis is a DSGE model with bank capital. Such a model allows them to analyse macroprudential instruments such as time-varying capital requirements. Of particular interest are the implications from a better understanding of the transmission of changes in capital requirements and the interaction of these changes with the transmission of monetary policy for the design of the monetary strategy. Sandra Eickmeier, Massimiliano Marcellino and Esteban Prieto construct in the project Financial conditions and the macroeconomy (ongoing) a new financial conditions index (FCI) for the U.S. based on a Bayesian VAR model with time-varying parameters and a handful of financial indicators. This FCI is compared to an FCI constructed based on a VAR with constant parameters which has been previously employed in the literature. It is also compared to one which is constructed based on a large financial dataset. Another relevant ongoing paper described in more detail under research group International Integration: Understanding Global Liquidity by Sandra Eickmeier, Boris Hofmann and Leonardo Gambacorta. Monetary strategy: interaction between monetary policy and fiscal policy / labour markets Barno Bls, Stefan Ried and Michael Scharnagl investigate fiscal and monetary policy interactions (ongoing) for selected EMU countries as well as for the EMU as a whole. Following Sims (2011), it first lays out a theoretical model in the spirit of the fiscal theory of the price level for understanding the possible fiscal impact on inflation. Further, using a Bayesian VAR approach, it addresses the question of dependence of monetary policy transmission on the most important measures of the fiscal stance (e.g. primary deficit, debt to GDP ratio, governments interest expense as a fraction of total expenditures) to obtain further insights into a topic that has regained importance recently. Moreover, it also sheds light on problems arising from divergent country-specific developments in the fiscal stance within the EMU that have received little attention until the emergence of the current sovereign debt crisis. Stefan Ried and Oliver Grimm examine macroeconomic policy in a heterogeneous monetary union (new). They use a two-country model with a central bank maximising union-wide welfare and two fiscal authorities minimising comparable, but slightly different country-wide losses. They analyse the rivalry between the three authorities in seven static games. Comparing a homogeneous with a heterogeneous monetary union, they find welfare losses to be significantly larger in the heterogeneous union. The best-performing scenarios are cooperation between all authorities and monetary leadership. Cooperation between the fiscal authorities is harmful to both the whole unions and the country-specific welfare. Michael Krause and Stphane Moyen analyse the jointly optimal monetary and fiscal policies in a model with long-run government debt (new). This added feature complicates the optimal policy problem, because it may affect the optimal steady-state rate of inflation as well as alter the cyclical response to shocks. For example, the path of inflation may offer an additional channel through which real debt may be stabilised, avoiding the effects of distortionary taxation. Krause and Moyen follow the approach used by Schmitt-Groh and Uribe (2007).

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Maarten Dossche and Vivien Lewis analyse labour hoarding and the zero lower bound on nominal interest rates (new). They ask whether the argument that a higher inflation target increases monetary policy effectiveness in the presence of the zero lower bound is appropriate for the euro area, where labour market frictions reduce the variability of inflation relative to the US. In a monetary business cycle model with hiring costs and unobserved effort, procyclical labour productivity acts as a counterweight to labour and capital compensation in determining overall marginal costs, thereby making inflation less volatile. These features can explain the empirical finding that in the euro area, labour productivity is strongly procyclical and inflation is more stable than in the US. References Amisano, G. and G. Fagan (2010), Money growth and inflation: a regime switching approach, ECB WP, 1207. Bernanke, B. S., M. Gertler and S. Gilchrist (1999), The Financial Accelerator in a Quantitative Business Cycle Framework, in: John B. Taylor and Michael Woodford (eds), Handbook of Macroeconomics, Elsevier, Amsterdam, 1341-1393. Blaes, B. (2011), Bank-related loan supply factors during the crisis: an analysis based on the German bank lending survey, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 31/2011. Buch, C. M., S. Eickmeier and E. Prieto (2010), Macroeconomic factors and micro-level bank risk, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 20/2010. Buch, C. M., S. Eickmeier and E. Prieto (2010), Macroeconomic factors and micro-level bank risk, CESifo Working Paper, 3194. Buch, C. M., S. Eickmeier and E. Prieto (2011), In search for yield? Survey-based evidence on bank risk taking, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 20/2011. Buch, C. M., S. Eickmeier and E. Prieto (2011), In search for yield? Survey-based evidence on bank risk taking, CESifo Working Paper, 3375. Busch, U. (2012), Credit Cycles and Business Cycles in Germany: A Comovement Analysis, available at SSRN, http://ssrn.com/abstract=2015976. Deutsche Bundesbank (2011), German banks lending to the domestic private sector since summer 2009, Monthly Report, September, 59-78. European Central Bank (2009), Loans to the non-financial private sector over the business cycle in the euro area, Monthly Bulletin, October, 18-21. Eickmeier, S. and T. Ng (2011), How do credit supply shocks propagate internationally? A GVAR approach, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 27/2011. Eickmeier, S. and T. Ng (2011), How do credit supply shocks propagate internationally? A GVAR approach, CEPR Discussion Paper, 8720. Gerke, R., F. Hammermann, J. Tenhofen and E. Gerba (2011), Changes in monetary transmission?, Deutsche Bundesbank Vermerk, 30. September 2011.

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Gertler, M. and P. Karadi (2011), A model of unconventional monetary policy, Journal of Monetary Economics, 58(1), 17-34. Grimm, O. and S. Ried (2007), Macroeconomic Policy in a Heterogeneous Monetary Union, Humboldt-Universitt zu Berlin, SFB 649 Discussion Paper, 2007-028. Halberstadt, A. and J. Stapf (2012), An affine multifactor model with macro factors for the German term structure: Changing results during the recent crisis, Deutsche Bundesbank, mimeo. Lanne, M., H. Ltkepohl and K. Maciejowska (2010), Structural vector autoregressions with Markov switching, Journal of Economic Dynamics and Control, 34(2), 121-131. Krause, M. and S. Moyen (2011), Public debt and changing inflation targets, Deutsche Bundesbank, mimeo. Kurz, C. and J.-R. Kurz-Kim (2011), A nonlinear Taylor rule: from an econometric point of view, Review of Economics and Finance, 1(3), 46-51. Nautz, D. and J. Scheithauer (2011), Monetary Policy Implementation and Overnight Rate Persistence, Journal of International Money and Finance, 30(7), 1375-1386. Rannenberg, A. (2012), Asymmetric Information in Credit Markets, Bank Leverage Cycles and Macroeconomic Dynamics, ECB Working Paper, forthcoming. Schmitt-Groh, S. and M. Uribe (2007), Optimal Simple and Implementable Monetary and Fiscal Rules, Journal of Monetary Economics, 54(6), 1702-1725. Sims, C. A. (2011), Stepping on a rake: The role of fiscal policy in the inflation of the 1970s, European Economic Review, 55(1), 48-56.

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Research group Corporate Finance, Household Finance, Monetary Policy and Financial Stability JEL Codes: Members: D1, D2, G3 Ulf von Kalckreuth* (coordinator), Tobias Schmidt,* Julia Le Blanc,* Junyi Zhu,* Elena Biewen,* Martin Eisele,* Markus Baltzer,* Leonid Silbermann,* Natalyia Barasinska,* Anne Koban,* Kerstin Stahn.*

Advisors/visitors/cooperating researchers: Axel Brsch-Supan (University of Mannheim), Michael Haliassos (University of Frankfurt), Dimitris Georgarakos (University of Frankfurt), Falko Fecht (Frankfurt School of Finance and Management), Steffen Meyer (University of Frankfurt), Almuth Scholl (University Konstanz ), Wolfgang Sofka (Tilburg), Helmut Stix (OeNB, Wien), Daniel Hwer (ZEW Mannheim), Oscar Stolper (University Giessen), Andreas Walter (Giessen), Daniela Dimitrova (CFS, University of Frankfurt), Solvejg Wewel (Free University Berlin), Iris Noack (Saarland University) General interest and policy relevance Financial conditions of firms and households, the financial decisions they take and the interaction of these decisions with real investment, saving and consumption are key elements in the transmission of monetary policy. Their study is one of the analytical cornerstones of monetary policy. Furthermore, a clear theoretical and empirical understanding of firm and household finance is indispensable for any discussion on the evolution of the financial system and financial stability. In order to analyse the decisions of economic entities, it is insufficient to look at aggregates only. Aggregates mask the heterogeneity of agents, and are prone to simultaneity problems that disappear once the reaction of individual decision makers to changes in their economic environment can be observed. Any stress-test type of analysis needs distributions as analytic raw material, as the effect of asset price or interest rate changes crucially depends on who holds the asset or the debt. Similar arguments apply for financial vulnerability of firms. This is why the group uses disaggregated data; some of them are being developed by the group itself. The group has two work streams: household finance and firm finance. A. Research on household finance Bundesbank research in this field is supported mainly by two extremely rich and unique sources of data that allow drawing a comprehensive picture of household finance in Germany. The groups own product is the Panel on Household Finance (PHF), an integrated part of the Euro Area Household Finance and Consumption Survey (HFCS). It collects household level data on the structure and the values of assets and liabilities, together with a rich array of information on income, labour, old age provision, transfers and socio-economic characteristics, attitudes and expectations. Second, the Bundesbank Security Deposit Database (SecuStat) collects data on portfolio structures at the level of the financial institution that manages the portfolio. For each single security, every financial institution reports the managed quantity by type of investor, as well as their own securities holdings, also at other banks or abroad. The two data sets complement each other. SecuStat has aggregate information on private households: all securities held, the quantities, the values. It thus will provide vital information for weighting, imputation and evaluating the survey data. In reverse, PHF has what is missing to SecuStat: detailed information on individual holders and their characteristics.

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The year 2011 was shaped by preparing and supervising the difficult field phase of the PHF (autumn 2010 to summer 2011), and by the need to check and process the incoming raw data, in order to make them accessible for scientific analysis. After the laborious phases of editing, imputation and weighting now are mainly finished, the first wave of the survey is ready to be used as an important data base for research. Processing and preparation of the survey micro data and a basic statistical evaluation will take until the winter of 2012, but the group will be doing scientific research on the basis of preliminary data much earlier. Initially, the emphasis will be on charting the territory of household finance in Germany, giving accounts on household wealth, debt, portfolio composition and savings that are mainly descriptive in nature, by assessing the distributions of absolute amounts and ratios. In the course of 2013, research will become more analytical. The group is committed to do joint research with colleagues in the Household Finance and Consumption Network (HFCN) of the Euro Area. Within the HFCN, research plans are taking shape, but are not yet finalised. Therefore, our project planning for the next two years is by necessity incomplete: some projects will be added, perhaps at the cost of others. In line with the duties of the network many resources of the group are absorbed by preparing and documenting the PHF data. This includes methodological research in the field of surveys. In addition, the group does research in a narrower sense. In accordance with the work programme of the HFCN, the group will contribute research papers along three major topics: Patterns and determinants of household saving Patterns and determinants of wealth and debt distribution among households Pattern and determinants of portfolio choice among households

The geographical focus will both be Germany and the Euro-area. Given the wealth of comparative data from other countries, it will be possible to look at the importance of institutional factors for household finance patterns. Currently, research on household finance can be grouped into eight research areas, which will be exposed in the following. 1. Documenting the PHF Authors: von Kalckreuth, Eisele, Le Blanc ,Schmidt, Zhu, Wewel Recent work: In January 2012, a Monthly Report on the survey was published, giving a general description and first results. Ongoing and new work An important outcome of the years 2011 and 2012 will be documenting and discussing the major characteristics of the PHF. The material will lead to at least one publishable paper and a series of technical papers. An introductory paper by von Kalckreuth, Eisele, Le Blanc, Schmidt, Zhu under the heading The PHF: a comprehensive panel survey on household finances and wealth in Germany (ongoing) is directed at a broader audience and provides a general overview on the survey, its variables and uses, the field phase and selectivity. Technical papers will be produced on issues such as variance estimation, editing, imputation and evaluation. Evaluation will be critical for the path of future evolution and will have to encompass both methodological issues and a comparison of survey results with outside infor-

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mation on aggregates and distributions. The HFCN sub-group on development and evaluation will serve as a forum for survey evaluation. 2. Evidence on financial instruments, the distribution of assets, debts and net wealth and stress-testing household finances in Germany (new) Authors: Schmidt, Le Blanc, von Kalckreuth, Natalyia Barasinska, Anne Koban The first step in analytical work with the PHF will be a descriptive exposition of major aggregates of the balance sheet items of private households. The focus will be on the microstructure of assets and liability, including distributions. This line of work will be a major outcome of the groups work in 2012. It will be greatly enhanced by ongoing similar work in other countries of the Euro area. Schmidt is going to look on Real Wealth in Germany (new), considering, among other things, homeownership and business wealth in Germany. Working on Financial wealth in Germany (new) Le Blanc aims at working out the stylised facts of portfolio behaviour, among other things direct and indirect share ownership and Riester takeup A look at Consumer Debt in Germany (new) by von Kalckreuth and Schmidt shall prepare a stress-test type of analysis: How is debt-burden distributed among the population and what would be the effect of different kinds of shocks: income, unemployment, interest and asset prices. Within the context of the HFCN, the group will be able to make informative comparisons regarding the effects of interest rate changes or business cycle downturns on private households. A related study by Barasinska and Koban on Households Borrowing in Germany and Its Implications for Banks Risk Position (new) will focus on microeconometric drivers of indebtedness and debt service using regression analysis. Ultimately, a study on The Distribution of Wealth among Households in Germany (new) by von Kalckreuth will start the groups research on household heterogeneity, with an international and comparative perspective. 3. Tracing major structures of household finance in the Euro area (new) Authors: Schmidt, Le Blanc, von Kalckreuth As a counterpart of the descriptive work for Germany, the research group of the HFCN is drawing together the major stylised facts on household finance in Europe. The emphasis in this line of work is comparative while the analysis of indicators on financial structures and distributions cannot be as detailed as the work on the country level, the major sources of heterogeneity within the Euro area will be worked out. This research work is very topical, given that the current risks for financial stability are partly rooted in household finances, The planning of comparative descriptive work is under way. The intended pace is fast, first results may be available by the end of this year. 4. Household portfolio choice and stock market participation Authors: Haliassos, Georgarakos, Le Blanc, Fecht, Baltzer, Stolper, Walter Recent work Using SecuStat data, Baltzer, Stolper and Walter (2011) have studied the local bias in the direct stock investment of German households, and in a continuation of this work the authors will investigate to what extent the so-called home bias the overweighting of national stocks is really only a local bias. Ongoing and new projects Life cycle models of portfolio choice and savings behaviour have become a major analytical tool in research on household finance. Such models have mostly been calibrated using U.S. data. In their project Differences in portfolio choice and wealth accumulation in Europe: The Role of Labor Income Risk (ongoing), Georgarakos and Le Blanc use panel data for a

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number of European countries to estimate country-specific labour income profiles and shock processes that are needed as ingredients for the life-cycle model. The panel data used in this step come from the European Community Household Panel Survey (ECHP). Based on this work on the national variations in the structure of shocks, it is intended to calibrate complete life cycle models for each of the countries in the Euro area, with all parameters specific to the country in question. This project by Georgarakos, Haliassos, and Le Blanc (Portfolio Choice and Stockholding across Countries: What can we learn from the Life Cycle Model? ongoing) will put the workhorse life cycle model to a hard test, by evaluating how far one can get in explaining cross-country differences in participation and portfolio allocation if one single standard life cycle model is calibrated to country-specific parameters and then household-level data are used to simulate the portfolio behaviour of each household in the data set. The data will come from the HFCN data of selected countries once all of these data have been gathered. Le Blanc and Fecht (Provision Income, Financial Advice, and Portfolio Composition new and tentative) intend to investigate the incentives of commercial banks towards giving financial advice to their customers and the resulting composition of assets in banks and customers portfolios. Differences in the fraction of provision income in banks total income are large, and it will be interesting to study the corresponding portfolios of customer. The focus is on savings banks and credit cooperatives. 5. Saving, Pension and Old Age Provision Authors: Le Blanc, Scholl, Dimitrova Recent work Using SHARE data, Le Blanc (2011) has presented a micro-econometric analysis of private retirement saving across 11 European countries. While all countries have implemented similar measures to enhance private retirement saving, there are still striking differences in the propensity to save privately for retirement that have to be explained with differences in institutional settings and historical experiences. In a related project, Le Blanc and Scholl (2011) have investigated the optimal retirement savings behaviour, from the households own perspective, given different ways of implementing funded pension accounts. They employ a lifecycle model with exogenous stochastic labour income to analyze how certain types of taxdeferred individual accounts affect households consumption, savings and portfolio allocation decisions as well as welfare over the life cycle. Ongoing and new Le Blanc (Savings behaviour in Germany: the disaggregated view new) will work out the stylised facts on savings behaviour in Germany: How is participation distributed over socioeconomic groups (regarding saving in general and concerning important forms of savings, such as subsidised pension contracts) and how much is saved, conditional on participation. Similar questions will be dealt with on a Euro area level. Household finance is fraught with puzzles that put into question the standard model of utility maximization subject to rational expectations, an intertemporal budget constraint and a limited life time. It is well established that many elderly save too much but also the opposite may occur. The resource constraint embedded in the standard model predicts that towards the end of life, debts should be paid back in expectation. Dimitrova and Le Blanc (Why do households hold debt in old age? - new) are studying the indebtedness of elderly people, to look for deviations and if possible explain them. 6. Homeownership Decisions in Europe (new) Authors: HFCN members, Tobias Schmidt

