On the Factors Causing a Boomlet Across Different Countries. A Case Study of the German Mortgage Market

Table of Contents

Abstract

Preface

Executive summary

Table of figures

I. Chapter 1: Introduction
1. The rationale for the topic
2. Research aim
2.1 Research questions
3. Methodology
3.1 Research procedure
3.2 Research philosophy
3.3 Research approach
3.4 Characteristics
3.5 Research strategy
3.6 Research design
3.7 Validity, reliability and ethical considerations

II. Chapter 2: Literature Review
1. European Central Banks’ onetary policy
1.1 Understanding the European Central Banks (ECB) regulations/ mechanism
1.2 ECB’s objectives
1.3 Task and responsibility
1.4 History of European Central Bank
1.5 Monetary policy of European Central Bank
1.6 Side Effects of Monetary Policy on financial stability
2. Macroprudential policies
2.1 Macroprudential tools that affect credit supply
2.2 Macroprudential tools targeting credit demand
2.3 Practical applications of prudential methods: Toolkits
2.3.1 Toolkits used to get over overlaps on borderline of the policies
3. What a housing market bubble is and the consequence
4. Case study of “Spanish housing bubble”
5. Case study of “housing finance and real-estate booms.”
5.1 Factors associated with cross-country differences in mortgage markets
5.2 Credit boom and house-price boom
5.3 Types of credit booms
5.4 Can we tell bad real-estate booms from the good sign?
5.5 Can credit booms help predict house-price booms?
6. Case study of “Speculative price bubble in Urban housing market in Germany.”
7. Report of “Empirica-Blasenindex I/2014”

III. Chapter 3: Discussions
1. Analysis of housing markets in two biggest economies: the United States & China 57
1.1 The United States
1.2 China
2. Germany vs. Spain housing bubble in the case study of Spanish housing bubble
3. Discussion on the case study of housing finance and real-estate booms
4. Discussion two resources “Speculative Price Bubbles in Urban housing Markets in Germany” &
“Empirica-Blasenindex I/2014”
5. Discussions ECB’s monetary policy, together with macro-prudential policy

IV. Chapter 4: Conclusion
1. Introduction
2. Conclusion in research objective
3. Conclusion in research aim
4. Limitation of the study
5. Opportunity for further research
6. Recommendation

References

Abstract

In any financial crisis, mortgage boom has been buoyed by the housing boomlet. When that spiral inverted, falling house prices lead to widespread failures and debt overhang. The purpose of this paper is to define the whether or not the German mortgage market occurs housing bubble as well as find out factors that prevent housing bubble in Germany. The methods are to analyze secondary data from prestigious financial institutes. The result is that there is no housing bubble in Germany at the national level, but there has been a housing bubble in several cities. Fusions of macroprudential policy (loan-to-value), monetary policy (interest rate) and other housing financial characteristics (term to maturity, cost of registering property, and tax deduction) are buffers to stop housing boomlet. In conclusion, the German mortgage market has not been affected by the United States housing bubble is due to the difference in manipulating macroprudential policy and housing financial characteristics.

Preface

To my family and my friends who have motivated me to finish this thesis

To a person, I will never forget in my life

And to unforgettable memories in Germany

Executive summary

The goal of the paper is to find and analyse factors that ignited housing buble cross countries and apply in Germany mortgage market. The reason for research is that the global financial crisis emphasized the risks associated with real-estate booms. In any great financial crisis, mortgage boom was buoyed by the housing rise and economic activity. When that spiral inverted, falling house prices make tightened lending standards, which bring to widespread failures and debt overhang. The consequence is recessions and high surges in public debt.

The thesis is composed of four chapters, each of them dealing with different perspectives of housing boomlet and macro financial factors.

Chapter One is introductory the reason, research aim, research questions and defines methodology used in the thesis. The chapter is subdivided into three parts. Part one is the rationale for the topic. Part two deals with research aim. Part three handles methodology.

