Description
The purpose of this paper is to relate the marginal crisis risk of Woodford to a number of
financial fragility indicators. The paper expands the interest rate gap approach by considering the
capital structure of investments and systemic risk, dating back to Modigliani-Miller. The model allows
for distinct impacts from asset inflation, leverage as well as incentives for speculative investments for
a central bank that aims to lean against the wind.
Journal of Financial Economic Policy
Perspectives on “marginal crisis risk” and “leaning against the wind” from the capital
structure of housing investments
Trond Arne Borgersen
Article information:
To cite this document:
Trond Arne Borgersen, (2013),"Perspectives on “marginal crisis risk” and “leaning against the wind” from
the capital structure of housing investments", J ournal of Financial Economic Policy, Vol. 5 Iss 3 pp. 272 -
280
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Perspectives on “marginal
crisis risk” and “leaning against
the wind” from the capital
structure of housing investments
Trond Arne Borgersen
Department of Economics and Social Sciences, Østfold University College,
Halden, Østfold, Norway
Abstract
Purpose – The purpose of this paper is to relate the marginal crisis risk of Woodford to a number of
?nancial fragility indicators. The paper expands the interest rate gap approach by considering the
capital structure of investments and systemic risk, dating back to Modigliani-Miller. The model allows
for distinct impacts from asset in?ation, leverage as well as incentives for speculative investments for
a central bank that aims to lean against the wind.
Design/methodology/approach – Framed in terms of the housing market and household
behaviour, the paper sets out an augmented loss function which takes a number of ?nancial
fragility indicators into account. By moving beyond the case where all risk increasing mechanisms are
driven by external monetary policy shocks, the approach shows why a central bank should be inclined
to lean against the wind even in the absence of interest rate gaps.
Findings – Taking the return to equity into account, and moving beyond the case where all risk
increasing mechanisms are related to external monetary policy shocks, the paper shows why a central
bank might be inclined to lean against the wind even in the absence of interest rate gaps. The
context-speci?c nature of the monetary transmission mechanism in general, and the structure of
the risk taking channel more speci?cally, calls for both internal ?nancial market features as well as the
link between ?nancial markets and the real economy to impact on how and when to lean.
Originality/value – There seems to be increased awareness of the need to take ?nancial stability
considerations in monetary policy. In fact, Woodford argues that the balance between ?nancial stability
objectives and price and output stability is part of the choice when choosing between alternative short
run paths for monetary policy. By taking a conventional approach to the capital structure of
investments, this paper integrates asset in?ation, leverage and incentives for speculation into a central
bank’s loss function in a way that to the best of the author’s knowledge is novel.
Keywords Household, Fiscal policies and behaviour of economic agents, Public economics,
Monetary policy, Central banking and the supply of money and credit,
Macroeconomics and monetary economics, Central banks and their policies, Central banks, Fiscal policy,
Housing
Paper type Research paper
Introduction
Despite a long lasting controversy regarding whether ?nancial stability should be
taken into account[1], Woodford (2012) argues that monetary policy should consider
other objectives than in?ation and the output gap when there is a risk that ?nancial
imbalances are building. The paper shows how the ?rst-order condition for optimal
monetary policy does not depend solely on the paths of prices and the output gap,
but is also related to what Woodford refers to as the “marginal crisis risk”[2].
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
Journal of Financial Economic Policy
Vol. 5 No. 3, 2013
pp. 272-280
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-01-2013-0001
JFEP
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Norges Bank (2012) incorporates ?nancial stability in its monetary policy framework
by inserting an interest rate gap – between the current and the equilibriuminterest rate,
as well as between the current and the last period’s interest rate – in its loss function[3].
The motivation for the interest rate gap is found in the argument relating a prolonged
period of time with a too low interest rate with increased risk taking and a higher
probability of ?nancial instability – stimulating the marginal crisis risk[4].
While the interest rate arguably is important for risk taking, both through
search-for-yield (see Rajan (2005) and through asset appreciation and the resulting
wealth effects (see for instance Diamond and Rajan (2009)) the relation might differ
between systems. Assenmacher-Wesche and Gerlach (2008) analyses the relation
between ?nancial structure and the impact of monetary policy on asset prices in
general, while Ahearne et al. (2005) and Calza et al. (2009) discuss the impact on house
prices more speci?cally. The distinct monetary transmission mechanisms in the USA
and in the Euro area were shown already by Ehrmann et al. (2001).