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Buying a home is usually the largest investment a household makes over his life-time. It is also linked to substantial mortgage debt. The portfolio of assets and liabilities portfolio is thus starkly different for renters and owners. The high levels of debt associated with buying a home make households that own more vulnerable with respect to interest rate changes than renters. The effects of rising house prices are also different for tenants and owners. They represent a wealth increase for owners, but make it harder for tenants to buy a home. All these differences are particularly important when comparing households in the EU, given that statistics on homeownership show great variation in the share of renters and owners across countries. Understanding balance sheet structures in Europe thus has much to do with understanding homeownership decisions. In order to gain insight into the effects and determinants of homeownership in different European countries, a multi-country project is foreseen. The basis for the analysis is micro-data on household finances and housing from several European countries. Schmidt and others will look at the conditional distribution of wealth, demographics, housing value, and housing characteristics, according to ownership status. This should yield insight into how homeowners can be characterised in different countries and what it is that people own or rent. 7. Income distribution and the incentive effects from taxes and transfers (new) Authors: Zhu Knowing the sources of income, the tax incidence can be calculated. This, in turn is the basis for calculating marginal tax rates, which is the basis for all work on incentive effects of taxation. In terms of economic theory, individual behaviour is heavily influenced by taxes and transfers that distort the payoff structure of economic choices. The PHF data is rather comprehensive in terms of income and other generic characteristics governing tax burden and transfer entitlements. They will allow generating estimated marginal tax and transfers on an individual level. The dispersion of income and characteristics creates much heterogeneity that can be used to identify incentive effects. Important applications range from investment in subsidised private pension schemes (Riester and Rrup pensions) over homeownership (the real returns of homeownership are tax exempt, as there is no taxation of wealth or imputed rents in Germany), savings in general, labour market decisions (participation and hours worked) to family structure. Using tax data from one country, one has to deal with the problem that the marginal tax rate is usually strongly correlated with income, so that it is hard to take apart the incentive effects of taxation from various types of income effects. The HFCN data provide a different sort of identification: the variations of national tax codes. Zhu (The distribution of income and the incidence of taxation in Germany evidence from a new large scale panel survey -- new) will explore the household data along these two dimensions, as the basis for future work. As an example of how the data base can be used for tax simulations, Zhu will work out the distributional consequences of a revenue neutral switch from the German type marital status relief (Ehegattensplitting) to a a relief based on the size of the family (Familiensplitting). This may develop into a separate paper. The German splitting tariff for married couples may encourage negative assortative mating (ex ante) or a division of labour ex post, as the amount of the implicit subsidy is a function of income heterogeneity among spouses. The PHF database is unique, as it contains both the information on outcomes and the data necessary to work out incentives and balance sheet constraints on an individual level. Zhu (An empirical analysis of the interaction of marriage taxation and income heterogeneity within households, new) aims at exploring the role of family splitting for observed distribution of labour income within households. In the future, with the help of the panel dimension, we will be able to distinguish heterogeneity ex ante (assortative mating) and ex post (division of labour). 8. Methodological research Authors: Zhu, Schmidt, Le Blanc, Noack

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In their work on the PHF, team members are confronted with a host of methodological problems work that sometimes leads to novel solutions or interesting evidence on ongoing discussions. This generates a secondary type of research ussi methodological matters. This type of research isbeneficial, as it helps team members to develop expertise and a research profile. In addition to its immediate contribution for developing the survey as a resource for science, methodological research may help bridge the potential conflict between the motivation of researchers (both intrinsic and extrinsic) and the need of careful and meticulous data work. For this reason, there is a separate subgroup on methodological research within the HFCN, to which the Bundesbank is contributing. Recent work First outcomes in this vein are the discussion paper by Schmidt (2011) on fatigue in payment diaries. Ongoing and new projects A paper by Schmidt, Le Blanc and Noack (Knocking on Respondents Doors - Interviewers and Unit Non-Response in a Large Wealth Survey -- ongoing) is exploring the role of interviewer effects and stratification for unit non-response and non-contact in the course of the PHF-fieldwork. This paper will serve as a nucleus for a broader investigation of this topic within the HFCN, by Tobias Schmidt and others. In the PHF, all household members can give either gross or net figures for all types of income, Junyi Zhu (Conversion of gross and net income figures in household surveys: implementation and evaluation -- ongoing) has worked out an algorithm converting gross income to net income and vice versa, while endogenising the choice of tax classes. This may be of value for surveys on income and wealth in general, to reduce item-nonresponse and potential reporting bias. Zhu is participating in a cross validation exercise of multiple imputation models in the HFCN. Ultimately, he is investigating methods of data driven specification selection in the context of imputation models in complex data environment, which may also lead to a separate publication. Related research can be found in the group on banking regulation and supervision (Kick et al: The relationship of bank distress and household finance) and Financial stability (Barashinska: Households borrowing in Germany and its implication for financial stability). B. Firm finance, monetary transmission and financial stability In the past, Bundesbank research in the group was structured along two major research questions: 1) What determines firm investment and is there a special role of finance? 2) How are firm finance and innovation behaviour interrelated? The investment and innovation behaviour of firms are as important for the long.-run growth pat of an economy as the savings behaviour of household. Due to human resource constraints, both major topics are currently receiving much less attention than they deserve. A major resource for the work on firm finance is the Bundesbanks financial statement database, USTAN. It constitutes the largest source of accounting data for nonfinancial firms in Germany. This database is being used alone, or in combination with other firm level data. Recent work

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Hwer, Schmidt and Sofka (2011) have completed a paper on the financing of innovation, using firm-level data from the Mannheim Innovation Panel amplified by information on the firms house bank. It turns out that information asymmetry regarding the business prospect of firms varies over banks: banks are able to learn from what they observe in other innovative firms of their portfolio. This positive effect of information access needs to be balanced with correlated risk concerns. In the past, USTAN data were matched with survey information on investment and innovation, information on direct investment or labour statistics data. The large scale KombiFID project has matched all company level data bases held by the German National Statistical Office and the Institute for Labour and Employment (IAB) to USTAN, subject to availability - see the exposition on KombiFid in the preceding research program 2011/2012) and the project website www.kombifid.de. At the Bundesbank, this project has been the main responsibility of Biewen. Ongoing and new projects In follow-up work to the KombiFID match, Biewen (KombiFID: a first glimpse of the Bundesbank data ongoing ) assesses the quality of the contribution from the Bundesbank, in particular the selectivity bias. As a separate endeavor (A joint project on data linkage by Deutsche Bundesbank and Federal Employment Agency) the Bundesbank has joined forces with the Institute for Labour and Employment (IAB) to match their respective firm level information in order to create a new and powerful scientific resource. Apart from USTAN, the Bundesbank contributes the micro-databases of MiDi, the data base on foreign direct investment, as well as of the Trade in Services Statistics. The IAB will contribute establishment level data on employment in general, such as the employee structure, wages, the payroll etc. On the side of the Bundesbank, this work is again mainly the responsibility of Biewen. Kerstin Stahn (Fixed capital adjustment of German firms over the business cycle ongoing) uses USTAN and the Financial Statements data pool to follow firm fixed investment over the business cycle; This is feasible, since the data sets now cover a period of almost 40 years. To be seen is, first, whether the measured sensitivity of fixed investment for changes in the business environment varies with the business cycle. Second, the project intends to investigate the importance of sectoral heterogeneity. The USTAN data base has been matched to the Mannheim Innovation Panel (MIP) run by the ZEW. Currently, this database is used by Silbermann (Financial Constraints and Cyclicality of R versus D: Evidence from Germany -- ongoing) for research on how the cyclicality of R&D depends on firms financial constraints. Von Kalckreuth, Silbermann and Zhu (Liquidity, Financial Structure, R&D and Investment new) will be using the data base for studying the demand for liquidity by firms: if a firm is financially constrained, then initiating an R&D project should induce additional demand for liquidity, to ensure that an investment project can be financed in case the R&D is successful. Further related research can be found in the group banking structure (Bayer, Haselmann, Vig: Real effects of capital supply shocks on capital structure and investment decisions of German corporation). References Deutsche Bundesbank (2012), The PHF: a survey of household wealth and finances in Germany, Monthly Report, January, 29-45.

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Hoewer, D., T. Schmidt and W. Sofka (2011), An information economics perspective on main bank relationships and firm R&D, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 19/2011. Kamstra, M. J., L. A. Kramer, M. D. Levi and R. Wermers (2010), Seasonal Asset Allocation: Evidence from Mutual Funds Flows, mimeo. Le Blanc, J. (2011), The Third Pillar in Europe: Institutional Factors and Individual Decisions, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 09/2011. Le Blanc, J. and A. Scholl (2011), Optimal savings for retirement and pension reform: the role of individual accounts and disaster expectations, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 33/2011. Schmidt, T. (2011), Fatigue in payment diaries empirical evidence from Germany, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 11/2011. Zhu, J. (2010), Asset accumulation and learning: theory and evidence from saving for childs college, Stoney Brooks University New York, unpublished

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Research group Public finances: Interactions with the overall economy and sustainability JEL Codes: Members: Josef Hollmayr*, Gerhard Kempkes, Martin Kliem*, Michael Krause, Stphane Moyen*, Christoph Priesmeier*, Frank Somogyi*, Nikolai Sthler* (coordinator), Dan Stegarescu

Advisors/visitors/co-authors: Anja Baum (University of Cambridge), Niklas Gadatsch (WHU Otto Beisinger School on Management), Xiaobei He (University of Frankfurt), Gerrit B. Koester (ECB), Alexander Kriwoluzky (University of Bonn), Eric Mayer (University of Wrzburg), Samad Sarferaz (ETH Zrich), Almuth Scholl (University of Constance), Tim Schwarzmller (IfW), Bundesbanks Public Finance Division General interest, policy relevance and outline of the research programme The interactions of fiscal policy and the economy play a key role in public finances. Fiscal policy interacts in various ways with monetary policy, capital and labour markets and the real economy. Thereby fiscal policy can contribute to stable and sustainable developments, but it can as well have a negative and distorting effects. On the one hand, fiscal policy can have an important stabilising role in downturns or in times of crises, but on the other hand, it is of utmost importance that the trust of the public and financial markets in sustainable public finances and adequate monetary policy is preserved. The current debate is highly influenced by the observation of high public debt and increasing fears that sustainability could get lost. Therefore, the following research questions are of utmost interest: 1) What are the (short run) effects of fiscal policy, especially in times of high debt? 2) How to define long run sustainability of public finance? 3) How should a consolidation strategy look like, including the role of structural reforms (for example of the tax system)? The aim of this research group is to shed light on selected aspects of these questions. The programme of the group is organized according to the following three workstreams: public finance and the real economy, fiscal policy and labour markets as well as public debt and fiscal sustainability. Empirical studies of fiscal policy interactions increasingly rely on the wide range of dynamic time series models. These models are frequently applied for example in the analysis of the relationship between public finances and macroeconomic variables like growth or business cycles and in investigations of more disaggregated dynamic budgetary interactions like the responsiveness of a certain tax category to changes in its bases. Time series modelling proves particularly useful for taking the crucial dynamic interdependencies of macroeconomic variables into account when theoretical fiscal policy hypotheses and budgetary relationships are analyzed. On the empirical side, we plan to mainly analyse the impact of economic developments on fiscal balances as well as address the issue of long-run sustainability using variations of several VAR approaches. On the theoretical side, dynamic stochastic general equilibrium (DSGE) models provide a reliable tool for structural fiscal policy analyses and are gaining momentum recently. For example, the applications of such models include the assessment of temporary versus perma-

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nent fiscal stimulus, the assessment of structural changes in public tax and spending policy, the analysis of fiscal multipliers, the role of private demand and sovereign default as well as fiscal policys interaction with monetary policy. Using various DSGE frameworks, we plan to analyse the role of labour market frictions for the effectiveness of fiscal policy, simulate the European Recovery Plan and adopt a model of sovereign default to analyse the economic effects of the assumption of joint liability in an economic union. Recent work as well as ongoing and planned projects In 2011 the group tackled several projects related to the effects of fiscal policy, the perils of high and increasing public debt as well as ways and means to avoid inefficient fiscal stimuli and to ensure the sustainability of public finances. Several projects were triggered directly by our experiences during the crisis. a) Public finance and the real economy Non-linear effects of fiscal policy on GDP growth over the business cycle are analyzed by Baum and Koester (2011), who expand the SVAR approach by Blanchard and Perotti (2002) to a threshold SVAR building on adoptions of threshold VAR models in monetary policy. They find that fiscal multipliers have been generally moderate but in times of output below trend substantially higher than on average, a finding that applies in particular to the government spending multiplier. Hollmayr (2011) sets up a New-Keynesian model for each of the eleven original member countries of the Euro area and ties them together with the GVAR methodology of trade weights to obtain a fully structural multi-country model for the whole currency union. Each country is estimated with Bayesian methods on the same observable variables and with the same priors. He finds that spillovers from a government spending shock in one country are negative. This is due to the fact that the interest rate channel dominates the trade channel. The monetary transmission upon a shock to the common Taylor rule yields heterogeneous effects on output and inflation. Stabilization policy dictates for the central bank to target inflation as aggressively as possible and for the fiscal branch to react heavily to deviations of debt from its steady state. Overall, for the evolution of key macroeconomic variables, fiscal shocks and spillovers seem to be less important than monetary shocks. This setup may result to be appropriate investigating more macroeconomic questions in a currency union. In this workstream, we are planning the following papers: Kster and Priesmeier (ongoing) want to evaluate the gradually evolving reaction pattern of German primary deficits to changes in the business cycle in time-varying VAR analyses. They plan to present empirical evidence for the major driving forces of the observable timevariation and want to compare their findings to the fiscal responsiveness in the US. Using a model framework in line with Sthler and Thomas (2012) as well as the Bundesbanks DSGE model, Gadatsch and Sthler (ongoing) plan to evaluate the economic effects of the European Recovery Plan and the consequences of expansionary fiscal policy conducted in Germany with a special focus on the spillovers to the rest of EMU. The latter issue is subject to intense discussions within the euro area. Hollmayr (ongoing) plans to establish a two country New-Keynesian model for a currency union building on Hollmayr (2011) estimated with Bayesian methods for data on Ireland and the rest of the euro zone. A number of questions can be answered with this setup: How does the presence of a financial accelerator affect the distribution of capital within the monetary union upon a shock to the capital tax rate and what stabilizing measures should both the monetary as well as the fiscal side use. Furthermore the macroeconomic consequences of a race to the bottom in the capital tax rate will be analyzed. First results suggest that, if asset

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prices in the small country undergo a boom-bust scenario, monetary policy should only lean against the wind if it is concerned about output. Furthermore, fiscal authorities seem to have even less incentives to target asset prices. Somogyi (new) assesses the effects of tax competition on income sorting using a regression discontinuity approach. Since Tiebout (1956), the question how differences in taxation influence the residential location choice is an ongoing issue in public finances. To address this question, the author uses a new micro dataset of the Swiss household panel which allows setting up the empirical problem as a quasi-experiment and, thus, solves the endogeneity problem present in the commonly used IV-approaches. b) Fiscal policy and labour markets Schwarzmller and Sthler (2011) extended the medium-scale two-country monetary union model with a frictional labour market developed by Thomas and Sthler (2012) by endogenous hiring and firing decisions of firms. This model has been used to analyse several labour market reforms currently under discussion, including a decrease in unemployment compensation, a cut in public employment and wages, lowering trade unions bargaining power and a reform of the employment protection legislation. The analysis finds that, in terms of output, employment and international competitiveness, reforms decreasing the workers outside options (such as a decrease in unemployment benefits, public sector wages and public employment) seem most beneficial to foster output, private-sector employment and competitiveness. Weakening trade unions also accomplished these goals, however at the cost of higher labour turnover. Reforming employment protection, at least when not applied at the right place may be counterproductive. There are two ongoing projects which can be seen as a follow up of this workstream: Mayer et al. (2010) show that and how liquidity-constrained households and involuntary unemployment resulting from a search labor market can affect the fiscal multiplier. Extending their model by allowing for a tractable way of introducing heterogeneous agents in lagerscaled DSGE framework, two additional research projects will be pursuit: First, He, Moyen and Sthler (ongoing) plan to use the extended model in order to address optimal tax policy across the business cycle. Arseneau and Chugh (2008, 2009) have shown in a DSGE model with a search labor market tax smoothing may no longer be optimal in such an environment. 2 It is interesting to assess to which extent this results still holds whenever a clear desire for consumption smoothing by liquidity-constrained households exists. Should the results no longer hold, it must be analyzed what exactly causes the changes. Second, Mayer, Moyen and Sthler (new) plan to use the extended framework to check how the framework with heterogeneous agents may change the fiscal multiplier derived in Mayer et al. (2010). Given the recent discussion on again using fiscal policy to stimulate the economy, a better understanding of the effects in presence of heterogeneous agents is of great importance. c) Public debt and fiscal sustainability In 2011 we completed one empirical paper inspired by the observation that public debt and expenditures are showing an upward trend which gained additional momentum in the recent crisis and endangers the long-run sustainability of public finances. The group found it impor2

The key to understanding the tax smoothing result in conventional models without a frictional labor market is that, there, wages are tightly connected to fluctuations in aggregated variables and, especially, output. Hence, stabilizing tax smoothing stabilizes wages, the consumption path and output. In presence of a matching labor market in which firms and worker bargain over wages, the link between wages and output is not so strict, however, and the desire to stabilize output by stabilizing the evolution of wage along the cycle must not occur. The reason for this is that, in principle, there is a huge range of wages which workers and firms would be willing accept in a matching environment.