Chapter Two examines literature review relavant housing bubble. The chapter consists of seven parts. Part one focuses on monetary policy of European Central Bank (ECB). Part two addresses macroprudential policies. Part three explains a housing bubble and the consequence. Part four makes recommendation for the case study of Spanish housing bubble. Part five presents case study of “housing finance and real-estate booms”. Part six reviews “case study of speculative price bubble in Urban housing market in Germany”. Part seven reports based on “Empirica-Blasenindex I/2014”.

Chapter Three is the discussions and subdivided into five parts. Part one considers analysis of housing markets in two biggest economies: the United States & China. Part two compares Spanish housing bubble causes with German housing bubble causes. Part three and four discuss “housing finance and real-estate boonm”, “Speculative Price Bubbles in Urban housing markets in German” & “Empirica Blasenindex I/2014”. Part five shifts the focus on ECB’s monetary policy & macroprudential policy and includes a new point of view.

Conclusions are drawn in Chapter Four. The main aim of the paper is to rebut and prove the initial hypothesis has been reached. I suggest that fusion of macroprudential policy (loan-to-value - LTV), monetary policy (interest rate) and other housing financial characteristics (such as term to maturity, cost of registering property, and tax deduction) are buffers to stop housing bust in Germany mortgage market.

Table of figures

Figure 1: Grants chart in the research procedure

Figure 2: The methodological pyramid

Figure 3: Monetary Policy Effects on Financial Stability (Brockmeijer, 2012, S. 7)

Figure 4: Prudential toolkits (Jacek Osinski, 2013, S. 23)

Figure 5: Model of prudential toolkits. Source: (Jacek Osinski, 2013, p. 24)

Figure 6: House finance characteristics in Germany (Eugenio Cerutti, 2015, p. 28)

Figure 7: Cross-Country Differences in LTV and Maturities of Mortgages (Eugenio Cerutti, 2015, p. 10).

Figure 8: Occurrence of Credit Booms during 1970-2012 (Eugenio Cerutti, 2015, S. 14)

Figure 9: Occurrence of House-price Booms and Credit Booms. Source: (Eugenio Cerutti, 2015, p. 15)

Figure 10: Drivers of Bad House-price Booms (Eugenio Cerutti, 2015, S. 35)

Figure 11: Triggers of house-price boom (Eugenio Cerutti, 2015, S. 34)

Figure 12: Cross-section of Outstanding Mortgage Debt/ GDP Average (Eugenio Cerutti, 2015, S. 7)

Figure 13: Housing price in geographical distribution. Source: (Kholodilin, Speculative Price Bubbles in Urban Housing Markets in Germany, 2014a, p. 33)

Figure 14: Critical value explation by diagram

Figure 15:Chow test: empirical size, power, and estimated break dates for T = 20 (Kholodilin, Speculative Price Bubbles in Urban Housing Markets in Germany, 2014a, S. 20)

Figure 17: Warning levels for the 12 largest circular cities and nationwide distribution (empirica, 2014, p.1)

Figure 18: Overall and individual Index for Germany (empirica, 2014, S. 2)

Figure 19: Overall index in Germany as well as for region types (empirica, 2014, S. 3)

Figure 20: U.S housing market by S&P Case-Shiller Index (Bloomberg, n.d)

Figure 21: Homeownership rate (Bloomberg, n.d)

Figure 22: Chinese cities become the least affordable in the world. (Anderlini, 2014)

Figure 23: Summary of German factors taken out from the case of Spanish housing bubble

Figure 24: German GDP growth over the years. Source: (destatis, 2017)

Figure 25: Equity Volatility Indices: VDAX versus VIX (Deal, n.d)

Figure 26: Indicators in the credit boom

Figure 27: Monetary Policy Effects on Financial Stability (Brockmeijer, 2012, S. 19)

I. Chapter 1: Introduction

The financial crisis in August 2007 has been the most severe of the post-World War II era. Once it spreads on the global scope of the crisis, affecting on a range of markets and institutions, as well as the number of systemically critical financial institutions that failed or came close to the worst crisis in modern history. It is imperative to learn the lessons of the crisis. Because of the complexity, its lessons are significant, and they are not always straightforward. Undoubtedly, both private sectors and financial regulators must improve their ability to monitor and control risk-taking. Baker (2008) has illustrated apparently that „The central element in the current financial crisis is the housing bubble“ (p. 73). The irrational exuberance emerging on bubble created an environment that was ripe for the brokers and dealers in Frankfurt financial market so much trouble.