Over time one has acknowledged that the monetary transmission mechanism, when
working its way through the ?nancial market, might take a number of different
routes[5]. Changes in monetary policy might either through Tobin’s q, the bank lending-
or bank balance sheet channel, the cash ?owchannel or through wealth effects – impact
on a number different ?nancial fragility indicators.
The paper provides an extension to the interest rate gap approach by taking into
account the capital structure of investments, a frame of reasoning dating back to
Modiglianai and Miller (1958). Separating between asset in?ation, leverage and incentives
for speculative investments we integrate ?nancial fragility indicators into the loss
function. We take the case for “leaning against the wind” as given and, by taking internal
?nancial market characteristics into account in the formulation of the loss-function, allow
for endogenous systemic risk along the lines of Woodford (2012). This also avoids the
undesirable aspect related to having the policy rate in a central bank’s loss function.
The policy rate is exogenous to ?nancial markets and impacts both on the return to
investments and the cost of borrowing, which in the absence of transaction costs will be
equal. Relating the policy rate to the return to equity and we include a conventional
capital structure approach to systemic risk, and separate between asset bubbles, excess
leverage and too strong incentives for speculation within the loss function, indicators
frequently used for analyzing ?nancial imbalances. In fact, analyzing ?nancial fragility
in Norway since the 1890s, Gerdrup (2003) de?nes indicators of ?nancial fragility in
close conformity with these three.
The relation between ?nancial structure and ?nancial stability is highlighted by
Davies and Stone (2004). Analyzing the impact of ?nancial crises on corporate ?nancial
structures the paper draws on several different theory camps relating ?nancial and
economic structures. We frame our extension of the loss function in terms of housing
investments, household behavior and the housing market. The housing market is
considered crucial for the current crisis (see for instance, Duca et al. (2010) and
IMF (2011). In Norway, is household behavior towards mortgage and housing markets
argued to be a relevant framework for understanding the risk taking channel of
monetary policy by Evjen and Kloster (2012)[6].
Our approach draws explicitly on Borgersen and Greibrokk (2012) highlighting
the capital structure of housing investments. The paper relates ?nancial fragility in the
household sector to the excess return to housing as incentives for increasing loan
Perspectives
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to value (LTV) ratios develops among both mortgagees and mortgagors when there is
short-sightedness on both sides of the mortgage market. The capital structure approach
to housing divides the return to home equity (RHE) between a price gain and a leverage
gain – where the latter is related to the excess return to housing and how housing
investments are ?nanced. In fact, excess return to housing creates stimulates risk
taking and increases ?nancial fragility. Hence, taking the relation between the policy
rate and the return to equity into account, the paper integrates ?nancial fragility
indicators directly into the central bank’s loss function in a way which the best of our
knowledge is novel. Extending the interest rate gap by a combination of a house
price gap, a leverage gap and an incentive gap allows us to take both internal ?nancial
market characteristics as well as the context speci?c relation between the ?nancial
market and the real economy into account when deciding to lean against the wind.
The rest of the paper is structure as follows. In the next section we brie?y introduce
the interest rate gap approach of Norges Bank and the marginal risk approach of
Woodford (2012). We also discuss some aspects of the monetary policy transmission
channels. The third part presents the capital structure approach to housing investments
and introduces our ?nancial fragility indicators. The fourth part introduces our
augmented loss function. The last part concludes.
Marginal crisis risk and a central bank’s loss function
We start out by introducing the loss-function given by Norges Bank (2012):
L
t
¼ ðp
t
2p
*
Þ
2
þ l y
t
2y
*
t
_ _
2
þg ði
t
2i
t21
Þ
2
þ t i
t
2i
*
t
_ _
2
ð1Þ
The ?rst component measures the weight given to the deviation between actual
in?ation p and the in?ation target p
*
, the second component allows for more ?exible
in?ation targeting by giving a weight l to the output gap (Y 2 Y
*
) the third
component ensures interest rate smoothing (i
t
2 i
t21
) and the fourth i
i
2i
*
t21
_ _
is to
include an interest rate gap where the central bank’s loss increases as the interest rate
deviates from a normal level.
The three latter components of the loss function are all related to the latest
amendment to Norges Banks criteria for an appropriate interest rate path – that
monetary policy is robust. The explanation for this criterion was given in Monetary
Policy Report (1/2012)[7]:
[. . .] interest rates should be set so that monetary policy mitigates the risk of a buildup of
?nancial imbalances, and so that acceptable developments in in?ation and output are also
likely under alternative assumptions concerning the functioning of the economy.
Evjen and Kloster (2012) argue that these amendments to the loss function could be
interpreted as representing the marginal crisis risk aspect of Woodford (2012).