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tant to improve our understanding of these developments, not least to be able to develop strategies how to overcome this trend. Kster and Priesmeier (2011a) studied the relationship between revenues, expenditures and economic development in Germany. In their VECM analysis they find evidence that government spending increases with economic development in the long run (Wagners law) and also revenue and expenditure developments are closely related. As a consequence public finances got on an unsustainable path after heavy exogenous shocks on the deficit. Their findings underline that an analysis built on common trends in expenditures and revenues is not sufficient for fiscal sustainability. Moreover, they recall the importance of the German debt brake for re-establishing sustainable public finances in Germany. Furthermore, Sthler (2011) provided a comprehensive overview of the literature on quantitative models of sovereign default. The current crisis has reawakened interest in sovereign defaults in general as well as in stabilisation measures aimed in particular at preventing the occurrence of such events. The debate in the euro area shows that such issues are no longer confined to developing countries but are also becoming increasingly more relevant for developed economies. Topics, such as contagion, suitable insolvency legislation or a workable at least partial assumption of joint liability in the context of the European Stability Mechanism (ESM), the European Financial Stability Facility (EFSF) and even Eurobonds, for example, have made it onto the agenda (see Arghyrou and Kontonikas, 2011). Extending this model class seems promising for developing structural models to assess these questions on a theoretical basis. There are three ongoing projects in this workstream: Scholl and Sthler (new) plan to use a quantitative model of sovereign default in line with Arellano (2008) extended by a two-country structure in the manner of Lizarazo (2009, 2010). The latter paper also includes risk-averse investors. In a first step, we assume the no-bailout clause holding. Then, we introduce joint-liability of sovereign debt in form of guarantees, supporting loans and common bonds. All these schemes are then compared to the situation with the no-bailout clause holding in terms of default probabilities, interest rate movements and welfare. Kliem, Kriwoluzky and Sarferaz (ongoing) pose the question what the long-run implications of an increase in public debt are. The authors estimate a time-varying VAR model consisting of fiscal data for the U.S. between 1792 and 2010.In particular, the project focuses on the frequency-characteristics of the U.S. public debt, e.g. the effects of higher public debt on output growth and inflation, and historical changes over time. Moreover, the authors analyze the long-run expectations about future public debt evolvement at different points in time. Stegarescu (ongoing) is investigating the factors determining government finances of the German Lnder over a long period of time (1974-2011). Despite similar institutions, extensive federal legislation in most areas and nearly completely equalized per capita revenues, the fiscal stance and the debt level of the Lnder is highly diverging with some Lnder pursuing clearly unsustainable fiscal policies. Preliminary results of the panel analysis indicate that the ratio of wages and salaries and other operating expenditure (government consumption) to government investment in fixed assets has a debt increasing impact, whereas expenditure allocation by government functions plays no conclusive role. d) Further projects Generally the sustainability of fiscal policy will continue to play a dominant role in the fiscal policy arena and will be an important aspect to be taken into account in future research projects. This will not only apply to the projects directly focusing on public debt and fiscal sus-

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tainability, but as well e.g. to the design of the ongoing studies of public finance interactions with the real economy and monetary policy. Koester and Priesmeier (2011b) expanded an existing study on the elasticities of profitrelated taxes (see Priesmeier et al., 2009) including a longer and newly compiled data set starting in 1970 for profit-related, wage and value added taxes. They find substantially lower long-run elasticities for profit-related taxes compared to previous studies and slightly lower ones for value-added taxes, whereas the long-run elasticity for wage tax is close to the consensus estimate in the literature. Additionally, there is evidence that differences between short- and long-run elasticities are especially important with respect to profit-related taxes. Here they estimate a far lower contemporaneous response than that currently applied in tax forecasting and cyclical adjustment, as well as a dynamic reaction pattern spanning several years, which can be explained by tax collection lags. They plan to allow for asymmetric reaction patterns and to evaluate their findings with respect to tax revenue forecasts. References Arellano, C. (2008), Default risk and income fluctuations in emerging economies, American Economic Review, 98, 690-712. Arghyrou, M. G. and A. Kontonikas (2011), The EMU sovereign-debt crisis: fundamentals, expectations and contagion, European Commission, Economic and Financial Affairs, Economic Paper, 436. Baum, A. and G. B. Koester (2011), The impact of fiscal policy on economic activity over the business cycle evidence from a threshold VAR analysis, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 03/2011. Blanchard, O. and R. Perotti (2002), An empirical characterization of the dynamic effects of changes in government spending and taxes on output, The Quarterly Journal of Economics, 117(4), 1329-1368. Deutsche Bundesbank (2008), Entwicklung der Steuereinnahmen in Deutschland und aktuelle steuerpolitische Fragen, Monatsbericht, Oktober, S. 35. Hollmayr, J. (2011), Fiscal spillovers and monetary policy transmission in the euro area, mimeo. Kster, G. B. and C. Priesmeier (2011a), Does Wagners law ruin fiscal sustainability in Germany?, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, forthcoming. Kster, G. B. and C. Priesmeier (2011b), Estimating dynamic tax revenue elasticities in Germany, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, forthcoming. Lizarazo, S. V. (2009), Contagion of financial crises in sovereign debt markets, ITAM Discussion Paper Series, 09-06. Lizarazo, S. V. (2010), Default risk and risk averse international investors, MPRA Discussion Paper Series, 20794. Mayer, E., S. Moyen and N. Sthler (2010), Government expenditures and unemployment: a DSGE perspective, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 18/2010.

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Morris, R., C. Rodrigues Braz, F. de Castro, S. Jonk, J. Kremer, S. Linehan, M. R. Marino, C. Schalck and O. Tkacevs (2009), Explaining government revenue windfalls and shortfalls: an analysis for selected EU countries, ECB Working Paper Series, 1114. Priesmeier, C., G. Kempkes, G. B. Koester and J. Kremer (2009), Econometric estimation of tax elasticities Evidence from applications to profit-related taxes in Germany, Paper prepared for the WGPF methods group, September. Schwarzmller, T. and N. Sthler (2011), Reforming the labor market and improving competitiveness: an analysis for Spain using FiMod, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 28/2011. Sthler, N. (2011), Recent developments in quantitative models of sovereign default, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 17/2011. Sthler, N. and C. Thomas (2012), FiMod a DSGE model for fiscal policy simulations, Economic Modelling, 29(2), 239-261. Tiebout, C. M. (1956), A pure theory of local expenditures, Journal of Political Economy, 64(5), 416-424.

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Research group International Integration, international shocks and external imbalances JEL Codes: Members: F02, F14, F15, F21, F23, F31, F32, F33, F36, F4, C2, C3, C68, E3 Elena Biewen*, Sven Blank*, Sandra Eickmeier* (coordinator), Christoph Fischer* (coordinator), Rainer Frey*, Annette Frhling*, Sabine Herrmann*, Mathias Hoffmann*, Oliver Hossfeld*, Axel Jochem*, Alexander Lipponer*, Kirsten Lommatzsch*, Norbert Metiu*, Tobias Schmidt*, Frank Somogyi*, Kerstin Stahn Claudia Buch (University Tbingen), Cornelia Dwel (University Gieen), Iris Kesternich (University Munich), Jrn Kleinert (University Graz), Cathrine Tahmee Koch (University Zrich), Monika Schnitzer (University Munich), Farid Toubal (University dAngers)

Advisors:

General interest and policy relevance Traditionally, economists have emphasised the beneficial welfare effects of international integration, such as better risk-sharing or a reduction in transaction costs. However, more integration may also mean more unwelcome external shocks. Furthermore more integration may foster external imbalances which prove unsustainable in the longer run. The discussion about such drawbacks became more lively in the course of the recent crisis, as external imbalances (worldwide and inside EMU) were blamed as one reason for and international contagion was seen as an important ingredient of the crisis. The group plans to shed more light on the degree of international integration, the various channels through which shock transmission works, and the effects of international integration (for example regarding real convergence or price developments). Regarding the channels, it analyzes more carefully the role of the exchange rate (regime), the role of international banks and multinational firms (FDI and of international service trade). A special focus lies on heterogeneity in the euro area. Research in the group thus contributes to the Competitiveness Network newly established in the Eurosystem. The research programme is organised around three workstreams, which deal with a variety of research questions: 1) State of international integration and channels through which it is accomplished: What is the state of international (and European) integration? Do we observe a home bias? What is the role of international banks and multinational firms? What drives trade in services and how does it affect the labour market? 2) External imbalances: Are external imbalances a problem and if yes, how can we reduce them? What is the role of the exchange rate (regime)? 3) Effects of international integration: How do shocks propagate internationally? Is international integration helpful for risk diversification? Does international integration foster real convergence? For each of the topics, the research programme briefly presents recent work which has been finalised or published during 2011 as well as ongoing and planned projects. A full list of references to the papers is provided at the end. State of international integration and channels through which it is accomplished

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a) Home bias Harms, Hoffmann and Ortseifer (2010) show that including distribution costs in a general equilibrium model of international portfolio choice helps to explain the home bias in international equity investment. In contrast to earlier work, their model is able to replicate observed investment positions for a wide range of parameter values, even if agents have an incentive to hedge labour income risk by purchasing foreign equity. Other explanations for the home bias are examined in more detail in Jochem and Volz (2011). The authors identify the determinants of portfolio restructuring in EMU member states since the introduction of the euro and especially during the financial turbulence of the past years. Besides traditional indicators of information and transaction costs as well as monetary and financial institutions, the perception of sovereign risk seems to have become a major determinant of portfolio allocation inducing a retreat into the home haven with which the investor is familiar. b) The role of globally active banks Herrmann and Mihaljek (2011) study the nature of spill-over effects in bank lending flows from advanced to emerging market economies and identify specific channels through which such effects occur. Based on a gravity model, the empirical analysis suggests that global as well as country-specific factors are significant determinants of cross-border bank flows. Greater global risk aversion and expected financial market volatility seem to have been the most important factors behind the decrease in cross-border bank flows during the recent crisis. Buch, Koch and Ktter (2011) analyse how the lending and borrowing of foreign affiliates of German banks has responded to domestic and US crisis support schemes. One of their findings is that banks covered by rescue measures of the German government have increased their foreign activities after these policy interventions, but they have not expanded relative to banks not receiving support. Dwel, Frey and Lipponer (2011) show that the change in German parent banks' crossborder lending is based almost exclusively on supply-side determinants, in particular on bank-specific factors. However, foreign countries demand and risk characteristics become relevant when loans are distributed by affiliates abroad. As a further finding, rising risk aversion among banks curbed cross-border lending during the financial crisis. Dwel and Frey (Competition for internal funds within multinational banks. Foreign affiliate lending in the crisis, ongoing) investigate the long-term loan supply by affiliates of large German banks both before and during the financial crisis. First results show that affiliates of large parent banks that collected more deposits and generated more income were more likely to extend credit abroad. Multinational banks increasingly concentrate their intrafunding resources on the important and profitable business fields abroad. In case of support, intra-bank funds are rather provided by the parent banks which are well capitalized. In the crisis, parent banks hold back funding capacities for their lending at home which belongs to their core activities. A related project focuses rather on the hierarchical structure of bank holding companies (BHCs). Koch, Sofka and Schmidt (Mandates and autonomy in the global banking crisis,ongoing) assess the impact of a rapid decline in locational advantages, as triggered by the crisis, on German BHCs foreign affiliates and the extent to which their respective strategic set-ups (mandate and degree of autonomy) have shaped the way foreign affiliates cope with the crisis. The study draws, inter alia, on microdata from the External Positions Report of German Banks.

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A third project on this topic, Schmidt, Sofka and Koch (The subsidiary portfolio of international BHC through the crisis, new) also uses the External Positions Report of German Banks to analyze the response of German BHCs and their affiliates to the crisis. The novel feature of this study is that they treat the BHC as a portfolio of subsidiaries and look at interdependencies between them. The goal of this study is to gain new insights into how BHCs deal with volatile host country environments and into the effectiveness of responses at different organizational levels, namely headquarters, portfolio and subsidiary. More projects on the role of global banks can be found in the group Banking structure. c) The role of trade in services Two further projects exploit Bundesbank micro-level databases on trade in services. In their project Margins of German trade in services (ongoing) Biewen and Blank describe the pattern of German firms international services trade. They proceed in two steps: First, they decompose the volume of services traded into different margins. This decomposition reveals how much each margin contributes to the cross-sectional variation of service exports and imports as well as to fluctuations over time. Second, they ask whether trade volumes and the corresponding margins are driven by country characteristics using macroeconomic and gravity-type variables. Biewen, Harsch and Spies study The determinants of service imports: internal versus external frictions (ongoing) provides evidence on how German multinational firms restructured their service activities during the last decade. The authors assess the determinants of service offshoring along the extensive and intensive margins. In particular, they evaluate how internal frictions in terms of a lower sales level (per employee) and external frictions in terms of a reduced availability of credit co-determine the likelihood and the extent of sourcing services from abroad. Research in this field will also contribute to the recently started ESCB wide research network on Competitiveness (Compnet) To facilitate further research on trade in services, the Balance of Payments statistics will be matched with the Bundesbanks data on corporate balance sheets as well as data on firms foreign direct investment. In addition, it is planned to augment the database by data from the Research Institute of the German Federal Employment Agency (IAB) which provides detailed information on the employment structure at the firm-level. Such a data base will help to realize research on labour effects of international trade of services in the future. External imbalances and exchange rates a) Understanding external imbalances Hoffmann, Krause and Laubach (2011) have examined the extent to which the U.S. current account can be understood in a purely real open-economy DSGE model, where agents perception of long-run growth evolves over time in response to changes in productivity. They first show that long-run growth forecasts based on filtering actual productivity growth comove strongly with survey measures of expectations. Including data on US TFP growth and the world real interest rate, the model is shown to be able to explain, under standard parameterisations, the evolution of the US current account quite closely. Hoffmann and Krauses project Explaining cross-country difference in the specialization of production (new) focuses on heterogeneity in the production structure across countries. They aim to examine, in a DSGE model with an endogenous production structure, why some countries production is concentrated on services that are mostly sold domestically, while the production of other countries (including Germany) is concentrated on exports.

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Turning from current account imbalances in a global context to trade imbalances on a European level, Lommatzsch (Diverging export performance of euro area member states: the role of price and non-price competitiveness, ongoing) investigates whether the consideration of non-price competitiveness factors in export equations helps explain the divergence in export performance observed in the euro area member states since euro inception. First results indicate that the most relevant additional influences are the extent of innovation and research, the share of high-technology sectors, participation in vertical specialisation (outsourcing), the profitability of the exporting sectors, and alternative business opportunities offered by the domestically oriented sectors (real estate, construction, retail trade). b) The role of the exchange rate regime Hoffmann and Tillmann (2012) provide panel evidence from a large set of advanced and emerging economies that greater financial integration (measured as a greater foreign assets and liabilities-to-GDP ratio) raises national price levels under managed exchange rate regimes and lowers them under floating exchange rates. They show that these results can be replicated by a two-country open-economy sticky price model under either segmented or complete asset markets. Thus, the paper proposes a novel argument to rationalise systematic deviations from purchasing power parity. In a follow up project (International investment positions and capital flows: the role of the exchange rate regime choice, new), Hoffmann plans to analyse in a two-country general equilibrium model with endogenous international portfolio choice the repercussions of the exchange rate regime choice for international integration in the form of capital flows and the composition of the international investment position. Fischer (2011) considers the two major currency blocs of the present world. He uses nested logit regressions to investigate the long-term structural determination of anchor currency choice. Since it is found that the estimated parameters are consistent with an additive random utility model interpretation, the study goes on to test for each country whether its estimated utility would rise if the country chose an alternative exchange rate regime. Finally, a currency bloc equilibrium is derived. A current project which is concerned with the related subject of the choice of a pricing currency is Buzaushina, Enders and Hoffmanns International financial markets influence on the pricing currency choice (ongoing). They explore the effects of financial market integration on the optimal choice of the pricing currency in the context of sticky nominal goods prices and find that price setters optimally move towards more local-currency pricing while the optimal debt portfolio includes more foreign assets following increased financial integration. By this, a positive link between home bias in portfolio choice and pass-through is generated, as observed in the data. In the project Macroeconomicpolicy coordination and microeconomic FDI incentives (new) Biewen, Buch and Kleinert aim to contribute to two questions: How does FDI react to real rate changes, and how does FDI react to policy measures aimed at reducing external imbalances in the euro area? The authors will apply firm-level data in their analysis. The outcome of this project could also serve as an input to Compnet. Turning to the topic of exchange rate determination, Hossfeld (Economic uncertainty and safe haven currencies: a factor augmented CVAR approach, ongoing) attempts at isolating the effects of safe haven flows on exchange rate movements. Methodologically, it is planned to combine a factor model and a cointegrated VAR model, where the factors should reflect economic uncertainty. They will be integrated into an otherwise standard behavioural equilibrium exchange rate model. The analysis will focus on effective exchange rates in order to show how international price competitiveness is affected by safe haven flows.

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Effects of international integration a) International shock transmission Eickmeier, Lemke and Marcellino (2011) analyse the changing international transmission of US financial shocks over the period 1971-2009. They use a factor-augmented VAR (FAVAR) model which allows for time variation in the parameters. They find inter alia that positive US financial shocks have a considerable positive impact on growth in other countries. The transmission to GDP growth in European countries has increased gradually since the 1980s, consistent with financial globalization. The size of US financial shocks varies strongly over time, with the `global financial crisis shock being very large by historical standards and explaining 30 percent of the variation in GDP growth on average over all countries in 20082009. In a related paper, Eickmeier and Ng (2011) study how shocks in credit supply to the private sector in the US, the euro area and Japan are transmitted to other economies. They use the recently-developed Global VAR approach (GVAR) to model credit to the private sector and credit spreads jointly with output, inflation and other financial variables in advanced and emerging economies. Trade and different types of financial weights are used to link the countries together. The authors use sign restrictions to identify credit supply shocks and investigate their dynamic international transmission in the GVAR. It is found that shocks to the supply of US private credit in particular have strong effects on GDP in foreign countries. Credit and foreign exchange markets are strongly involved. In their current project Understanding global liquidity (ongoing), Eickmeier, Gambacorta and Hofmann extract interpretable global liquidity (monetary policy, credit supply and credit demand) factors from a large dataset of interest rates, monetary and credit aggregates covering lots of advanced and emerging market economies. They analyze the temporal evolution of the factors, their importance for individual countries and variables and their predictive content for global growth and inflation. In future work they plan to assess in detail the interaction between emerging market and advanced economies liquidity. The project of Buch, Lipponer, Niles-Russ and Schnitzer (Large banks and regional macroeconomic volatility, new) considers more specifically the repercussions of shocks to large banks. They explore the implications of granularity in the banking sector for macroeconomic stability using Bundesbank micro data on German banks. The key research questions to be dealt with are: How important are (idiosyncratic) shocks hitting large banks for the real economy? Are shocks hitting those banks abroad transmitted to the domestic real economy? In China's Role in Global Inflation (new), Eickmeier, Khnlenz and Slopek analyze to what extent Chinese supply and demand shocks contributed to global inflation in the past 2 decades. They use a FAVAR which includes macroeconomic variables from OECD countries and a few Chinese variables which capture Chinese demand and price or wage developments. They assess heterogeneity across countries in the response to the Chinese shocks and analyze the role of different transmission channels by assessing their impact on unit labor costs, import and export prices, commodity prices and exposure to foreign competition. Somogyi is preparing the study Food prices and political stability (ongoing). In the last years, increased food prices led to political instability in developing countries. The relationship between inflation and political instability is well documented in the literature. A link to food prices has, however, not yet been established. The goal of this project is to examine this link. The project further tries to understand which institutional and economic factors determine the food price pass-through to inflation and political instability in various countries.

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Herrmann and Kleinert (International capital flows: Lucas Paradox, Allocation Puzzle and the financial crisis, new) examine the Lucas Paradox as well as the Allocation Puzzle of international capital flows by referring to a panel data set of EMU countries as well as major industrialized and emerging economies. They want to shed light on the question to what extent the euro area is different and which factors contribute to the fact that in contrast to the global level the neoclassical theory applies quite well in the euro area. The project further investigates whether the financial crisis changed the pre-crisis capital flow structure. In addition to standard panel estimators, spatial econometrics techniques are used to explore spillover effects which depend on trade and financial linkages. b) Risk sharing Despite home bias in equities, investment in domestic multinational firms may contribute to international portfolio diversification as these firms are less prone to shocks originating at home. Blank and Hoffmanns project Risk sharing and the international diversification in production (ongoing) investigates the impact of firms multinational activities on crosscountry risk sharing in a DSGE framework where firms may choose to locate stages or most of the production process abroad. Their setup explicitly takes account of households international equity investment decisions, which leads to an endogenously determined portfolio allocation in equilibrium. Blank (The impact of frictions in goods and financial markets on international consumption risk sharing, ongoing) analyses the consequences of frictions in goods and financial markets for the allocation of risk across countries. As firms are heterogeneous in this setup and trade is subject to fixed costs of exporting, the extensive margin of trade in goods is determined endogenously and responds to unanticipated changes in macroeconomic conditions. In addition, firms operations depend on external finance which is subject to credit constraints. Thus, the framework enables to analyze the interplay of real activity and financial conditions and the impact on international consumption risk sharing. c) Heterogeneity and convergence in the euro area Frhling and Lommatzsch (2011) focus on the heterogeneity across product categories. They investigate output sensitivity of inflation in the euro area using price indices at the COICOP 4-digit level, inter alia by extracting the first common factor from the disaggregated prices. The results indicate that two thirds of the items in the euro area HICP are cyclically sensitive. The domestic business cycle is found to be an important determinant of inflation but given the weak factor structure of disaggregated prices it is only one among a number of nearly equally important factors. Fischer (2012) examines whether the establishment of the EMU caused price convergence, ie a reduction in heterogeneity, among member states. He uses an extremely detailed and comprehensive scanner database on washing machine prices and sales volumes for 17 European countries to perform a hedonic regression which yields country-specific time series for quality-adjusted price differentials. Log t tests firmly reject price convergence among EMU countries. Small convergence clusters can be identified but they are unrelated to EMU membership. A more general analysis of convergence patterns in the EMU will be performed in Borsi and Metius project Regional economic convergence and its determinants (ongoing). They will investigate economic convergence using aggregate macroeconomic variables for European regions and countries with a special focus on members outside the monetary union. A recently developed clustering algorithm and convergence test to form convergence clubs will be employed to estimate the speed of convergence over the last two decades. Subsequently, they intend to investigate the extent to which regional characteristics can account for the differences in the speed of convergence between the identified convergence clubs.