The finding of an article in the Bundesbank (2013) illustrated that the prices for houses and apartments have climbed by a total of 8.25 %. In Germany’s largest cities, prices of apartments have increased by more than one-quarter over the past three years. The Bundesbank warned that this could cause fears of a broad-based property prices boom (Possible overvaluation of residential property in German cities, 2013). In an article by Klimes (2013), the Germany’s central bank has apparently informed the markets of country’s house prices can be seen to overvalue by more than 20% in some urban areas. The Bundesbank highlighted prices in the urban housing market are overvalued by 10% higher than the attribution of demographic and economic factors. More interestingly, the Bundesbank pointed out two points are the cause of inflation: money flowed from distressed Eurozone members into Germany was casualties of sovereign debt crisis, along with low-interest rates set by European Central Bank across the continent that has cut returns in financial assets. However, these are not two most important factors of housing prices overvaluation; there are factors which trigger the adjustment of housing prices in Germany. This dissertation will dig into academic resources to bound the overview about Germany mortgage market for the period 2000s- 2013s.

In an article by Damm (2017), he highlighted that the property prices are climbing over and over. The prices have increased by 10 Percent in 2016. Since 2004 it was increased by 56 percent in Cologne and 115 percent in Berlin. The Bundesbank quoted the exaggeration in the housing bubble is between 15 % and 30 % in 2016. Interestingly, the expert from Commerzbank has emphasized monetary policy results in the increase in housing prices. The note firstly analyzes mortgage markets across variable countries. It documents the heterogeneity of housing finance institutions once housing finance characteristics (mortgage characteristics), institutional factors (the rule of law/ rule by law), and macro factors (inflation volatility) predict cross- country differences in mortgage-market depth. Thereupon, these indicators predict the German mortgage market if it explores the profits of housing-finance development for home ownership and welfare.

1. The rationale for the topic

Germany economy is the strongest economy in the Eurozone, their debt is not particularly high, and they have an enormous amount of products to offer the global markets. The financial market plays a role in performing the essential function of channeling funds from economic players that own surplus funds to those having a shortage of funds. In other words, it allows funds are moving from an economical player who lacks productive investment opportunities to people who have such opportunities. However, the financial crisis is always a shadow of every economy, and housing bubble indirectly is the cause of systemic financial crises. As a consequence, this dissertation firstly would like to scrutiny the X-factors that might be the cause of housing bubble cross countries. It then finds the answer whether or not German mortgage market drops into housing bubble for the periods approximately 2000s - 2013s. As a perspective of a graduate for Master Degree International Management specialized in Finance and Accounting, this thesis contributes a broad range of knowledge for understanding how mortgage market work, also for financial career.

2. Research aim

The study targets to answer the question whether or not the German mortgage market confronts with a housing boomlet. It also investigates which buffers help avoid a housing bubble occurrence in Germany.

2.1 Research questions

- Which factors are the causes of housing bubble in cross-countries?
- Is bad real-estate boom in general good sign?
- Which type of credit boom can predict house-prices boom?  Is there any housing bubble in Germany?
- Hypothesis 1: If Yes, which factors help manage?
- Hypothesis 2: If No, which buffers help avoid?

3. Methodology

Master of science (M.S.c) focuses on academic resources from public institutes such as IMF, BIS, and Empirica Institute. Price (2009) highlighted that the research methodology develops skills in conceptualizing research strategy, utilizing available literature review, and data collection to communicate a series of well-conscious answers based on the topic question.

3.1 Research procedure

The Gantt’s chart was drawn to flow the time frame (as monthly) and key tasks on the dissertation.

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Figure 1: Grants chart in the research procedure.

3.2 Research philosophy

Epistemology (the theory of knowledge - literature review) has chosen due to flexibility, practice in this subject, and suitability. This research adopted the philosophy of epistemology in 2012 by Thornhill. The result of the housing bubble is the set of natural knowledge from a human being as well as the development of knowledge. He also revealed that it is not faithful to choose which one is the best research philosophy methodology.