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A different aspect of heterogeneity, the prevalence and transmission of country-specific shocks will be examined in Eickmeier and Straccas project Has EMU changed the transmission of country-specific shocks in the euro area? (ongoing). They plan to estimate country-specific macroeconomic shocks and analyse their propagation to individual euro-area countries. They use a Global VAR model, which allows controlling for common shocks, and assess whether the transmission has changed with the handover of monetary policy to the ECB and whether the shock adjustment in euro-area and non euro-area countries differs. References Buch, C. M., C. T. Koch and M. Ktter (2011), Crises, rescues, and policy transmission through international banks, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 15/2011. Dwel, C., R. Frey and A. Lipponer (2011), Cross-border bank lending, risk aversion and the financial crisis, Deutsche Bundesbank Discussion Paper, Series1: Economic Studies, 29/2011. Eickmeier, S., W. Lemke and M. Marcellino (2011), The changing international transmission of financial shocks: evidence from a classical time-varying FAVAR, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 05/2011. Eickmeier, S., W. Lemke and M. Marcellino (2011), The changing international transmission of financial shocks: evidence from a classical time-varying FAVAR, CEPR Discussion Paper, 8341. Eickmeier, S. and T. Ng (2011), How do credit supply shocks propagate internationally? A GVAR approach, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 27/2011. Eickmeier, S. and T. Ng (2011), How do credit supply shocks propagate internationally? A GVAR approach, CEPR Discussion Paper, 8720. Fischer, C. (2011), Currency blocs in the 21st century, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 12/2011. Fischer, C. (2012), Price convergence in the EMU? Evidence from micro data, European Economic Review, forthcoming. Frhling, A. and K. Lommatzsch (2011), Output sensitivity of inflation in the euro area: indirect evidence from disaggregated consumer prices, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 25/2011. Harms, P., M. Hoffmann and C. Ortseifer (2010), The home bias in equities and distribution costs, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 24/2010. Herrmann, S. and D. Mihaljek (2011), Determinants of cross-border bank flows to emerging markets new empirical evidence on the spread of financial crises, BOFIT Discussion Papers, 03/2011. Herrmann, S. and D. Mihaljek (2011), Determinants of cross-border bank flows to emerging markets new empirical evidence on the spread of financial crises, in: Capital flows to converging European economies from boom to drought and beyond, European Economy, Occasional Paper, 75, Proceedings of the Workshop held on 1 October, European Commission, Brussels.

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Hoffmann, M., M. Krause and T. Laubach (2011), Long-run growth expectations and global imbalances, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 01/2011. Hoffmann, M. and P. Tillmann (2012), Integration financial integration and national price levels: the role of the exchange rate regime, Journal of International Money and Finance, forthcoming. Jochem, A. and U. Volz (2011), Portfolio holdings in the euro area home bias and the role of international, domestic and sector-specific factors, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 07/2011.

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Research group Forecasting, Early Warning and Monetary Policy JEL Codes: Members: C1, C46, C5, C61, E32, E37, E47, E58, F41, F47, G01, G12, G17, G33 Dirk Bleich, Sandra Eickmeier, Andreas Einsenbraun, Michael Fischer, Victoria Galsband, Klemens Hauzenberger*, Mevlud Islami, Malte Knppel*, Phillip Koziol, Jeong-Ryeol Kurz-Kim* (Coordinator), Vladimir Kuzin, Jens Mehrhoff, Norbert Metiu*, Andreas Rthig, Michael Scharnagl, Guido Schultefrankenfeld*, Alexander Schulz, Christian Schumacher* (Coordinator), Kai Tnzler, Birgit Uhlenbrock, Karsten Webel, Mark Weth, Laura Wichert, Rafael Zajonz

Advisors/visitors: Jrg Breitung (University of Bonn), Sylvia Kaufmann (OeNB) General interest, policy relevance and outline of the research programme Forecasting is an indispensable element in the decision-making process of most central banks. As a part of their communication strategy, many central banks publish their forecasts in order to increase transparency and to guide expectations of future monetary policy. In the monetary policy strategy of the Eurosystem, projections of key macroeconomic variables play an integral part. The Broad Macroeconomic Projection Exercises (BMPE) are carried out in the context of the Eurosystem, comprising the ECB and the national central banks of the euro area. In the European System of Central banks (ESCB), which comprises the ECB and the national central banks (NCBs) of all EU Member States, the Bundesbank has to contribute to the Working Group on Forecasting (WGF) and the Working Group on Econometric Modelling (WGEM). Specific challenges have emerged from the recent financial crisis. Following these developments, research in the Eurosystem has become more focused on the ability of early warning indicators to predict financial market developments, risks for financial stability and the consequences for the real economy. The Bundesbank is also involved in the Early Warning Systems and Systemic Risk Indicators group of the ESCB Macro-prudential Research Network (MaRs). The Forecasting, Early Warning, and Monetary Policy research group evaluates and develops econometric forecast models and methods relevant for the Bundesbank tasks and the Eurosystem. The work of the group comprises two work streams: 1) macroeconomic forecasting, and 2) early warning. The groups work stream on macroeconomic forecasting focuses on the following topics and research questions: How can we improve the forecast accuracy of output and inflation? Attempts to answer this question should lead to improvements in the suite of forecast models employed in the regular forecast exercises of the Bundesbank. How can we exploit financial data for forecasting? Furthermore, how can the real effects of crashes in stock markets be identified and quantified? How can we exploit international data for forecasting national developments? How should central banks produce and evaluate probabilistic forecasts? The group investigates forecast uncertainty and forecast risks, which are, for example, used in the construction of fan charts.

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The Bundesbank maintains a real-time database named GERDA, see Knetsch (2010), consisting of historical vintages of German macroeconomic time series. These data are important to analyze a variety of open issues in economic analysis and forecasting. One question is how important the statistical revisions actually are and whether they matter for forecasting.

The work stream on early warning focuses on the following research topics:

Early warning and alarm index:

Historically stock market crashes often have triggered serious problems in the real sector and the financial system. Therefore we aim to develop an early warning model for stock market crashes. Our early warning model is based on two aspects which are well-founded in the literature: a stable long-run relationship between fundamental values and stock price, as well as the herding behavior of stock market investors. Using the early warning model, an alarm index for stock market crashes is provided. By doing this, various econometric and statistical methods are investigated and refined to capture early warning indicators.

The group aims to contribute to a better understanding of sharp stock market movements and to what extent regulatory measures can help to reduce the risk of exuberance in stock market price developments. The group aims to contribute to a better understanding how stock market crashes can affect the real economy.

Work stream 1: Macroeconomic forecasting Recent Work at the Bundesbank To improve the forecast performance of the existing methods and models, the research group in 2011 continued to work on topics related to nowcasting quarterly GDP. Nowcasts can be regarded as projections of current-quarter GDP growth using higher frequency data. The projects carried out by the group take account of realistic real-time data problems, such as mixed sampling frequencies and ragged-edge data due to different statistical publication lags. Kuzin, Marcellino and Schumacher (2011) have compared recently developed mixed-data sampling (MIDAS) regressions using single indicators with mixed-frequency VAR models in relation to forecasting euro area GDP using monthly indicators. Kuzin, Marcellino and Schumacher (2012) have investigated the performance of pooling versus model selection for nowcast models, and found a very robust performance of pooling in six industrialized countries. Foroni, Marcellino and Schumacher (2011) have discussed unrestricted MIDAS (U-MIDAS) regressions, a variant of MIDAS with more general lag polynomials than in the literature. The group has also worked on factor-augmented VAR (FAVAR) models. Eickmeier, Lemke and Marcellino (2011) explore a FAVAR with smoothly time-varying parameters based on frequentist methods. The paper assesses changes in the transmission mechanism of monetary policy in the US and evaluates its predictive ability. Likewise related to the empirical estimation of factor models is the paper by Breitung and Eickmeier (2011), which proposes statistical tests for structural breaks in the factor loadings with applications to the United States and the euro area. Two projects have investigated the role of international data for forecasting. One project was concerned with New Zealand as a small open economy, see Eickmeier and Ng (2011), and the other one concerned with the German economy, see Schumacher (2010). Both papers show that only sophisticated variable preselection methods help to identify those inter-

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national indicators that improve forecasts in factor model and multiple regression frameworks. Together with the staff of the Economics Department, the team has also contributed to the regular forecast exercises of the Bundesbank by making use of the nowcast methods addressed in the research papers above. The favourable pooling results in Kuzin, Marcellino and Schumacher (2012) also motivate the combination of many models in the regular nowcast exercises of the Bundesbank. In the context of the publication of central bank forecasts as fan charts, Knppel and Schultefrankenfeld (2011a) investigate how macroeconomic risk forecasts can be evaluated. Based on these results, Knppel and Schultefrankenfeld (2011b) investigate the macroeconomic risks assessments of inflation-targeting central banks. Moreover, tests for evaluating multi-horizon density forecasts have been proposed in Knppel (2011). Ongoing and future projects Improving the suite of forecast models used at the Bundesbank will remain one of the main goals of the group. The group will investigate the role of international data for forecasting in more depth. A project will consider the estimation of international dynamic factor models using Bayesian techniques (Kaufmann, Schumacher, Sparse Bayesian Factor Model, ongoing) when the dataset takes into account a large number of different variables from different countries. Another project extracts global liquidity indicators from a large dataset comprising interest rates, monetary and credit aggregates from advanced and emerging market economies and assesses the predictive content of these indicators for global growth and inflation (Eickmeier, Hofmann, Gambacorta, Understanding Global Liquidity, ongoing). For details, see the research group International Integration. Further projects investigate the role of financial data and forecasting. One project measures the impact of financial uncertainty shocks on GDP by employing the response surface analysis (Kurz-Kim, A short-run forecasting using the response surface analysis, new). The focus of the research is to provide a short-term GDP forecast under high financial uncertainty. To improve the short-run forecasting performance of the usual error correction model (ECM), another project considers a generalized ECM containing different sampling frequencies of underlying data (Kurz-Kim, A generalized single equation error correction model, ongoing). Finally, a project explores the information content of daily financial indicators for nowcasting German GDP. Based on Factor-MIDAS models with monthly data that are used in the regular forecast exercises of the Bundesbank, the project evaluates the change in nowcast accuracy when adding daily financial indicators to the dataset (Galsband, Nowcasting German GDP using daily indicators, ongoing). In another attempt to improve the forecasting methods, the group will explore the performance of shrinkage in Bayesian time-varying parameter models with many predictors and mixed-frequency data (Hauzenberger, Hierarchical shrinkage in a mixed-frequency time-varying parameter model for forecasting GDP, new). Another project aims at nowcasting GDP in the euro area by using factor models (Wichert, Nowcasting Euro area GDP using Factor Models, new). The project discusses whether aggregated country nowcasts for the euro area perform better than nowcasts based on areawide models estimated on aggregated data for the euro area. More work will be done on density forecasts of central banks. Partly building on Knppel and Schultefrankenfeld (2011b), the determinants of the shape of fan charts will be studied (Knppel, Schultefrankenfeld, What determines the shape of fan charts?, ongoing).

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Central banks have extensively discussed which interest rate assumptions should underly their forecsts, without asking how relevant different assumptions would be. Therefore the impact of the interest assumptions commonly used in central bank forecasts on forecast accuracy will be investigated (Knppel, Schultefrankenfeld, The Empirical (Ir)Relevance of the Interest Rate Assumption for Central Bank Forecasts, ongoing). In the literature, the evaluation of multi-period density forecasts is often carried out separately for each singe forecast horizon. Using insights from earlier work by Jorda, Knppel and Marcellino (2010), it is planned to propose a method for the joint evaluation of all forecast horizons of the fan chart (Jorda, Knppel and Marcellino, Evaluating the calibration of density path forecasts, new). The group plans to explore the predictability of statistical data revisions based on the German real-time database GERDA. The literature provides different ways to exploit the many data vintages available for this purpose, and the team will evaluate these approaches (Schumacher, Schultefrankenfeld, The predictability of data revisions in German GDP, new). The role of metadata for predicting (conditional) data revisions is a second strand of research (Lorenz, Dietrich, Mehrhoff, Metadata and data revisions, ongoing). Changes in methodologies and base years lead to different data regimes and different patterns of revisions. The impact of these changes on business cycle analysis and forecasting will be investigated. A third research topic expands on classical revision analyses by focussing on the variance of the published indicator (Mehrhoff, Webel, On the loss of accuracy of economic indicators released too early, ongoing). To this end, the lower degree of hard data in early estimates is treated theoretically and empirically from a sampling point of view. Monitoring current economic developments and forecasting is typically based on seasonally adjusted data. A project will evaluate the functionalities of the new statistical software package X-13ARIMA-SEATS (Webel, Seasonal adjustment with the X-13ARIMA-SEATS package, ongoing). Work stream 2: Early warning Recent work at the Bundesbank The (Bundesbank) early warning model is continuously being revised, updated and improved. For example, in addition to the government bond rates, the expected earning is added in the fundamental sector to test bubbles and critical times, based methodologically on the threshold error correction models To measure the intensity of the bond crisis in the GIPSI countries, the credit default swaps of the countries are analysed and summarised in an alarm index In the field of the statistical methods for early warning, Kurz-Kim (2012) applied the log-periodic power law for capturing early warning indicators. Rthig (2011) studies the leadlag relationship between speculation and hedging activity in currency futures markets and find that speculators lead hedgers in all markets examined. Similarly, Rthig and Chiarella (2011) also analyze the interrelationship between small traders in currency futures markets and speculators and find s strong herding behavior of the small traders. Ongoing and future projects A survey paper on the Bundesbank early warning model is being considered as a possible contribution for the MaRs. By doing this, the (Bundesbank) early warning model will be extended for the EuroStoxx 50. Furthermore, a couple of research papers for the various submodels will be also written separately. A theoretical and empirical analysis of fundamentals, herding behaviour, and risk analyses regarding the sovereign debt crisis are the topics.

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Islami and Kurz-Kim (A financial stress indicator and the real impact of financial uncertainty, new) analyse the causal relationship between the financial crisis and the banking/sovereign debt crisis. They also provide a financial stress indicator which is able to forecast financial crises and banking/sovereign debt crises alike. Using various economic/financial indicators, Kurz-Kim and Schultefrankenfeld (Rational panic and a stock market sentiment indicator, new) construct a stock market sentiment indicator. This sentiment indicator should help us to explain the short-run dynamics of stock prices, especially in critical times. Kurz-Kim and Metiu (Contagion and tail dependence, new) investigate the causal relationship between international financial markets during calm and crisis periods. Quantile regressions are employed to test for Granger causality in the distribution of financial returns, which is expressed in terms of its conditional quantiles. We propose a test of shift-contagion based on the observation that financial markets usually move closer together as returns become more extreme. Our approach entails testing for a shift in the quantile range at which the Granger-causal relationship holds at some point in time. Koziol and Kurz-Kim (A credit crunch indicator based on credit volume and its risk, new) consider an early warning indicator for credit crunch based on a large micro banking data. A credit crunch indicator will be constructed by using credit volume and its risk. The recent financial crisis showed that a banking crisis causes a credit crunch which again can cause an economic contraction/crisis. Therefore, to develop an early warning indicator for credit crunch is of important to predict its impact on the real economic activity and/or on stock markets. Using the standard likelihood ratio test, Kurz-Kim and Scharnagl (Testing bubbles as a random walk with trend breaks, new) test for the existence of a bubble which is assumed as random walk with trend breaks under alternative hypothesis. They also compare their test with the modified Dickey-Fuller test by which the null hypothesis assumes that the underlying stochastic process is a random walk over the full sample, whereas under the alternative the process switches from a random walk to a mildly explosive process. In the line with the current political and economic discussion on prohibiting (uncovered) short-selling, Kurz-Kim and Tnzler (The impact on volatility of a ban on uncovered short-selling, new) analyse the corresponding empirical data and develop a model to measure the impact on stock markets of a ban on uncovered short-selling. References Breitung, J. and S. Eickmeier (2011), Testing for structural breaks in dynamic factor models, Journal of Econometrics, 163(1), 71-84. Eickmeier, S., B. Hofmann and L. Gambacorta (2012), Understanding Global Liquidity, mimeo. Eickmeier, S., W. Lemke and M. Marcellino (2011), Classical time-varying FAVAR models Estimation, forecasting and structural analysis, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 04/2011. Eickmeier, S and T. Ng (2011), Forecasting National Activity Using lots of International Predictors: An Application to New Zealand, International Journal of Forecasting, 27, 496-511. Foroni, C., M. Marcellino and C. Schumacher (2011), U-MIDAS: MIDAS regressions with unrestricted lag polynomials, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 35/2011.

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Jorda, O., M. Knppel and M. Marcellino (2010), Empirical simultaneous confidence regions for path-forecasts, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 06/2010. Knetsch, T. (2010), The Bundesbanks Macroeconomic Real-time Database for the German Economy (Gerda), Schmollers Jahrbuch, 130, 241-252. Knppel, M. and G. Schultefrankenfeld (2011a), How informative are central bank assessments of macroeconomic risk?, International Journal of Central Banking, forthcoming. Knppel, M. and G. Schultefrankenfeld (2011b), Evaluating macroeconomic risk forecasts, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 14/2011. Knppel, M. (2011), Evaluating the calibration of multi-step-ahead density forecasts using raw moments, Deutsche Bundesbank Discussion Paper, Series 1: Economic Studies, 32/2011. Kurz-Kim, J.-R. (2012), Early warning financial crashes using the log periodic power law, Applied Economics Letters, 19, 1465-1469. Kuzin, V., M. Marcellino and C. Schumacher (2011), MIDAS vs. mixed-frequency VAR: Nowcasting GDP in the Euro Area, International Journal of Forecasting, 27, 529-542. Kuzin, V., M. Marcellino and C. Schumacher (2012), Pooling versus model selection for nowcasting GDP with many predictors: Empirical evidence for six industrialized countries, Journal of Applied Econometrics, forthcoming. Schumacher, C. (2010), Factor forecasting using international targeted predictors: The case of German GDP, Economics Letters, 107, 95-98. Rthig, A. (2011), On speculators and hedgers in currency futures markets: who leads whom?, International Journal of Finance and Economics, 16, 63-69. Rthig, A. and C. Chiarella (2011), Small traders in currency futures markets, Journal of Futures Markets, 31, 898-914. Schumacher, C. (2010), Factor forecasting using international targeted predictors: The case of German GDP, Economics Letters, 107, 95-98.

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Research group Financial Stability JEL Codes: Members: D1, E4, E5, G0, G1. G2, G3 Puriya Abbassi*, Nataliya Barasinska*, Till Frstemann*, Michael Grill*, Arne Halberstadt*, Frank Heid* (coordinator), Bjrn Hilberg*, Anne Koban*, Matthias Khler*, Ulrich Krger*, Barbara Meller*, Norbert Metiu*, Jana Ohls*, Natalia Podlich*, Natalia Puzanova*, Alexander Schulz*, Niels Schulze*, Leonid Silbermann*

Advisors/visitors: Gnter Beck (Universitt Siegen), Claudia Buch (Eberhard Karls Universitt Tbingen), Ben Craig (Federal Reserve Bank of Cleveland), Falko Fecht (European Business School), Florian Hett (Johannes Gutenberg-Universitt Mainz), Thomas Hildebrand (European School of Management and Technology), Peggy Lehnert (Universitt Siegen), Jrg Rocholl (European School of Management and Technology), Michael Ktter (Rijksuniversiteit Groningen) General interest and Policy Relevance The events of the recent past have vividly shown that the understanding of a stable and sound financial system is still hampered by the absent comprehension of the underlying sources and amplification mechanisms challenging the stability of broader financial markets. For instance, contributions on the extent to which frictions and deficient incentives have aggravated stability problems are still rare. Our research questions are: What are proper tools to measure interconnectedness and resulting contagious effect among financial market segments more accurately? How do market failures foster contagion and what are the consequences for bank behaviour? This avenue of research is also highly important for future regulation as it provides insights on how to account for various incentive schemes and market failures. On the basis of recent work, a series of new projects have been launched to improve our understanding of the underlying dynamics endangering financial stability. In particular, the research programme is centred on two workstreams. A first workstream deals with frictions in financial markets (for example as a result of asymmetric information), deficient incentives as deeper causes of financial stability issues and regulation as a measure to avoid or reduce financial stability problems. A second workstream discusses various contagion aspects in financial systems (and the interbank market in particular), which may act as an accelerator and hence induce systemic instability. Recent Research Projects Johannes Brumm, Michael Grill, Felix Kubler, and Karl Schmedders (2011) examine in Collateral Requirements and Asset Prices the effect of collateral constraints and margin requirements on asset prices in a general equilibrium setup. They consider a Lucas-style infinite-horizon exchange economy with heterogeneous agents and endogenous collateral constraints. Their main contribution is to resolve the apparent contradiction between theoretical and empirical results. While theoretical contributions imply that collateralized borrowing contributes to market volatility, empirical evidence shows that the regulation of margin requirements for stocks does little to reduce stock market volatility. In their model with different collateralizable assets, stocks constitute only a comparatively small fraction of total margineligible assets. The regulation of margin requirements on this fraction of collateralizable assets has no significant impact on its volatility. However, the volatility of other assets decreas-

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es monotonically as margins on stocks are increased. These important spillover effects have been neglected in much of the previous literature as well as in the policy debate. To test if safety nets create moral hazard in the banking industry, Lammertjan Dam and Michael Koetter (2011) develop in Bank bailouts, interventions, and moral hazard a simultaneous structural two-equations model that specifies the probability of a bailout and banks risk taking. They identify the effect of expected bailout probabilities on risk taking using exclusion restrictions based on regional political, supervisor, and banking market traits. The sample includes all observed capital preservation measures and distressed exits in the German banking industry during 1995-2006. According to their results, the marginal effect of risk with respect to bailout expectations is 7.2 basis points. A change of bailout expectations by two standard deviations increases the probability of official distress from 6.2% to 9.9%. Only interventions directly targeting bank management and, to a lesser extent, penalties are found to mitigate moral hazard. Weak interventions, such as warnings, do not reduce moral hazard. In Systemic risk contributions: a credit portfolio approach Klaus Dllmann and Natalia Puzanova (2011) put forward a Merton-type multi-factor portfolio model for assessing banks contributions to systemic risk. This model accounts for the major drivers of banks systemic relevance: size, default risk and correlation of banks assets as a proxy for interconnectedness. They measure systemic risk in terms of the portfolio expected shortfall (ES). Banks (marginal) risk contributions are calculated based on partial derivatives of the ES in order to ensure a full risk allocation among institutions. They compare the performance of an importance sampling algorithm with a fast analytical approximation of the ES and the marginal risk contributions. Furthermore, they show empirically for a portfolio of large international banks how their approach could be implemented to compute bank-specific capital surcharges for systemic risk or stabilization fees. They find that size alone is not a reliable proxy for the systemic importance of a bank in this framework. In order to smooth cyclical fluctuations of the risk measure, they explore a time-varying confidence level of the ES. In Do capital buffers mitigate volatility of bank lending? A simulation study Frank Heid and Ulrich Krger (2011) address the question of the pro-cyclical effects of capital requirements in a general framework, which takes into account banks potential adjustment strategies. They develop a dynamic model of bank lending behavior and simulate different regulatory frameworks and macroeconomic scenarios. In particular, they address two related questions in their simulation study: How do business fluctuations affect capital requirements and bank lending? To what extent does the capital buffer absorb fluctuations in the level of minimum required capital? In Asset prices, collateral and unconventional monetary policy in a DSGE model Bjrn Hilberg and Josef Hollmayr (2011) set up a New-Keynesian model that features the interaction of heterogenous agents on an interbank market for collateralized lending. Within this framework they analyze a situation where increased liquidity supply by the central bank is only partially passed on to the interbank market. They show that by varying haircuts on eligible assets in repurchase agreements the central bank is able to reduce the tension on the interbank market and propose an exit strategy from such an unconventional monetary policy tool after the interbank market stress subsided. The project on Contagion at the interbank market with stochastic LGD by Christoph Memmel, Angelika Sachs, and Ingrid Stein (2011) investigates contagion at the German interbank market under the assumption of a stochastic loss given default (LGD). They combine a unique data set on the LGD of interbank loans with data on interbank exposures. They find that the frequency distribution of the LGD is u-shaped. Under the assumption of a stochastic LGD, simulation results show a more fragile banking system than under the assumption of a constant LGD.

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Norbert Metiu (2011) extends in his project on Sovereign risk contagion in the eurozone the canonical model of contagion proposed by Pesaran and Pick (2007) in order to test for contagion of credit events in euro area sovereign bond markets. He finds evidence for significant contagion effects among long-term bond yield premiums between 1. January 2008 and 1. February 2012. In another project Credit contagion between financial systems, Natalia Podlich and Michael Wedow (2011) study contagion effects from a broader perspective by focusing on the interlinkages between different financial systems instead of between individual institutions. More specifically, their contribution is to provide an empirical framework to measure the strength of contagion effects emanating from the financial systems of the US and Europe on the German financial system. A more thorough understanding of the significance of contagion between financial systems is important from a financial stability perspective to obtain a measure of how systemic risk is transmitted internationally and to adopt adequate policy measures. Ongoing and Planned Research Projects Frictions in financial markets and regulation The project on Adverse selection in interbank markets (new) by Puriya Abbassi and Florian Hett intends to identify empirically the severity of asymmetric information in the interbank money market and the associated costs for the German banking sector. The financial crisis has shown that this might severely impair the functioning of interbank markets, which in turn has widespread implications for the stability of broader financial markets and financial intermediation. In a first step, they intend to derive a measure that accurately reflects asymmetric information prevailing in the German banking sector. In a second step, the focus will rely on the relationship between their measure and the level of volatility of credit premiums in the money market in order to separate periods with and without adverse selection as postulated by the efficient market hypothesis. Claudia Buch, Michael Ktter, and Jana Ohls study the link between Banks and sovereign risk (new) by empirically analyzing how banks respond to risks and returns on government bond markets, to changes in bail-out expectations and to the implementation of rescue measures. The empirical approach employs a difference-in-difference methodology and uses a quarterly dataset on the government bond holdings of German banks since 2005 and bank supervisory data. This approach takes both the variation between countries over time and the variation between banks with different exposures to sovereign bonds into account. In The cost of insuring defined benefit plans in germany - Adverse selection and concentration risk (new) Till Frstemann and Ferdinand Mager will empirically analyze the risk profile of the Pensions-Sicherungs-Verein (PSVaG) with respect to concentrations risks. It also takes into account possible adverse selection problems arising from the ongoing shift from a book reserve system to funded pensions in Germany. Bjrn Hilberg and Barbara Meller assess in Refinancing advantage of systemic important financial institutions in Germany (ongoing) the size of the implicit too-big-to-failsubsidy in Germany to have a sound base for the implementation of macroprudential policies, which aim at reducing the benefit of a bank to be systemically important. To isolate the effect of systemic importance on funding costs, they intend to use a threshold regression proposed by Hansen (1999), where they control for macroeconomic as well as for bankspecific factors. In Flight to where? Evidence from bank investments during the financial crisis (ongoing) Thomas Hildebrand, Jrg Rocholl, and Alexander Schulz investigate how banks react to the financial crisis and a deteriorating solvency and liquidity condition in their invest-

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ment decisions and the composition of their financial assets. In using the securities deposit statistics of the Deutsche Bundesbank that comprises all security investments by all German banks on a security-by-security basis between 2006 and 2011, they focus on whether and how banks use sales and purchases of these securities as the most direct and immediate way to change their overall asset structure. Contagion in financial systems In Liquidity in Financial Markets and Demand for Reserves (ongoing) Puriya Abbassi and Falko Fecht empirically show that a dry-up of asset market liquidity associated with a higher price volatility indeed increases banks demand for liquidity as suggested by banking theory, see e.g. Allen and Gale (2004) and Brunnermeier and Pedersen (2009). Together with Nyborg and stberg (2010), this project implies that liquidity spirals exist. In Households borrowing in Germany and its implications for financial stability (ongoing) Nataliya Barasinska and Anne Koban investigate the determinants of German households borrowing and debt service behavior using micro data on household finances. Loans to private households in Germany make the largest part of the domestic lending of German banks. Households debt service behavior may thus have a significant impact on the risk position of banks and ultimately affect the financial stability. The study employs the unique panel of household finance (PHF) data collected by the Deutsche Bundesbank. Using this data, the project addresses two questions: 1) How does borrowing behavior (i.e. probability of borrowing, degree of indebtedness, debt structure) depend on household-specific characteristics? 2) Which households characteristics play the key role in debt service behavior? While focusing on the effects of household-specific variables, they also take into account macroeconomic factors and examine how debt behavior of households with different socio-economic characteristics responds to the changing economic environment. Low monetary policy rates are said to be among the reasons that have led to excessive risktaking by banks in the period before the financial crisis (Allen and Carletti, 2010). Rajan (2005) argues that banks have incentives to increase risk if interest rates are low because managers search for yield. Managers may also want to increase risk-taking if their compensation is linked to performance or if shareholders use short-term returns to evaluate their performance (Shleifer and Vishny, 1987). In the project Is there a risk-taking channel in the banking sector? Evidence from German banks (new), Gnter Beck, Matthias Khler and Peggy Lehnert analyze the existance of a risk-taking channel in Germany. In addition to the existing literature, the authors aim at analyzing whether the effect of the risk-taking channel is different depending on the business model and the ownership structure of the bank. Ben Craig, Michael Ktter, and Ulrich Krger investigate the empirical evidence for contagious effects arising from interbank market linkages (ongoing) during distressed periods. Employing a spatial lag regression model this project uses bilateral claims and liability positions to assess the degree of interdependence among German banks. The project on Optimal regulation of margin requirements (ongoing) by Johannes Brumm, Michael Grill, Felix Kubler, and Karl Schmedders asks whether the regulation of margin requirements can contribute to stability in financial markets. To explore how margin regulation affects welfare and volatility, they consider a Lucas-style infinite-horizon exchange economy with heterogeneous agents and collateral constraints. They first consider margin requirements that are determined endogenously by market forces to introduce then a regulator, which can set margin requirements exogenously. The project Impact of financial integration on lending behavior of financial institutions (new) by Falko Fecht, Natalia Podlich, and Niels Schulze aims to analyze systemic risk, which could possibly arise from the nature of the lending behavior of financial institutions. For this purpose, they look into the German interbank market and examine the lending behavior

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to different corporate sectors to test empirically whether financial institutions, which are strongly connected via the interbank market are less diversified in their lending to corporate sectors than those with no or only small interbank linkages. The project on Non-linear effects of international financial shocks on the German economy (new) by Michael Grill, Bjrn Hilberg, and Norbert Metiu empirically examines whether conditions in the financial sector play a role as a nonlinear propagator of structural shocks. They analyze the joint dynamics of the world economy in a dynamic system comprised of the euro area/Germany and the US economy using a structural threshold vector autoregression (STVAR). They use nonlinear impulse response functions and historical decompositions to evaluate the dynamic linkages within their system, and to assess the contribution of financial frictions to economic fluctuations. In his project on Financial stability indicators: The meaning of sector developments for the overall system (new) Arne Halberstadt develops a set of financial stability indicators using a dynamic hierarchical factor model. In this framework, he first extracts sector-specific indicators from a set of observable time series. These sector-indicators (representing for example banking risk, credit risk, market risk) are condensed into an overall indicator. One advantage of the DHFM procedure is a higher efficiency in the aggregation. Most notably, however, it allows tracing the relevance of a sector-indicator for the overall indicator dynamically over time. By that, he can account for the systemic meaning of sector developments for the overall financial system. Another relevant ongoing project described in more detail is under the research group Monetary Transmission and Monetary Strategy: An affine structure model with inflation data, macro factors and liquidity premia for Germany by Arne Halberstadt and Jelena Stapf. The project on The network structure of Bankssecurity holdings (new) by Thomas Hildebrand, Jrg Rocholl, Alexander Schulz, and Leonid Silbermann maps the network structure of German bankssecurity portfolios. This exercise is complementary to anlysing the interbank loan network (e.g. Memmel, Sachs, and Stein, 2011). While counterparty risks are routinely monitored in banksrisk management common exposures and the subsequent risk of being affected by potential asset fire sales of other parties cannot be assessed on an individual level. Thus, this paper aims at identifying also indirect interlinkages and possible transmission channels for contagion from similar investments. In her project The follow-up work on systemic risk contributions (new) Natalia Puzanova models a financial system as a portfolio of assets, the assets being financial institutions, to refine the definition of the expected of default, to incorporate stochastic loss given default, and to estimate time-varying asset correlations using DCC-GARCH. The second contribution of her project would be the inclusion of contagion effects. As a third contribution, she intends to design the systemic risk measure as to have an early warning indicator. References Allen, F. and E. Carletti (2010), An Overview of the Crisis: Causes, Consequences and Solutions, International Review of Finance, 10(1), 1-26. Allen, F. and D. Gale (2004), Financial Intermediaries and Markets, Econometrica, 72(4), 1023-1061. Brumm, J., M. Grill, F. E. Kubler and K. H. Schmedders (2011), Collateral Requirements and Asset Prices, Swiss Finance Institute Research Paper, 11-10. Brunnermeier, M. K. and L. H. Pedersen (2009), Market Liquidity and Funding Liquidity, Review of Financial Studies, 22(6), 2201-2238.

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Dam, L. and M. Koetter (2011), Bank bailouts, interventions, and moral hazard, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 10/2011. Dllmann, K. and N. Puzanova (2011), Systemic risk contributions: A credit portfolio approach, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 08/2011. Hansen, B. E. (1999), Threshold effects in non-dynamic panels: Estimation, testing, and inference, Journal of Econometrics, 93(2), 345-368. Heid, F. and U. Krger (2011), Do capital buffers mitigate volatility of bank lending? A simulation study, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 03/2011. Hilberg, B. and J. Hollmayr (2011), Asset prices, collateral and unconventional monetary policy in a DSGE model, ECB Working Paper Series, 1373. Memmel, C., A. Sachs and I. Stein (2011), Contagion at the Interbank Market with stochastic LGD, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 06/2011. Metiu N. (2011), Financial contagion in developed sovereign bond markets, Research Memoranda 004, Maastricht: METEOR. Nyborg, K. G. and P. stberg (2010), Money and Liquidity in Financial Markets, CEPR Discussion Papers, 7905. Pesaran, M. H. and A. Pick (2007), Econometric issues in the analysis of contagion, Journal of Economic Dynamics and Control, 31(4), 1245-1277. Podlich, N. and M. Wedow (2011), Credit Contagion between Financial Systems, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 15/2011. Rajan, R. (2005), Has Financial Development Made the World Riskier?, NBER Working Paper, 11728. Shleifer, A. and R. Vishny (1997), The Limits of Arbitrage, Journal of Finance, 52, 35-55.