Based on the methodological pyramid (figure 2), this topic can follow from a particular flow to the highest stage: Data collection methods are from academic resources. This research adopted by Quinlan (2011) that explains fundamental philosophies and different stages of research methodologies as well as data collection methods.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: The methodological pyramid.

The thesis focuses on qualitative data, but inside qualitative data requires a lot of quantitative interpretation. It was followed via their quote by Thornhill et al. (2012) and Quinlan (2011). They mentioned there are mainly two epistemological positions: Positivism (Quantitative data) and Interpretivism (Qualitative data). Saunders (2012) also supported this argument that qualitative research associated with an interpretive philosophy. Such study is referred as naturalistic since researchers need to operate within a research context with a purpose to build trust, participation, in-depth understanding and intensive meanings.

3.3 Research approach

The research plan for this topic runs from a cross-country perspective of the housing bubble to specify into German housing bubble. The study adopted in 2005 by Blackmon that there are two kinds of research approaches, scientific approach (objective) and ethnographic approach (subjective). Due to the complicated characteristics of the financial market, the research is decided to analyze literature review to find out the answers. Various studies supported the arguments that qualitative research starts with an inductive approach. For instance, Price (2009) suggested that the inductive reasoning (bottom-up approach) moves from broad generalization to more clear-cut observations. This is adopted to overview the primary monetary as well as macroprudential policy by delineating housing financial characteristics cross- countries. Finally, it answers the case of the German housing bubble and takes out new points of view.

3.4 Characteristics

Saunders (2012) noted data collection is flexible so that questions and procedures can alter and emerge during a research process that is both interactive and naturalistic. The success of investigation depends on gaining physical access to a reader, building affinity and demonstrating sensitivity to achieve cognitive access to their data. This study uses data collection as the core method due to the complexity of the topic.

3.5 Research strategy

A research strategy is an idea of how an investigator follows the road finding and answering his research question. It is the methodological connection between the following choice of methods and philosophy to collect as well as analyze datas. Works by Saunders (2000, 2003, 2007, 2009, 2012) have supported this claim.

Yin (1984) identifies the case study research method “an empirical inquiry, which investigates a contemporary phenomenon within its real-life context” when the boundaries between context and phenomenon are not evident. This research seeks case studies that specify in a contextual research phenomenon. The specific case studies are housing finance and real-estate booms: A Cross-Country Perspective by (Eugenio Cerutti, 2015), Speculative Price Bubbles in Urban Housing Markets in Germany by (Kholodilin, Speculative Price Bubbles in Urban Housing Markets in Germany, 2014a), Spanish housing bubble (SNBCHF, 2013), and empirica-Blaseindex I/2014 by (empirica, 2014). There are three types of case study design: Critical case, unique case, and revelatory case. Due to the difficult situation of topic question, case study designs includes critical cases and unique cases. For instance, the significant case is empirica-Blaseindex I/2014 by (empirica, 2014), this is a real case study of Spanish housing bubble and housing finance and real-estate booms: A Cross-Country Perspective by (Eugenio Cerutti, 2015).

3.6 Research design

There are types of research design such as exploratory studies, descriptive studies, and explanatory studies. Works by Saunders (2000, 2003, 2007, 2009, 2012) have supported the argument: “An exploratory study is a valuable means to ask open questions to discover what is happening and gain insights about a topic of interest. It is particularly useful if you wish to clarify your understanding of a problem, such as if you are unsure of the precise nature of the problem. It may be that time is well spent on exploratory research, as it might show that the study is not worth pursuing. There are many ways to conduct exploratory research. These include a search of the literature;” (p. 171). As result, this study digs into literature reviews to gain insights of housing bubble phenomenon.

Cooper and Schindler (2008) suggested that qualitative research methodology is designed to serve how and why things occur and target to gain an in-depth knowledge of the situation. These authors emphasize that qualitative research is when a researcher wants to analyze participants’ emotions, behaviours, language, and motivations (p.162). Investigations by Bryman & Bell (2011) supported this argument; qualitative research apparently took into account with the word rather than a number.