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Research on Banking Regulation and Supervision JEL Codes: Members: C1, C2, C3, C4, C5, C6, C7, F3, F4, G0, G1, G2, G3, H2, L5, M4, R1 Klaus Dllmann* (coordinator), Daniel Foos*, Christine Fremdt*, Co-Pierre Georg*, Yalin Gndz*, Thomas Kick*, Philipp Koziol*, Caroline Liesegang*, Eberhard Mayerhofer* (Marie-Curie Network), Christoph Memmel*, Thilo Pausch*, Marcus Pramor*, Peter Raupach* Markus Behn (University of Bonn), Tobias Berg (Humboldt-Universitt zu Berlin), Allen N. Berger (University of South Carolina), Marcel Bluhm (Xiamen University and Goethe University Frankfurt), Philippe Durand (Banque de France), Armin Eder (Helvetia Insurance), Oliver Entrop (University of Passau), Falko Fecht (European Business School), Wolfgang Gick (Harvard University), Gunter Lffler (University of Ulm), Julia Nasev (University of Cologne), Enrico Onali (Bangor Business School), Andreas Pfingsten (Finance Center Mnster), Benedikt Ruprecht (University of Augsburg), Isabelle Thomazeau (Banque de France), Monika Trapp (University of Cologne), Marliese Uhrig-Homburg (Karlsruhe Institute of Technology), Vikrant Vig (London Business School), Peter Welzel (University of Augsburg), Marco Wilkens (University of Augsburg) Adrian Alter (University of Konstanz), Sven Bornemann (Finance Center Mnster), Ben Craig (Federal Reserve Bank of Cleveland), Till Frstemann (University of Paderborn, now Bundesbank), Rainer Haselmann (University of Bonn), Nadja Jahn (University of Mnster), Orcun Kaya (Goethe University Frankfurt), Michael Koetter (University of Groningen), Vu Nguyen* (Marie-Curie Network), Esteban Prieto (University of Tbingen), Klaus Schaeck (Bangor Business School), Andrea Schertler (Leuphana University Lneburg)

Co-authors:

Visitors:

General interest, policy relevance, and outline of the research programme of the group Research conducted in this group is intended to support the development of regulation, in particular in the national and international committees of banking regulation where the Bundesbank is involved. It also assists the supervisory oversight function of the Bundesbank. Furthermore, the group supports interaction with economists in academia working on banking issues, in particular banking regulation and oversight. The research group is organized in three work streams. The first work stream focuses on research on banking regulation in order to support the development of new regulatory initiatives, implementation issues of new regulation, and the evaluation of its economic impact. As the case may be, projects take a more long-term and forward looking perspective in order to identify issues that may become relevant for banking regulation in the future. Or they address requests on topical issues in the ongoing development or implementation of new regulation. Part of this work is carried out jointly with economists in other central banks and supervisory authorities under the umbrella of the Research Task Force of the Basel Committee on Banking Supervision. Important research questions addressed in this work stream are the following: How should regulation be designed? How should regulatory minimum capital requirements be calibrated?

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How does regulation affect bank management and risk-taking behaviour? How do accounting rules and taxation interact with capital and liquidity regulation? Which regulatory instruments are well suited to contain systemic risk?

The second work stream on risk modelling and stress testing includes the assessment of risks in the financial system and advancing methodologies for stress tests. For this purpose it is concerned inter alia with the following research questions: How can existing risk indicators for individual banks be improved? Which lessons can be drawn from the financial crisis for the modelling of credit risk, market risk and liquidity risk? Which role do new financial instruments play? How should stress tests of funding liquidity risks in banks be designed? How can supervisory off-site stress tests be improved? How can, for example, contagion effects be incorporated?

The third work stream comprises a range of projects that deal with the economics of banking. Relevant research questions of this work stream are the following: Where are the differences in risk management practices in banks? How are bank distress and household finance related (see also the program of the research group on household finance)? How do competition, concentration, and regional differences in the banking sector affect bank stability?

A list of individual projects in these work streams is presented in the following section which includes ongoing projects as well as projects that will be started in the next two years. It also includes three projects that are carried out under the aegis of the Marie-Curie-project on Risk Assessment and Measurement (RISK), which was established in 2009 and in which the Bundesbank is responsible for coordinating research activities on Regulatory Requirements and Risk Modelling Frameworks. The project list comprises in total 35 assigned projects of which 8 projects are already completed 3 and 7 projects will be completed in the 2nd quarter 2012. The remaining 20 projects are either ongoing or will be started over the next two years. A special emphasis is on the work stream on banking regulation that comprises 12 projects (+ 1 completed). 8 projects (+ 4 completed) belong to the work stream on risk modelling/stress testing and 7 projects (+ 3 completed) have been assigned to the work stream on economics of banking contains. These numbers do not include 9 projects which are co-authored by members of the financial stability department and presented in the sections of the research groups on financial stability and banking structure. Banking Regulation

Completed means that these projects have been submitted or have been published in the Discussion paper Series of the Bundesbank. Several papers have already been published in refereed journals (see reference list at the end of this section).

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Regulatory and supervisory interventions may have both intended and unintended consequences. This is, in particular, true with reactive interventions in crisis periods. The important and often complex issue of intended and unintended incentives of regulatory rules is therefore a central theme of research on the design of prudential banking regulation. Bundesbank research considers various fields of this taxonomy as a core area from an empirical as well as a theoretical perspective. Ongoing and new research can draw from results of recently completed projects. The following projects consecutively refer to four research strands: (i) The relationship of regulation and bank behaviour. (ii) The assessment of regulatory tools for systemic risk, for example the requirement of capital buffers for systemic risk on top of the minimum regulatory capital requirements. (iii) The assessment of cyclical effects from regulatory minimum capital requirements. (iv) The regulation of the trading book and counterparty credit risk. As resources become available, a fifth strand on the role of taxation and accounting rules is envisaged. The first strand of projects is concerned with the relationship between regulation and bank behaviour, in particular the consequences of regulatory requirements such as minimum capital rules and of regulatory interventions. Recent work The project Regulation, credit risk transfer with CDS, and bank lending by Thilo Pausch and Peter Welzel has been just completed. The authors integrate Basel II and Basel III regulations into the industrial organisation approach to banking and analyse the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending decisions and risk sensitivity of a risk neutral bank. Regulation is found to increase risk-sensitivity of banks: Compared to a situation without regulation the optimal loan volume decreases more the higher the riskiness of loans. Moreover, CDS trading is found to interact with the former effect when regulation accounts for the risk mitigating effect of credit risk transfer with CDS, which is the case under the substitution approach in Basel II and Basel III regulations. A risk neutral bank decides to over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. The substitution approach, however, weakens the tendency to overhedge or under-hedge in biased CDS markets. The authors, therefore, conclude that the substitution approach conveys the intention of Basel regulations to strengthen the soundness and stability of banks on the bank level. Ongoing projects Armin Eder, Falko Fecht, and Thilo Pausch consider the relationship between liquidity and solvency risks. In a theoretical model of the Diamond-Dybvig style, in which deposittaking banks and a financial market coexist, bank behaviour is analysed taking into account a positive probability of a future financial crisis. This extends the existing theoretical literature which typically assumes that financial crises do not affect banks decisions ex-ante. In the framework asset price deteriorations due to fire sales of assets by one bank may induce contagious bank runs. This may bring banks to holding a liquidity buffer to prepare for future financial crises. In contrast to the existing literature, however, considering a positive probability for future financial crises allows for an analysis when a liquidity buffer may be optimal from a banks point of view and which determinants affect this decision. Based on these insights policy implications regarding regulatory minimum liquidity requirements will be stated.

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The behaviour of a bank under the liquidity regulation of Basel III is analyzed by Thilo Pausch. An extended version of the industrial organization approach to banking is applied to (theoretically) analyze: (i) whether the interaction of credit risk and liquidity risk make a per se risk neutral bank effectively behave risk averse when taking a long-term perspective on optimal behavior; (ii) whether the availability of a buoyant interbank market makes a bank ignore the interaction between credit risk and liquidity risk in optimal decision making; (iii) whether and in which way current liquidity standards included in Basel III help to recover riskadjusted bank behavior. Markus Behn, Rainer Haselmann, Thomas Kick, and Vikrant Vig investigate how the political economy affects bank bailouts and regional lending. They focus on bank lending in the most disaggregated way that is on the bank-customer level. The research questions are as follows: First, they aim to determine which economic and also political factors trigger capital support measures by the deposit insurance fund, the equity holders, or in particular during the crisis by the government. Second, they focus on the regions (county level) and determine the effect these measures have on the regional credit supply, and whether they are eligible to support regional economic growth. Third, they are interested whether regulatory interventions can mitigate the moral hazard arising from excessive bank bailouts. Fourth, they control for bank-specific characteristics of interest like a bank's market power, its monitoring ability, its ability to provide customer services (number of bank branches), regional macroeconomic variables, etc. Tobias Berg and Philipp Koziol explore on adverse selection in banks loan granting process. For banks, it is in their own best interest to accurately assess the creditworthiness of (potential) borrowers. Inaccurate ratings can lead to adverse selection and therefore lower returns. Since the introduction of Basel II, internal ratings play a crucial role for regulatory purposes. The question of this project is to analyze whether adverse selection plays a role in the loan granting process. In particular, it will be analyzed whether probability-of-default estimates are negatively correlated to loan volume (changes) in the cross section of borrowers. If this is the case, one explanation could be adverse selection, i.e., banks with lower probability-of-default estimates are more likely to provide the most competitive interest rate to a client. This hypothesis can be investigated by looking at lead-lag relationships and the link between capital adequacy and changes to internal probability-of-default estimates in the cross section of banks. The recent financial crisis has revealed the importance of the systemic dimension of financial risk. The following two projects address regulatory tools for systemic risk, in particular the consequences of a regulatory capital charge for systemic risk. A third project by Puzanova/Duellmann on the allocation of systemic risk in a banking system is carried out together with the research group on financial stability and listed there. Robustness and informativeness of systemic risk measures is the topic of Gunter Lffler and Peter Raupach. Recent literature has proposed new methods for measuring the systemic risk of financial institutions based on observed stock returns. This paper examines the reliability and robustness of such risk measures. Adding option positions to a portfolio that is linear in the market portfolio can easily create situations in which systemic risk is consistently misestimated. Protective put strategies that are immune against extreme shocks are judged to have high systemic risk because estimation methods rely on less extreme return realizations in which option premia depress returns relative to unprotected institutions. On the other hand, extreme tail risk can be masked by buying protection against less extreme events. The estimation problems are illustrated for portfolios with standard equity options but they carry over to credit risk. This raises doubts about the information content of the proposed measures. In particular, a direct application to regulatory capital surcharges for systemic risk could create wrong incentives for banks.

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Adrian Alter, Ben Craig and Peter Raupach consider Centrality-adjusted capital requirements. The aim of this project is to determine a function that maps individual-banksystemic contributions into capital requirements. The analysis is based on an index of centrality measures from the network topology of the interbank lending and borrowing market. The first building block is a risk engine that produces exogenous shocks to the non-bank exposures of all German banks on which we have precise data. These shocks feed into the second building block, the total of interbank lending. Here, defaults of banks may carry over to other banks and, after several rounds, cause losses to bank debtors or, if bailed out, to the public. The third building block conveys various network theoretic measures that directly rely on interbank lending. They test whether the building blocks can be used to capture the systemic importance of banks in the system. Capital charges are defined based on these measures which provides grounds for an analysis of whether corresponding capital reallocations in the system make the system more stable, i.e. whether they reduce the losses to the public. The authors, then, try to optimize the reduction. The research project On the determinants of interbank networks by Marcel Bluhm and Co-Pierre Georg aims to empirically investigate network formation on the German interbank market. For this purpose the formation of interbank market connections over time will be investigated and statistical methods will be used to identify micro- and macro-based factors which can explain the results. The analysis will allow to statistically identify determinants of network formation at the individual bank level. Furthermore, indicators for interbank market access and systemic risk in the banking sector can be developed. The next two projects of this work stream focus on the assessment of cyclical effects from regulatory minimum capital requirements and their mitigation. The Cyclical behaviour of capital requirements for German banks will be ex-amined by Marcus Pramor. Building on bank-level data, a panel data model will compare the dynamics of minimum required capital, risk-weighted assets, and exposures under Basel II. The focus will be on co-movements with the macro-economy and on disentangling the role of risk parameters and the contribution from individual portfolios (corporate, retail, securitization). Given the very short time dimension of available data and the fact that the sample period is dominated by the financial crisis, achieving consistent and dependable estimation results will be a challenge. The performance of a counter-cyclical capital buffer regime that mitigates potential (pro-) cyclical effects of the risk-based capital requirements under Basel II is examined by Klaus Dllmann. Mitigation of cyclicality can ideally be achieved by a capital buffer that expands and contracts with the cycle and ensures a timely build-up and release. The objective of this project is to develop a model and to evaluate the appropriate macro or financial indicator variables that determine the size of the buffer over time. This setup should provide a countercyclical buffer that performs well throughout the cycle and that ideally operates without the need of a manual switch-off at the beginning of a crisis in order to avoid an adverse signaling effect. The following three projects could provide useful insights in two areas of capital regulation, that have been significantly revised in the Basel III framework, namely the treatment of credit risk in the trading book and counterparty credit risk. Work on the first project is quite advanced whereas the other two projects are at a relatively early stage. Christine Fremdt and Peter Raupach ask: Are building block approaches suitable for the risk measurement of trading book positions? They analyze the effect of the regulatory practice to capture credit risk by the Incremental Risk Charge instead of using multifactor models. The focus of the project is on two basic risk factors: credit risk (represented by a rating) and the risk premia paid for it (represented by corporate spread indices). They find empirically supported setups where it is not conservative to calculate spread risk and credit

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risk separately even for very simple and widespread positions like corporate bonds. This finding calls for a joint modelling and raises doubts about the reliability of the IRC. Intertemporal models for the credit risk of trading book positions is a project planned by Peter Raupach. It builds on new capital rules for the trading book, ac-cording to which banks are required to hold a capital buffer against the credit risk of trading book positions, the socalled incremental risk charge. Banks may use an internal model, which has to assume that positions are held over one year and rebalanced within the year after their credit risk has changed, towards a constant level of risk. The freedom to choose the stochastic processes underlying the portfolio credit risk is suspected of giving banks large discretion over resulting capital. The objective of this study is to assess this discretion within a consistent framework and to discuss the appropriateness of different approaches. Furthermore, the constant-levelof-risk assumption seems inadequate especially for high-risk positions such as equity; this asks for proper alternatives, should the error be large. In a project funded by the EU Marie-Curie Network Risk and Risk Reporting, which Bundesbank is a member of, Eberhard Mayerhofer will focus on the risk measurement and regulatory capital requirements for counterparty credit risk. This project addresses fundamental questions on current market practice of modelling and pricing counterparty risk, as well as the justification of new regulatory requirements imposed by Basel III. Banks are required to hold additional capital against the risk that the credit quality of a counterparty in a financial contract worsens during its lifetime. This risk is typically reflected in uncertainty what concerns the evolution of so-called Credit Value Adjustment (CVA) of the otherwise fair price. The assessment of CVA risk is complicated and depends very much on portfolio composition, rules for netting of counterparty exposures and the managment of collateral. Open issues for further research on regulation (new projects) Considering the extent of the recent financial crisis after a long history of financial regulation that dates back in many countries to the Great Depression of the previous century the question of an optimal design of regulation should be newly addressed. Should regulators, for example, shift more attention on disclosure policies rather than on refining minimum capital requirements? The overall calibration of the minimum capital requirements poses a related research question. Of particular interest are, for example, the balance between the level of minimum capital requirements for the banking book vs. the trading book and the evaluation of instruments that could control potential pro-cyclical effects of risk-based regulatory capital requirements. How can model risk be taken into account in risk-based regulation? Interest rate risk in the banking book is arguably the most important risk category of a bank that is not addressed by the capital and liquidity regulation forthcoming in the Basel III framework. Recent developments in the application of monetary policy may be indicative that interest rate risk may play a more important role in the future which would advocate more research on the regulation of this risk category. Basel III has introduced the first internationally harmonized regulatory framework for liquidity risk and an internationally harmonized leverage ratio as a complement to the risk-based minimum capital requirements of Basel II. The inter-action of these three regulatory concepts and its consequences for the behaviour of banks offer a scope for further research. The interaction of these regulatory requirements with the relevant accounting rules and tax regimes also opens a promising avenue for further research. Furthermore, an assessment of the impact of mark-to-market accounting on bank behaviour and risk taking appears to be warranted since it has often been named as a fire accelerant in the recent financial crisis. In this context, the impact of fair-value accounting on the volatility

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of banks earnings should be evaluated. Following Memmel and Raupach (2010), banks try to keep their capital ratio close to a bank-specific target ratio. If so, an increase in the volatility of earnings due to the cyclicality of mark-to-market accounting may impact the sensitivity of banks to changes in the economic environment and affect credit-supply. Risk modelling and stress testing Identifying and measuring credit, market, and liquidity risks has been an important focus area of this research group. In the following we distinguish between (i) risk measurement and modelling, i.e. how key financial risks drive the markets and affect the pricing of financial instruments in bank portfolios, (ii) stress testing, i.e. how micro and macro level shocks affect the financial and corporate sector, and (iii) credit risk and liquidity risk in financial markets. The first strand of research on risk measurement and modelling focuses on rating methodologies and how key financial risks drive the markets and affect the pricing of financial instruments in bank portfolios. Recent work Improvements in rating models for the German corporate sector (2011) has been a project by Till Frstemann on common statistical rating models for commercial debt that are based on one global estimation. The author analysed whether and to what extent their predictive power could be ameliorated by using group-specific estimations. The project took advantage of a balance sheet database in the Bundesbank, which includes enough observations to deliver robust estimates even after being split into subsamples. The importance of qualitative risk assessment in banking supervision before and during the crisis (2011) is a completed project by Thomas Kick and Andreas Pfingsten. It is still an open question whether supervisors provide information, based on on-site inspections, which is not yet known from the numbers, or simply duplicate the quantitative information, or even overrule it by their impressions gained through visits. A partial proportional odds model is applied to explain the supervisors ordinal grading (risk profile) by a CAMEL covariate vector that contains only quantitative information, and also the bank inspectors qualitative risk assessment is included into the model. It turns out that not only the quantitative CAMEL vector is clearly important for the final supervisory risk assessment; it is, indeed, also qualitative information on a banks internal governance, ICAAP, interest risk, and other qualitative risk components that play an equally important role. Ongoing projects Finally, an early-stage project by Yalin Gndz, Christoph Memmel, and Peter Raupach explores if industry and regional factors drive German banks' credit portfolio risk. Using a unique data set about the German banks' loans to the German real economy, the authors plan to investigate the banks' credit portfolio risk. This data set includes the volume of loans per bank and industry as well as the corresponding write-offs, which makes it possible to analyse the industry and regional factors driving the credit risk. The authors control for bank-specific factors (size, region, business model) and analyze by how far the weighted average of nation-wide and regional industry factors explain the rate of a bank's write-off in its credit portfolio. A further analysis of unexplained risks deals with the assumption of conditional independence made in credit portfolio models. Stress testing builds the second strand of research and has gained in importance in surpervisory practice in recent years, especially during the financial crisis. Research on stress testing has focused on how to derive stress scenarios that ought to parallel the real life circum-

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stances, and on how macroeconomic conditions should be fed into the risk parameters of bank portfolios. Recent work Stress testing German banks against a global cost-of-capital shock is a project carried out by Klaus Dllmann and Thomas Kick and completed in January 2012. The authors investigate the impact of a global cost-of-capital shock on the credit portfolios of 24 large German banks. For this purpose they integrate two models: A macroeconometric model which is used to forecast the impact of a global credit crunch on selected industry sectors and a multifactor portfolio model of credit risk that is an extension of Dllmann and Erdelmeier (2009). Besides its focus on the link between the macroeconometric model and the portfolio risk model, the analysis is also set apart by the highly granular information on the composition of banks' real portfolios, namely the loan volumes and banks' internal estimates of default probabilities. Ongoing projects Multi-period stress tests of banks credit portfolios is a project proposed by Klaus Dllmann, Thomas Kick and Philipp Koziol that builds on the work by Dllmann and Kick (2012). It will generalize the model in a dynamic setting that allows a stress scenario encompassing multiple years. Furthermore it will extend the stress scenario by including also the impact on recovery rates and revisit the static dependence structure of the model. A new approach of stress testing systemic risk contributions of large international banks is developed by Klaus Dllmann, Marcus Pramor und Natalia Puzanova. Building on the model of systemic risk contributions by Dllmann and Puzanova (2011), the new paper develops stress scenarios in a macroeconomic VAR model that drives the default probabilities of large and internationally active banks. By using the Global VAR (GVAR) framework, cross-country effects can be endogenised, which is of particular importance in analysing systemic risk. The resulting changes in the level of risk and the contributions by individual banks will give an indication of the sensitivity of systemic risk to different stress scenarios. Macroeconomic capital stress tests focused on the tail of the distribution is an ongoing project carried out by Thomas Kick and Caroline Liesegang. It is an ex-tension of the work by Schechtman and Gaglianone (2010) who stress-test credit risk in the Brazilian household sector combining a macroeconomic VAR and a time-series quantile regression model. As in times of stress the relationship between macroeconomic variables and financial stability indicators can tremendously change, there is need to focus on the right tail of the distribution and not simply on the conditional mean as it is done in traditional stress tests. This project differs from Schechtman and Gaglianone (2010) in three aspects. First, a structural SVARmodel is applied, using the sign-restrictions approach to generate macroeconomic stress more consistently. Second, the authors focus directly on banks capital ratios (capital adequacy ratios and leverage) as banking stability indicators, instead of non-performing loans ratios. Third, quantile regression is applied in a panel (instead of a time-series) context. Optimal disclosure of supervisory information in the banking sector is the topic of an ongoing project of Wolfgang Gick and Thilo Pausch. The main focus is on the role of supervisory stress tests in the banking sector. Based on the recent literature on cheap-talk signalling games the paper analyses in which way the publication of information regarding the design and the results of stress tests affect investor behaviour in the banking sector. Bank supervisors, which are aware of this effect, are shown to be able to design stress testing exercises and disclosure mechanisms in a way that is beneficial for both supervisors and bank investors as well. Optimally designed stress tests are, hence, found welfare enhancing.