3.7 Validity, reliability and ethical considerations

The research consists of a number of the ethical standard such as ethical behaviours, ethical responsibilities in research, and ethics approval process. Various studies supported this argument (Diener, 1978; Bell,2011; Price,2009). Bell (2011) recalls ethical principles in four main areas: invasion of privacy, lack of informed consent, deception and harm to participants. In this thesis, because of scientific and professional characteristics, all of the retrieved resources are taken from prestigious financial institutes. These are open resources, which publicly released. The research follows from APA reference style guide.

Sauders (2012) highlighted there will be consistent findings between data collection techniques and analytic procedures once they were repeated on another occasion or by a different researcher. In practice, due to the fluctuation of economic related to the mortgage market, it is vital to collect case studies at the same time: an interval. There is not a lot of academic German housing bubble research in 2016, 2017 so the German housing bubble researchers since the 2000s until 2013s. This is a long interval even though it is not in recent but not too far away.

II. Chapter 2: Literature Review

This section firstly overviews ECB’s monetary policy as well as general macroprudential policy because these tools help efficiently manage the housing financial characteristics.

Secondly, it identifies the meaning as well as a consequence of a real estate market. To answer the question of German housing bubble, the literature review is supported by sequential mention of understanding case studies such as “Spanish housing bubble” (SNBCHF, 2013), “housing finance and real-estate booms” (Eugenio Cerutti, 2015), and “Speculative price bubble in Urban housing market in Germany” (Kholodilin, Speculative Price Bubbles in Urban Housing Markets in Germany, 2014a). There is a German mortgage market’s index from “Empirica- Blaseindex I/2014” by (empirica, 2014). The case study „Spanish housing bubble“ lists the causes triggered housing bubble in Spain. The case study „housing finance and real-estate booms“ find factors associated with cross-country differences in variable countries' mortgage markets, explaining types of credit booms to unveil if housing bubble occurs, will the national economy drop into bad economic condition or still in good economic condition. Also, it researches which types of credit boom could help predict house-price booms. The case study “Speculative price bubble in Urban housing market in Germany” will analyze German mortgage market at the city level. The general German mortgage market’s index will be taken out from a report “Empirica-Blaseindex I/2014”. The purpose of these studies is to analyze from cross- country perspective of the mortgage market to be more specific into German mortgage market’s case studies.

1. European Central Banks’ onetary policy

When borrowers go to lenders to borrow for a mortgage loan, there are two types of interests: Fixed interest (default risk is at the bank - monthly payments is fixed) and floating interest (default risk is at the borrower - monthly payments is fluctuated). In figure 6, German banks use significantly fixed interest to adopt mortgage loan. The German interest rate relies on ECB’s monetary policy. Thereby, it is vital to understand its basic monetary policy.

1.1 Understanding the European Central Banks (ECB) regulations/ mechanism

There are three terms related to European bank system: ECB (European Central Bank), ESCB (European System of Central Banks), and Eurosystem. Because ECB influences the single monetary policy, the discussion will focus on this section without defining ESCB and Eurosystem.

1.2 ECB’s objectives

The primary purpose is to maintain price stability, which protects the value of the euro. Price stability is vital for economic growth and job creation - mains of the European Union’s aims. It represents the most significant contribution monetary policy that can manipulate in the financial system.

1.3 Task and responsibility

The European Central Bank (ECB) has responsibility for the prudential supervision of credit institutions, which is members of the euro area and non-euro area Member States, within the Single Supervisory Mechanism that comprises the competent national authorities. Also, Eurosystem has responsibility for implementing and defining monetary policy, conducting foreign exchange operations, sponsoring the smooth operation of payment systems, managing the exchange reserves in euro areas, and maintaining financial stability and macroprudential policy. As a result, ECB helps give to the safety soundness of the banking system, and the stability of Eurozone financial system.

As a part of monetary policy, the primary tool of the central bank is to manage interest rates. An individual cannot open a bank account at a central bank or ask for a loan. It does not act as a bank for the commercial banks, but it serves as a bank for the commercial banks to influence the flow of money and credit in the economy to manipulate stable prices. The central bank works like a national bank in each country. Commercial banks come to a central bank to borrow money, typically in a short-term loan. Commercial banks have to give collateral - a kind of asset as government bond that can guarantee that they will repay the money.

Commercial banks can give a long-term against short-term deposits; they can confront “liquidity” problems - a situation where they have can not swap money into cash swiftly. This step helps keep the financial system stable. Central banks play a role for monetary policy by issuing coins and banknotes, often ensuring the smooth functioning of payment systems for banks, trading financial instruments, managing foreign reserves, and informing the public about the economy. Central banks supervise the commercial banks to ensure the lenders are not taking risks. Later it will discuss the role of ECB on monetary policy which has an enormous impact on the interest rates and so far for the German mortgage market.

1.4 History of European Central Bank

In 2016, In a book by Mishkin indicated that before January 1999 the Federal Reserve had no components regarding its importance in the central banking world. Hence, the game has completely changed with the initiative of European Central Bank (ECB) and European System of Central Banks (ESCB) in which drives monetary policy for European Monetary Union countries. These countries have a similar GDP with that of the United States and a population that exceeds of United States. The decisions in the Eurosystem are taken part in a centralized manner by ECB but executed via the NCBs (National Central Banks) in decentralization. In June 1988, according to ECB (ECB, n.d), The European Council confirmed the objective of the progressive realization of Economic and Monetary Union (EMU). It instructed a committee chaired by Jacques Delors, the President of European Commission, to research and suggested forming a union. The ECB was established in 1998, located in Frankfurt, Germany.

The ESCB encompasses the ECB and the NCB of 28 EU member states, mainly use euro as national currency. The Eurosystem, however, comprises of the ECB and the NCBs of nineteen countries that have adopted the euro. EU countries refer only to those countries using the euro as their currency.

The decision-making process at the European Monetary Union takes place at three levels: the Governing Council, the Executive Board, and the General Council. The General Council plays a role as an advisory body, the Executive Board is the daily execution of decisions of the Governing Council; and the Governing Council has responsibility for the decision-maker.

The Governing Council known as the decision-making part of ECB is the combination of six members of the Executive Board as well as the National Central Banks of the nineteen euro- area nations. The primary task of Governing Council is to formulate the monetary policy for the Eurozone.

1.5 Monetary policy of European Central Bank

The way ECB manipulates monetary policy is that the central bank is the only issuer of bank reserves, banknotes based on the monopoly supplier. By this reason, the central bank can influence money market conditions and drive short-run interest rates. By using the supply of monetary base, a change in money market interest rates induced by the central bank sets in motion, some mechanisms and actions by economic agents, eventually affecting economic developments such as output or prices. This process is called monetary policy transmission mechanism yet it is complex with its broad features and are understood. The neutrality of money is a widely accepted and empirically validated proposition in the economic profession. In the long term, after all, adjustments in the economy have gone through, a change in the quantity of money (ceteris paribus condition) will have an impact on a shift in the standard level of prices and will not tempt permanent changes in real variables namely employment and output. A change in the quantity of money will demonstrate a change in the unit of account and so far the general prices level which is the result of other variables unaffected.

Due to the influence on financing system on the economy and expectations, monetary policy decisions affect other financial variables namely asset prices, especially mortgage market price. Changes in other asset prices typically affect inflation indirectly, to the extent that wealth effects impact on the private sector consumption decisions. They may also have implications for financial stability when prolongs asset price bubbles suddenly burst.

1.6 Side Effects of Monetary Policy on financial stability

According to Investopedia, monetary policy is the combined action of the central bank, regulatory committees and currency board that determines the rate as well as the size of money supply growth, which in turn affects interest rates. Monetary policy can be seen through interest rate adjustment, controlling the amount of money in bank reserves, and buying and selling government bonds. As a result, monetary policy has a huge impact on financial stability. In a journal by (Marek Jarociński, 2008), it is said allegedly that monetary policy shocks and housing demand are strongly correlated with the existing empirical literature. In other words, housing demand shocks have an enormous impact on housing prices that lead to residential investment.