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The next four projects which build the third strand of research address credit risk and liquidity risk in financial markets. Recent work Yalin Gndz and Marliese Uhrig-Homburg (2011a) perform a comparative study of structural and reduced-form models of credit default swaps (CDS). The completed study provides a rigorous empirical comparison of structural and reduced-form credit risk frameworks and provides an extension to Gndz and Uhrig-Homburg (2011b). As major difference the authors focus on the discriminative modelling of the default time. In contrast to previous literature, both approaches are calibrated to bond and equity prices. By using the same input data, applying comparable estimation techniques, and assessing the out-of-sample prediction quality on the same time series of CDS prices the authors are able to judge whether empirically the model structure itself makes an important difference. Interestingly, the models' prediction power is quite close on average. Ongoing projects Yalin Gndz and Orcun Kaya use sovereign CDS returns and return volatilities as a proxy for informational efficiency of the sovereign markets and persistence of country risks. They apply two semi-parametric methods and a parametric dual memory model of long memory to the sovereign CDSs of 11 Euro area countries with particular attention to the post-credit-crunch period. The analysis reveals that there is no evidence of long memory for the return series of Euro area countries, which indicates that the price discovery process functions efficiently for sovereign CDS markets. On the other hand, both semi-parametric methods and the parametric model imply persistent behavior in volatility of CDS returns for highly indebted economies. Endogenous liquidity is estimated by Philippe Durand, Yalin Gndz and Isabelle Thomazeau using transaction and order-book information. The term endogenous liquidity refers to the impact of liquidity on market prices in case of a liquidation of large positions. The authors apply their model, based on a concept of endogenous liquidity, to the order book of equity prices in order to reveal any unrealized endogenous liquidity effects; i.e. any effects that have not (yet) happened due to liquidity constraints. Moreover, they apply the model to a set of credit default swap (CDS) transactions, in order to find a realized endogenous liquidity component. Nevertheless, dealers in CDS markets might be slicing the large transactions into several small pieces to avoid liquidity constraints. Yalin Gndz, Julia Nasev and Monika Trapp look at inventory effects in trader portfolios. CDS traders that are worried about their inventory might adjust quotes to minimize inventory risk and maximize trading profits. The authors analyze the relation between the traded volume and CDS premia for a variety of reference entities. In a final step, inventory characteristics are analyzed via regressions. Open issues in risk modeling and stress testing (new projects) In the context of managing and regulating liquidity risk in banks, a highly relevant question concerns the optimal design of stress tests. Related questions are: which is the relation between liquidity risk and credit risk? How can second-round and network effects be incorporated? How can stress tests be used to define optimal liquidity buffers? Economics of Banking The third research work stream focuses on the economics of banking. Research in this work stream is conducted both theoretically and empirically.

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The first strand of research on risk management, performance and governance in the banking sector analyses the link between banks risk management policies and performance from a micro-perspective. Recent work In order to identify leading macroeconomic indicators for the stability of the banking system Nadya Jahn and Thomas Kick have carried out an (already completed) project on Earlywarning Indicators for the German Banking System: A Macro-Prudential Analysis. Hereby, they introduce a continuous and forward-looking stability indicator for the banking system based on information on all financial institutions in Germany between 1995 and 2010. Explaining this measure by means of panel regression techniques, the authors identify significant macroprudential early warning indicators (such as asset price indicators, leading indicators for the business cycle and money market indicators) and spillovers. Whereas international spillover effects play a significant role across all banking sectors, regional spillover effects and the credit-to-GDP ratio are most important for cooperative banks and less relevant for commercial banks. The manuscript has been submitted to the Bundesbank Discussion Paper Series. Ongoing projects Entrop, Kick, Ruprecht and Wilkens focus on In terest Rate Derivates and Risk Management. They use the model of Froot and Stein and analyze whether the probability that a bank defaults drives on-balance and off-balance interest rate risk management decisions. In the first step of the analysis, the probability of default is estimated using a Hazard-Rate Model. Furthermore, the Z-Score (Distance to Default) is used as an alternative estimate for the probability that a bank defaults. In the second step, the probability of default and further bank and macro variables are regressed on the decision to use derivates for hedging and onbalance sheet interest rate risk management. The relationship of bank distress and household finance is analysed by Thomas Kick, Klaus Schaeck, and Enrico Onali. The extensive involvement of households in financial markets and their role in the building up of risk that led to the 2007-2009 financial crisis has substantially raised the interest in household financing patterns. In an ongoing project, they investigate the relationships between bank distress and households income and portfolio allocation. This question is very important due to the crucial role of households for asset bubbles and subsequent recessions. Specifically, the authors estimate the impact of bank distress (instrumented by regulatory interventions) on the loan supply to households. Regulatory interventions are correlated with bank distress, but are exogenous with respect to household income and portfolio choices. By homing in on the impact of a reduction in loan supply to households due to bank distress, the authors are able to identify the dynamics of bank distress on households finance. Further, they can address the impact of bank distress on borrowing constraints, and the impact that these constraints may have on consumption (amount and composition) of households. In the context of Related relationship lending: When the supply of credit becomes personal, Thomas Kick and Klaus Schaeck investigate relationship lending from the most personal perspective. Observing the credit relationship a bank has with a firm in which bank board member(s) also hold positions in the (supervisory) board of the borrower firm, they answer the following questions: How frequent is this kind of relationship? What happens to the lending relationship in the case of a board turnover; that is, does the relationship remain with the previous bank, or does the board member take it to a new employer? Is there a moral hazard problem with this kind of relationship lending, i.e., is there a higher default risk for the respective loans?

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Domikowsky, Dllmann and Pfingsten examine the cyclicality of loan loss provisions in German banks. This project seeks to answer the empirical research question if loan loss provisions predominantly amplify the economic cycle because they increase in an economic downturn or if they primarily mitigate this cycle because they are already built in the up-turn as a forward-looking buffer. The results will be informative, for example, for the discussion on an expected loass approach in the IFRS accounting rules. Finally, Thomas Kick and Esteban Prieto analyze Bank Risk, Competition and the Macroeconomy: Evidence from Regional Banking Markets. Their study investigates the bank competition-stability nexus using a unique regulatory data set for the period 1994 to 2010. First, they use outright bank defaults as the most direct measure of bank risk available and contrast the results to weaker forms of bank distress. Second, they control for a wide array of different time-varying characteristics of banks which are likely to influence the competitionrisk taking channel. Third, the authors include different measures of competition, contestability and concentration, each corresponding to a different contextual level of a banks competitive environment. From a policy perspective, the results indicate that a competitionreducing regulation does not necessarily enhance the stability of individual banks. Instead, current results indicate that the degree of competition affects bank risk in a manifold number of ways: some of them with stability-enhancing effects, but others apparently not. The next four papers are primarily concerned with the impact of different governance mechanisms on bank performance and risk taking. Recent work Does it pay to have friends? Social ties and executive appointments in banking is a research question asked by Allen Berger, Thomas Kick, Michael Koetter, and Klaus Schaeck. Hereby, the authors exploit a unique sample to analyze how similarities and social ties affect career outcomes in banking based on age, education, gender, and employment history to examine if homophily and connectedness increase the probability that the appointee to an executive board is an outsider (an individual without previous employment at the bank) compared to being an insider. The results show that homophily based on age and gender raises the chance of the successful candidate being an outsider, whereas similar educational backgrounds reduce the chance that the appointee comes from outside. When examining performance effects, the authors find weak evidence that social ties are associated with reduced profitability. The project has been completed in the end of 2011 (see Berger et al., 2011). The Impact of Executive Board Composition on Bank Risk Taking is evaluated by Allen N. Berger, Thomas Kick, and Klaus Schaeck. Exploiting a unique dataset from Germany which operates a two-tier system of corporate governance that separates inside directors (i.e., executives that run the bank) into a management board, and outside directors into a supervisory board, the authors show how age, gender, and education composition of executive teams affect risk taking. They use difference-in-difference estimations that focus on mandatory executive retirements and find that younger executive teams increase risk taking, as do board changes that result in a higher proportion of female executives; in contrast, if board changes increase the representation of executives holding Ph.D. degrees, risk taking declines. The project has been completed in the beginning of 2012 (see Berger et al., 2012). Ongoing projects In a subsequent project the impact of board structure on performance is addressed by Thomas Kick and Andrea Schertler in their project on Bank Mergers, Board Composition, and Efficiency. Hereby, mergers in the German banking market are investigated from a board perspective. Following regular mergers (economies of scale mergers) or restructuring mergers (distressed mergers) the authors answer the following questions related to board

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composition: What happens to the bank management in the aftermath of a merger? Is it the management of the acquired bank that is laid off? Are rather less experienced or older managers the ones who are dismissed? The project also aims at examining bank performance and efficiency following regular and distressed mergers: Does RoE and risk-adjusted RoE improve after a merger if the banks supervisory board dismisses redundant managers faster and what happens to bank efficiency? Finally, in a project Taking a Bath while Receiving the Baton - An Empirical Analysis of CEO Behavior during Turnovers in Banks the development of income-decreasing discretionary expenses around CEO turnovers in banks is investigated by Sven Bornemann, Thomas Kick, Andreas Pfingsten, and Andrea Schertler. The authors expect incoming executives to take an earnings bath during the initial stage of their tenure. For a sample of German banks over the period 1993-2009, they document that (1) incoming CEOs increase discretionary expenses, i. e. engage in big bath accounting, during their first (partial) year in charge, (2) incoming CEOs from outside the bank take a larger earnings bath than the ones from the inside, (3) the propensity to engage in big bath accounting does not depend much on whether the incumbent CEO retires or departs for any other reason. The findings are robust to several modifications; this holds even when controlling for the incoming CEO's objective to cure shortages in the existing stock of risk provisions, which may otherwise provide an alternative explanation for observing extraordinary amounts of discretionary expenses in turnover years. The second strand of the work stream concentrates on structural issues in banking. Research in this area focuses on the link between bank lending and structural developments arising from internationalization and competition in the banking sector. The results of this research are important to supervisors in assessing the impact of structural developments in the banking sector on bank behaviour and the real sector. These projects are included in the work stream Banking Structure. Open issues in economics of banking (new projects) There are currently no research issues beyond the projects listed above that require immediate research attention. References Berger, N., T. Kick, M. Koetter and K. Schaeck (2011), Does it pay to have friends? Social ties and executive appointments in banking, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 18/2011. Berger, N., T. Kick and K. Schaeck (2012), Executive board composition and bank risk taking, Deutsche Bundesbank Discussion Paper, 03/2012. Dllmann, K. and M. Erdelmeier (2009), Stress testing German banks in a downturn in the automobile industry, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 02/2009. Dllmann, K. and T. Kick (2012), Stress testing German banks against a global cost-ofcapital shock, Deutsche Bundesbank Discussion Paper, 04/2012. Dllmann, K. and N. Puzanova (2011), Systemic risk contributions: a credit portfolio approach, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 08/2011.

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Frstemann, T. (2011) Improvements in rating models for the German corporate sector, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 11/2011. Gndz, Y. and M. Uhrig-Homburg (2011a), Does modeling framework matter? A Comparative study of structural and reduced-form models, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 05/2011. Gndz, Y. and M. Uhrig-Homburg (2011b), Predicting credit default swap prices with financial and pure data-driven approaches, Quantitative Finance, 11(12), 1709-1727. Kick, T. and A. Pfingsten (2011), The importance of qualitative risk assessment in banking supervision before and during the crisis, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 09/2011. Memmel, C. and P. Raupach (2010), How do banks adjust their capital ratios?, Journal of Financial Intermediation, 19(4), 509528. Pausch, T. and P. Welzel (2012), Regulation, credit risk transfer with CDS, and bank lending, Deutsche Bundesbank Discussion Paper, 05/2012. Schechtman, R. and W. P. Gaglianone (2010), Macro stress testing of credit risk focused on the tails, BIS Working Paper, http://www.bis.org/events/srbbrobc100318/agenda/pisch_paper.pdf.

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Research group Banking Structure JEL Codes: Members: G15, G18, G21 Puriya Abbassi*, Andr Ebner, Daniel Foos*, Till Frstemann*, Rainer Frey*, Michael Grill*, Bjrn Hilberg*, Thomas Kick*, Melanie Klein, Matthias Khler*, Bjrn Kraaz, Christoph Memmel (coordinator), Tobias Schmidt, Heiko Sopp, Eva Sbbeke, Nicolai Sthler

Advisors/visitors: Ban Craig (Federal Reserve Bank of Cleveland), Falko Fecht (European Business School), Rainer Haselmann (Rheinische Friedrich-WilhelmsUniversitt Bonn), Michael Ktter (Rijksuniversiteit Groningen), Gnseli Tmer-Alkan (VU University Amsterdam), Michael Wedow (European Central Bank) General interest, policy relevance and outline of the research programme The financial system contributes to the efficient allocation of the economys resources; sustainable growth of the real economy is only possible when the financial system functions properly. Therefore, it is important to better understand the intermediation processes in the financial system. A good understanding of the financial system, for instance, makes it possible to anticipate the long-run effects of government interventions, such as laws and financial regulations, and to assess the impact of structural developments in the banking sector. The German financial system is much bank-orientated. Therefore, the research in this group primarily focuses on these intermediaries. A serious concern in many countries was whether a strong reduction in the willingness and ability of banks to lend to the private sector during the crisis constrains the financing of the real sector with serious consequences for the economy as a whole. Against this backdrop, a subset of research questions are the following: How do bank characteristics, including their interconnectedness, influence the banks funding and lending behavior? What are the effects of public support on the banks behavior (including on potential competitors)? What are the consequences for the real economy? This research is carried out in a first workstream Behavior of banks. A second workstream concentrates on the international business of banks. German large banks in particular are strongly engaged in international banking. On the one hand, the international orientation allows them to diversify risk; on the other, the international integration may also be an important propagator of international shocks. In particular countries where foreign banks played an important role were concerned whether they will be hit strongly by the reluctance of these banks to grant new loans. Important research questions are therefore: What determines the foreign business of banks? Do foreign branches and subsidiaries behave differently compared to foreign activities of domestic banks? What is the role of the internal capital market? All projects of this group rely on (German) bank micro-data, which is not accessible to the general public. Research Projects Workstream Behavior of banks

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Recent work The behavior of banks has been the subject of many Bundesbank research projects. Typically, the net interest income is the most important source of banks revenues. Accordingly, several projects have dealt with this income. Memmel and Schertler (2011) have recently investigated how banks manage their net interest income and show that strategic decisions concerning the banks business model have a huge impact and that derivatives are mainly used for hedging purposes. Memmel (2008, 2011) has analyzed the impact of term transformation on the banks net interest income and finds that the banks balance sheet composition explains a substantial part of the changes in the net interest income and that banks behave procyclical, i.e. that they increase their exposure to term transformation risk when the term structure becomes steeper. Busch and Kick (2009) investigate to what extent the banks interest and the non-interest income interact and find that the banks riskadjusted return goes up when the banks increase the share of fee-based income. Other projects investigated the banks lending decisions. Stein (2011) analyses how relationship lending affects the interest rate and finds that firms with a close banking relationship have lower interest rate expenses. Bve, Dllmann and Pfingsten (2010) study the sectoral concentration in the banks credit portfolio. They show that banks with a concentrated credit portfolio have lower expected losses, probably due to better monitoring abilities. Abbassi and Linzert (2011) investigate the financial market effects of non-conventional monetary policy measures on euro area term money market rates. Their findings show that crisis-related monetary policy has been effective in addressing inefficiencies surrounding the money market and in reducing longer-term interest rates, which serve as the basis for fixedincome securities throughout the economy. Ongoing and new projects Retail- and Corporate Interest Rates Charged By German Banks (ongoing) Authors: Thomas Hartmann-Wendels, Ramona Busch, Tobias Schlter, Snke Sievers There is empirical evidence that the pass-through of official- and market interest rates to bank interest rates research is sticky and to some extent incomplete for retail products of banking institutions. Based on new theoretical considerations this project analyzes factors explaining different pass through behavior across institutions and especially incorporates the German specialty of a disjoint banking system being divided into the three pillars private banks, savings banks and cooperative banks. The theoretical predictions will be tested by conducting empirical research, which models the pass through process using vector autoregressive models and an error correction framework by taking into account the three distinctive groups in Germany. The analysis of the financial crisis during 2008 and 2009 will be of special interest regarding disturbed and illiquid capital markets hindering market based funding and shifting institutions funding to more stable, retail based financing. Retail Deposits & Funding Stability (planned) Authors: Roman Inderst, Tobias Waldenmaier For many, one of the lessons drawn from the financial crisis is the importance of banks funding sources, both in terms of liquidity and stability. Outside bank runs, retail deposits generally seem to be considered as relatively stable. The research attempts to clarify and quantify this view, in particular in light of considerable changes in competition over time and considerable heterogeneity between banks in Germany. The authors also intend to analyze separately the impact of the crisis. The proposed study aims to shed light, in particular, on the following questions: 1) Demand side: How elastic is retail deposit finance, both in the aggregate (deposits vs. outside good) as well as between banks (market share)? What