There are some channels by which monetary policy might affect financial stability. It can be seen such as borrowing constraints, risky behaviour of financial institutions, and externalities through aggregate prices. The following figure demonstrates the prediction from theoretical models of the effects of changes in the monetary policy stance on financial stability.

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Figure 3: Monetary Policy Effects on Financial Stability (Brockmeijer, 2012, S. 7).

Change in monetary policy can affect the tightness of borrowing constraints and the likelihood of default. On the one hand, monetary easing relaxes collateral constraints, lowering financial distortions on both demand and supply side of credit. On the contrary, a tightening of rates can harmfully influence borrowers’ quality, leading to higher default rates, and triggering possibly a financial crisis.

Changes in monetary policy can affect the risk-seeking behaviour of financial intermediaries in two ways. There are a risk-taking channel and risk-shifting channel.

Risk-taking channel: Borio (2008) emphasized that low monetary policy rates encourage banks to expand their balance sheets and decrease efforts in screening borrowers. It results in other agents to seek more risks to achieve higher returns. These effects are worse if monetary policy accommodates for too long during expansions. Farhi (2012) highlighted that if monetary policy is expected to be lowered in recessions to back up the financial system, this may create additional bonus to correlate risks.

Risk-shifting channel: High monetary policy can decrease intermediation margins, and lead lenders, particularly poorly capitalized intermediaries, to seek more risk (Bhattacharya, 1979). This channel may be stronger before financial crisis if intermediary leverage is high and competition limits the pass-through of lending policy rates. More generally, a flattening yield curve related with surges in policy rates can lead banks to seek risk with a purpose optimizing profits. The monetary policy affects externalities operating through aggregate financial prices and exchange rates. It plays a role in the collateral value due to the effect on asset prices and exchange rates, which in turn affects the tightness of borrowing constraints.

Asset prices: Bernanke (2005) noted that low-interest rate would increase asset prices, which stem from further growth in leverage and bring in asset price booms, worsening the whole financial cycle. On the other hand, in an article by Adrian (2005), a tight monetary policy can trigger collateral constraints to blind, fire sales to go booming, which results in adverse asset price externalities.

Exchange rates: In open economies, the high-interest rate can attract capital flows which result in raising the currency and leading to excessive borrowing in foreign currency and laying the ground for exchange rate externalities during the depreciation period.

The intensity of these effects is subject to the point in the financial cycle. When financial imbalances build up, low monetary policy rates diminish current defaults, but in turn, it induces banks to take riskier loans and raise leverage. When prices reach close to the peak of the financial cycle, this can bring risk-shifting and borrower defaults. Moreover, incentives to link risks due to the expectation of future monetary easing can be stronger in the upsurge of the financial cycle.

The intensity also depends on the financial structure and capital account openness. For example, securitization reduces the intensive effect of monetary policy on credit extension by banks. But the importance of risk-taking and the risk-shifting channel may not decrease since they come to work through both banks and non-banks. Furthermore, in opened economies, the domestic monetary policy has a weaker influence over local long-term rates and asset prices, but exchange rate externalities have a stronger impact.

- In open economies like Germany, high monetary policy rates can give incentives to capital inflows and foreign exchange borrowing. When the monetary policy is tighter, foreign exchange lending to households increased ahead of the crisis, which leads to worsening the situation. In the same time, when the central bank redeems rates to support the economy in a downturn, this results in a depreciation and aggravating exchange rate externalities arising from tightening constraints.
- Domestic monetary control has weakened for advanced economies like Germany when international financial integration raised over several years. Bernanke (2005) highlighted that a global saving accumulation decreased long-term rates in developed economies like Germany. By this reason, it brings in the relationship between short rates and long rates becoming weak, in that way decreasing the infiltration of policy rates to asset prices.

1.7 Quantitative easing

One of outstanding ECB monetary policy at this moment is quantitative easing (QE) with a purpose to control inflation below 2%. In March 2015, ECB created new money electronically to buy financial assets such as government bonds or corporate bonds from commercial banks as part of its non-standard monetary policy measures. The following steps are:

1. The European Central Bank purchases government bonds or corporate bonds from commercial banks.
2. This increases the price of these bonds, so commercial banks have money in the banking system.
3. As a result, the interest rates fall, loans become cheaper.
4. It motivates consumers to borrow more and spend less to repay their debts.
5. Higher consumption, more investment support economic growth, and job creation.
6. The prices rise, the ECB achieves an inflation rate below, but close to, 2% over a period.

2. Macroprudential policies

Macroprudential policy is a new policy that was introduced to stabilize the financial system. In figure 3, there is loan-to-value (LTV) rate that plays a role in the balance of housing mortgage across countries. According to The Economist (2014), macro-prudential regulation is a financial approach that aims to lessen the risk on the financial system. Although there is a monetary policy with high-interest rates to prick asset bubbles, it raises interest rates; the unemployment also climbs up which lead to risk an outbreak of deflation.

The modern financial system consists of a diverse type of markets and assets; these regulations were designed to ensure the safeguard. Before the financial turmoil 2008, banking regulations was predominantly a static affair, with leverage caps (the tool limit the amount of money bank can borrow) and capital requirements (the tool that banks hold enough level of money on their balance sheets) that fixed over the time. Nevertheless, when the crisis demonstrated, these rules are inadequate. The 2010 Basel III accord tightened restrictions and had an initiative on the concept of countercyclical buffers. The buffers allow regulators to raise capital requirements once credit growth is high relative to GDP, an indicator that there is instability in the macro-financial market. These counter-cyclical regulations aim to prevent financial crisis occurrence by reining in lenders before an asset bubble occurs. More controversially, regulators are experimenting with targeted rules trying to prevent specific markets from developing bubbles. For instance, the Reserve Bank of New Zealand imposed higher LTV ratios on mortgage lenders. This step limited the flow of credit to buyers without harming the rest of the economy. The Bank of England also shares the regulations to prevent the increase of house-price credit by restricting the size of mortgages to borrowers’ incomes.

Three divisions contain a discussion of principle and definition of different types of macro-prudential tools such as credit supply (i.e., tools used to control banks), and credit demand (i.e., tools used to monitor households and corporations). In the second part, we discuss the effects of various macro-prudential tools on house prices and debt. The third part is to explain the interaction between monetary and macroprudential policies; it digs in-depth the cost regarding lower GDP shortly that arises when various tools are used to reduce financial imbalances.

2.1 Macroprudential tools that affect credit supply

In the macro-prudential tool, it uses capital requirements to influence the bank's equity and supply of credit. The purpose of capital requirements is to amplify the resilience of the financial system. The banks’ capital was built like buffer against unexpected losses thereby diminishes the risk of a banking crisis. Moreover, there will be riskier if the bank use tools like state guarantees and capital injection, the risk of chance will be reduced once they have a significant share of equity.

After the financial crisis, Basel III, which is a new set of international regulations for banks, sets out how much capital the bank must have in the account (BIS, 2011). There is a minimum requirement, but also there are several different buffer requirements. Then, on top of these buffer requirements, there is a specific own funds requirement, which is the overall assessment of the supervisory authority of an appropriate capital requirement level for each bank.

When a minimum level of the capital ratio is set, the purpose of the risk weights for the capital requirements is affected by the extent of risk assumed by the bank. If the bank takes more risk, it must have enough equity. This renders capital allocation more efficient in the economy. When the Basel III regulations are fully adopted, another macro-prudential tool will introduce to complement the risk-weighted capital requirement - the leverage ratio requirement. The leverage ratio is a bank’s equity about its total lending.

As a result, high capital requirements raise the resilience of the financial system to shocks, which reduces the risk of a financial crisis. But equity funding is typically more expensive for the banks than debt funding. When the bank increases capital funding, its funding costs by this way increase. This might be the result of higher lending rates for customers, lower credit, and lower GDP. Nonetheless, if the households and the firms have excessive debt, borrowing less might have a positive side effect.

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