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are the determinants of this elasticity? 2) Supply side: How do banks/different bank types manage retail deposits over time? How stable is this part of their overall financing? 3) Interest pass-through: How does this depend, in both a panel and cross-sectional perspective, on bank characteristics as well as prevailing competition? (See also the related project on the interest rate pass through process in the Group Monetary Transmission and Monetary Strategy.) Determinants of Bank Interest Margins: Impact of Maturity Transformation (nearly completed) Authors: Oliver Entrop, Christoph Memmel, Benedikt Ruprecht, Marco Wilkens Banks transform long-term, illiquid and risky loans into safe deposits that are due within short notice. In doing so, they take risks, for which they are remunerated. In addition, they can generate income by making use of their market power and by setting their credit and deposit conditions accordingly. In a theoretical model, the authors explore how the bank rates depend on the costs, credit and interest rate risk, and the banks market power. The hypotheses derived from the theoretical model are checked in an empirical study of all German universal banks. Government support of ailing banks: a distortion of the competitive landscape in loan markets? (planned) Authors: Puriya Abbassi, Michael Wedow During the financial crisis, numerous eurozone financial intermediaries received public support either in form of liability guarantees, capital injections or asset protection. While these measures have been carefully evaluated and finally approved by the European Commission to ensure the competitive playing field, a formal analysis backing up this line of argument is still due. The focus of this paper is therefore to investigate the impact of state support measures on banks loan provision, including both the pricing and the volume. Using a multivariate regression framework with panel data on German banks lending behavior, the first aim of the paper is to analyze the impact of government support on the supported banks funding provision in the loan market. In a next step, the authors intend to identify the potential effect(s) on the competitors of the supported banks. More specifically, conditional of the initial direct effect competitors benefit when a supported bank has to back out of a market i.e. through higher market share or interest rate margins. Alternatively, the competitor of a supported bank may lose market share when it is not able to compete on prices. Real effects of capital supply shocks on capital structure and investment decisions of German corporations (ongoing) Authors: Christian Bayer, Rainer Haselmann and Vikrant Vig The project investigates the real effects of a bank shock on borrowing firms in the context of Germany, a developed economy with well-developed financial markets. Tracing the effect of shocks is empirically challenging since banks shocks are often accompanied by changes in firms investment opportunities. The authors identify the fraction of loans German corporations receive from banks that have been affected by the crisis. Using a differences-indifferences research design, they document considerable changes to the debt structure of firms firms reduce the usage of debt and debt becomes concentrated. Finally, the authors document real effects on firms, smaller in particular and, surprisingly, find that the real effects of the capital supply shock are modest. Impact of social networks on lending relationships and capital allocation (nearly completed) Authors: Rainer Haselmann and Vikrant Vig

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The authors construct measures for social proximity between banks and their lenders, as potential determinants of lending relationships are social networks. They further exploit somewhat exogenous entrance of borrowers to social networks to rule out selection concerns that may bias the findings. The authors find that firms borrow significantly more from networks banks than they do from outside banks; being part of a social network seems to relax financial constraints for these firms. On examining the mechanisms that generate this increase in equilibrium level borrowing, the results from this study are suggestive of a favoritism story rather than an information story. German Unification as a Natural Experiment to Study Financial Development and Regional Economic Growth (ongoing) Authors: Rainer Haselmann, Thomas Kick and David Schnherr The idea is to study the development of bank branches in the New German states (Bundeslnder) on county level after the Reunification. The focus of this project is on explaining the determinants of banking expansion (and contraction) in Eastern Germany. Second, the authors want to use this event to observe how entrance of bank branches affects the external finance provision of corporations. Therefore, they incorporate micro-level firm data, especially credit relationships, to test the effect of a regional bank branch network on firms external finance possibilities and/or different indicators of firms performances. Third, the authors allow for a heterogeneous reaction of branch entrance on local loan supply; that is, they examine in how far this reaction depends on the size and concentration of the local banking market. The causal effect of banks equity holdings on the lending relationship: Evidence from Germany (planned) Authors: Daniel Foos, Bastian von Beschwitz If a bank holds an equity stake in one of its borrowers, it may be able to derive additional information on the company and to influence its decisions. This can have positive effects as it reduces the asymmetric information problem and the risk shifting problem due to increased monitoring. On the other hand, the bank can use its influence to promote its own business with potential negative effects on the borrowing firm. In this study, the authors want to use the German tax reform on capital gains in 2000 as an exogenous shock to banks equity holdings. Before the reform, capital gains at the corporate level were subject to a 50% tax, which prevented companies from selling their holdings in other companies, even if there was no economic reason to hold on to the stake. Especially German financial institutions were holding very large minority stakes in unrelated companies. The authors plan to study the following aspects: Do banks lend less to a company of which they sold a holding, thereby hinting to their reduced ability to monitor the company? Which types of credit do banks grant to affected companies, and do they require additional collateral to be pledged after the divestiture? Do banks engage in additional hedging through credit derivatives after divesting the monitoring stake? Finally, the authors will look at different subsets of borrowing firms, thus analyzing the relevant factors of borrowers opaqueness, which makes bank monitoring more relevant. Lending Conditions, Macroeconomic Fluctuations, and the Impact of Bank Ownership (ongoing) Author: Daniel Foos Using panel data of more than 850 German banks from the years 1987-2005, the author observes that savings and cooperative banks adjust their lending volume and conditions less cyclically than private commercial banks. This result and the intensity of the link between macroeconomic fluctuations and bank behavior are not driven by bank size or capitalization. Instead, these findings may result from the specific business model of savings and cooperative banks, which depends on strong and stable bank-borrower relationships.

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Preliminary results also indicate that a more stable loan growth policy leads to higher individual bank profitability. This finding is robust regarding different measures of business activity, including regional economic conditions. Credit concentration and write-offs (ongoing) Authors: Nadya Jahn, Christoph Memmel, Andreas Pfingsten In this project, the authors investigate the write-downs in the banks credit portfolio. They explore whether banks with a high sectoral concentration in the credit portfolio have lower or higher write-downs compared to banks with a less concentrated portfolio. The hypothesis being tested, empirically backed in earlier studies, is that banks with a concentrated credit portfolio develop a sector-specific knowledge, which improves the banks screening and monitoring skills, thereby leading to lower write-downs. To analyse this question, the authors use the borrowers statistics, making use of the sectoral breakdown of the write-downs in this data set. The Role of Interbank Relationships and Liquidity Needs (ongoing) Authors: Ben Craig, Falko Fecht, Gnseli Tmer-Alkan This project contributes to a more profound understanding of the interbank market structure and the liquidity supply in this market. The authors study to what extent peer monitoring (or more precisely relationship lending) prevails in the German interbank market. Controlling for the position of the bank in the network topology of the system, the authors find that banks with a more concentrated borrowing structure bid significantly more aggressively in the ECBs refinancing operations. Thus, concentrated borrowers have to pay a premium when they require funding from other interbank lenders other than their relationship lender. Banks, Markets and the Endogeneity of Liquidity Risks (ongoing) Authors: Falko Fecht, Nicolai Sthler The authors use a search theoretic framework to study the interaction between the liquidity of financial markets and the liquidity insurance provided by the banking sector. The more firms search for direct finance in financial markets, the more preferable it is for investors to withdraw money from the banking sector in order to invest directly. But the more likely it is for firms to find financing in the markets, the lower is their demand for bank loans. Consequently the lower is banks interest income and the interest rate they can pay on deposits. This interaction gives rise to multiple equilibria. In one equilibrium financial market are very liquid but bank financing is less relevant whereas in the other equilibrium financial markets are fairly illiquid while bank intermediation plays an important role. Workstream Banks foreign business For existing work, please refer to the research group International integration. Diversification and Determinants of Credit Portfolios Evidence from German Banks (ongoing) Authors: Benjamin Bninghausen, Matthias Khler The authors analyze in their project the geographical loan distribution of internationally active banks in Germany. Using the External Position Reports of German Banks, the authors investigate portfolio diversification with respect to potential substitution effects between different forms of foreign lending options such as cross-border lending or domestic lending by foreign branches and subsidiaries. Moreover, they examine which factors affect the choice of diversification mode and how the institutional variables explain cross-border lending.

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Markups and International Trade in Financial Services: Disentangling Market Power from Productivity (ongoing) Authors: Rients Galema, Michael Koetter, Caroline Liesegang The authors investigate trade in financial services using a micro perspective and bankspecific data on foreign activities from the External Position Reports of German Banks. Recently developed theories in international economics show that the choice whether and how banks engage abroad depends on their productivity relative to peers (Melitz, 2003). In turn, the export of financial services may also affect the productivity of domestic firms. However, heterogeneous firm-level productivity as explanation for international trade mostly focuses on manufacturing. The main parts of the project have been conducted and finalized end of 2011. For the projects of Koch, Sofka and Schmidt, Sofka and Schmidt and Dwel, Frey and Lipponer, please refer to the research group International Integration. References Abbassi, P. and T. Linzert (2011), The effectiveness of monetary policy in steering money market rates during the recent financial crisis, European Central Bank Working Paper, 1328. Bve, R., K. Dllmann and A. Pfingsten (2010), Do specialization benefits outweigh concentration risks in credit portfolios of German banks?, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 10/2010. Busch, R. and T. Kick (2009), Income diversification in the German banking industry, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 09/2009. Memmel, C. (2008), Which interest rate scenario is the worst one for a bank? Evidence from a tracking bank approach for German savings and cooperative banks, International Journal of Banking, Accounting and Finance, 1, 85-104. Memmel, C. (2011), Banks exposure to interest rate risk, their earnings from term transformation and the dynamics of term structure, Journal of Banking and Finance, 35, 282-289. Memmel, C. and A. Schertler (2011), Banks management of the net interest margin: Evidence from Germany, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 13/2011. Stein, I. (2011), Price impact of lending relationships, Deutsche Bundesbank Discussion Paper, Series 2: Banking and Financial Studies, 04/2011.

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Topic 1: Inflation perspectives after the crisis In the aftermath of the crisis of 2008/9, there is considerable concern that high public debt and liquidity provision by the ECB and other important central banks will lead to higher inflation in Europe and worldwide. Even if currently inflationary pressures in industrial countries appear low, there is fear that inflation will come in through the backdoor via commodity and oil prices increases. These may be triggered by the ample liquidity or the expansionary policies in emerging markets. However, it is not universally accepted that high public debt and liquidity need to lead to high inflation. A case in point is Japan, whose public debt is high and rising, and where monetary policy is loose, but prices are falling rather than rising. There is also a clear theoretical possibility that the expectation of low (or zero) interest rates over a long horizon may result in an economy to settle at a deflationary equilibrium, where monetary policy becomes irrelevant as a stabilization tool. Key to avoid such a deflationary scenario is the credible expectation of future inflation. Alternative proposals actually advocate a higher inflation target (higher than 2%) as a tool to reduce the risk of deflation and at the same time alleviate imbalances on households and governments balance sheets. (See, for example, the proposals by Rogoff or Blanchard). The goal of this research task force would be to (i) gain a better understanding of inflation developments and outlook in the aftermath of the financial crisis and to (ii) assess alternative policy strategies in light of the findings. There are several researchers planning and working on projects that take different empirical and theoretical angles to shed light on the causes of inflation. That work is the core of the task forces research effort. (See also the research programme). The task force will in addition provide a unified perspective on the relevant literature, and synthesize the work of their members into a more comprehensive understanding of the relevant issues. The interaction of the task force members will ideally also lead to the identification of joint projects that go beyond the work already planned. The output of the task force will be both high-level academic research output and a synthesis of the state of policy-relevant research that aids policy makers in their deliberations. The currently planned projects comprise: S. Eickmeier, B. Hofmann, L. Gambacorta (Understanding global liquidity) plan to extract interpretable global liquidity indicators and assess their role for global inflation. S. Eickmeier, B. Hofmann (Analyzing the effects of liquidity shocks from advanced and emerging economies) separate global liquidity shocks from advanced and emerging economies and look at their dynamic transmission on international asset and commodity prices, interest rates and inflation. S. Eickmeier, M. Lombardi (The transmission of monetary policy to commodity prices: speculation vs. fundamentals) analyze the role of monetary policy on various commodity prices via speculation vs. fundamental channels. S. Eickmeier, M. Khnlenz, U. Slopek (China's role in global inflation) look more carefully on the role of China as a (possible) exporter of inflation after many years during which China has helped to keep price developments under control. A. Buzaushina, Z. Enders, M. Hoffmann (International financial integration Page 65 of 68

and the falling exchange rate path-through) develop a framework to understand the changing transmission of international shocks on inflation. Taking fiscal policy into the picture M. Kliem, A. Kriwoluzky, S. Sarferaz (Long-run implications of an increase in public debt) investigate empirically how, over the long run, public debt in the U.S. is related to inflation and output. M. Krause and S. Moyen (Optimal monetary and fiscal policy in a model with long-run government debt) take a normative view in analysing the interaction of fiscal and monetary policy, to understand the link between public debt and the optimal target inflation rate. V. Lewis (Labour hoarding and the zero lower bound for interest rates) questions the argument that a higher inflation target is needed to avoid the zero lower bound problem in Europe. Finally, M. Mandler (Threshold effects in European inflation dynamics: the role of money) looks after the role of money as a driver of inflation.

Topic 2: Stress tests against macroeconomic shocks This task force develops and implements methods to assess the impact of macroeconomic shocks on banks credit portfolios. For reasons of manageability, the task force confines itself to the direct effects and neglects possible stress amplifications within in the financial system. Stress tests concerning the banks credit risk have been investigated for several years, and yet, the stress test methods can still be improved; in particular, by using additional data sources and new analytical tools. For the first step the task force will work on the design of the stress scenarios and, in the second step on the link between the economic conditions and the banks credit portfolio. (1) How to design stress scenarios that are exceptional, but plausible and that capture all the relevant risk drivers for the banks credit portfolio? Michael Grill, Bjrn Hilberg, and Norbert Metiu design a stress scenario using nonlinear relationships between different economic and financial variables. This refined procedure is in contrast to previous methods, where the focus is on linear relationships. Moreover, this procedure makes it possible to incorporate additional relevant economic and financial variables (apart from the traditional ones like GDP growth and interest rates). The selection of the relevant variables is based on a study by Yalin Gndz, Christoph Memmel, and Peter Raupach who use the banks actual provisioning data for different industry sectors of the German real economy. (2) How robust are banks to macroeconomic shocks? Klaus Dllmann, Thomas Kick, and Philipp Koziol investigate banks ability to withstand macroeconomic stress scenarios. Banks can be roughly classified into two groups according to their business model: Banks that are large and often internationally active and banks that are small or medium sized and whose focus is on the region where they are located. a. How vulnerable are large and domestically systemically important banks? This approach comprises two steps: First, a macro-econometric model is used to forecast the impact of a substantial increase of the user cost of business capital for firms worldwide on three particularly export-oriented industry sectors in Germany. Second, the impact of this economic multiPage 66 of 68

sector stress on banks credit portfolios is captured by an asset value portfolio model. The German credit register provides access to highly granular risk information on loans which is necessary to capture name concentrations and sectoral concentrations as accurate as possible. The results will be informative also for the design of future stress tests that are coordinated on the European level. b. How can single or groups of regional banks withstand macroeconomic shocks? This approach will focus on regional banks of small and medium size (i.e., small private banks, savings banks, and cooperative banks). This project is based on the borrowers statistics which provides a better coverage than the credit register because of the 1.5 m minimum threshold for exposures included in the credit register. Reference: Dllmann, K. und Kick, T. (2012), Stress testing German banks against a global cost-of-capital shock, Bundesbank Discussion Paper Series No 04/2012.

Topic 3: Bank Lending, Capital Regulation, and the Business Cycle The recent financial crisis, being preceded by a large expansion of bank lending, and potentially followed by a severe contraction of credit volumes and conditions in some countries, attracts new interest to the interactions between bank lending behavior and the business cycle. Furthermore, the international Basel II framework for banking regulation and its substantial revisions in response to the crisis call for a thorough assessment of their impact, in particular with regard to potential pro-cyclical consequences. From a macro-prudential perspective, concerns have been raised that riskbased capital requirements evolve pro-cyclically, thereby amplifying economic cycles. In order to investigate the nexus between bank lending, capital regulation, and the business cycle, the task force will focus on addressing the following questions: 1. How do credit cycles and business cycles interact? Michael Scharnagl and Falko Fecht examine the mechanism through which financial markets can affect the real economy, analyzing the impact of variables describing bank behavior (e.g. bank earnings) on the evolution of loans. The application of wavelet methods helps to identify cycles of various frequencies (short and long term) in the time series of data, and to compare their relative importance over time. In a comparative analysis of cyclical bank behavior in Germany, Daniel Foos observes that savings banks in the public sector adjust loan volumes and conditions less cyclically than banks with cooperative or private owners. As the intensity of the link between macroeconomic fluctuations and bank behavior is not driven by bank size or capitalization, this finding may result from differences between the business models of savings and cooperative banks, and their dependency on strong and stable bank-borrower relationships.

2. How does the regulatory regime interact with the cyclicality in the real sector? Page 67 of 68

A current project by Klaus Dllmann and Philipp Koziol deals with the evaluation of minimum capital Requirements for bank loans to Small and Medium Enterprises (SMEs). The systematic risk in SME exposures is analyzed relative to other asset classes in order to discover whether the level of required capital under Basel II / III adequately reflects the risks in SME lending. Marcus Pramor is seeking to analyze the co-movements of minimum required capital, risk-weighted assets, and exposures under Basel II with the macro-economy, disentangling the role of risk parameters and the contribution from individual portfolios.

3. Which instruments could mitigate the pro-cyclical implications of bank behavior? Klaus Dllmann and Daniel Foos evaluate whether and how a countercyclical capital buffer regime can mitigate potential (pro-) cyclical effects of the risk-based capital requirements under Basel II. The envisaged theoretical set-up aims to provide a buffer framework that performs well throughout the entire cycle, without the need for any manual adjustments by regulators (neither in boom nor at the beginning of bust phases).

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