Norges Bank (2012) states further that:
[. . .] monetary policy is robust, is covered by the second, third and fourth segments.
Experience shows that ?nancial imbalances often buildup in periods of high capacity
utilisation. For that reason, increasing the weight l of the output gap in the loss function may
reduce the risk of a build-up of such imbalances. [. . .]
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The last segment states that the loss increases when the interest rate deviates substantially
from a normal level it
*
. This consideration can help to mitigate the risk of a build-up of
?nancial imbalances – even in periods when capacity utilisation is not particularly high.
Over time, income level, saving behaviour, the tax system and the structure of ?nancial
markets determine the level of household and corporate indebtedness. Low interest rates for
extended periods can increase the risk that debt and asset prices will move up and remain
higher than what is sustainable over the economic cycle. In addition, banks may ease credit
standards and ?nancial market participants may increase risk taking. High debt levels make
borrowers more vulnerable and increase the risk of long-term instability in the real economy.
A sudden, unexpected drop in incomes, higher unemployment or other macroeconomic
shocks may result in a fall in property prices, creating imbalances between borrowers’ debts
and the value of leveraged assets[8].
By incorporating the interest rate level in the loss function, the Bank is seeking to counter the
build-up of such imbalances. This does not imply that the interest rate becomes an
independent objective of monetary policy. Rather, the purpose is to overcome ?aws in our
analytical tools related to the effects of low interest rates.
Norges Bank admits that the step of including the interest rate in the loss function re?ects
a ?awin its analytical tools. Being a ?rst approach, the simplistic and easy-to-understand
framework anchored in a well-established driver of ?nancial instability, is
understandable. The approach also ?ts with arguments about realistic macro?nancial
stability expectations for monetary policy (see again IMF (2009)). However, a framework
for leaning against the wind should not be too simplistic, if only to ensure that one not gets
the impression of correcting ?nancial instability as “a quick ?x”.
To make the framework for expressing ?nancial stability concerns within a
conventional monetary policy framework more related to the ?nancial fragility
approach we could start by taking common knowledge into account. Since Modiglianai
and Miller (1958) systemic risk, ?nancial fragility and the capital structure of
investments have been on the table. If monetary policy is to take systemic risk and
?nancial stability into account, these relations between ?nancial fragility and system
risk is a natural starting point.
Financial fragility indicators and the capital structure of housing
investment
Borgersen and Greibrokk (2012) start by assuming a dwelling with a market value, V.
The purchase of the dwelling is ?nanced by equity, E, and a mortgage, D. The total
(expected) return to housing investments is given by the house price growth, p.
The total return must compensate creditors and provide a return for home equity.
The former is determined by an exogenous mortgage rate, r
B
. The RHE, expressing the
wealth effect for home owners, is denoted e. We introduce two ratios, LTV, D/V, and
equity-?nanced housing, E/V. From standard investment theory we know that:
p ¼ e
E
V
þ
D
V
r
B
ð2Þ
which, by rearranging, can be expressed as:
e ¼ p þ
D
E
ð p 2r
B
Þ; ð3Þ
Perspectives
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Expression (3) shows how RHE is endogenously determined by the interaction between
the mortgage and the housing market. RHE is divided between a price gain, p, and a
leverage gain, (D/E) ( p 2 r
B
). The leverage gain increases with the mortgage-to-equity
ratio (D/E) and the difference between the rate of appreciation and the mortgage rate-
referred to as the excess return to housing[9]. The excess return to housing creates
incentives for increasing leverage among short-sighted market players.
The relation between RHE and the excess return to housing given above abstracts
away from the endogenous relation between collateral values and credit, as discussed
by for instance Kiyotaki and Moore (1997). Over time it is reasonable to assume that
higher leverage stimulates appreciation, and RHE, at the same time as the increased
risk associated with higher leverage might materialize. Expression (3) can be
interpreted as the short run expression for the relation between RHE, housing
appreciations and LTV-ratios.
Expression (3) incorporates two of the indicators de?ned by Gerdrup (2003) when
analyzing ?nancial fragility in Norway:
(1) asset price in?ation; and
(2) non-?nancial sector indebtedness.
The third component, excess return to housing, can also be argued to have a strong
relation to the last of the indicators used by Gerdrup (2003), tough competition among
credit institutions. This tougher competition might on one hand reduce the borrowing
rate for households and simultaneously stimulate the rate of appreciation. Hence,
tougher competition among credit institutions is closely correlated with the excess
return to housing.
To bring the ?nancial fragility indicators in conformity with the approach used to
express the preferences of a central bank we expand (3) from its equilibrium:
e
t
2e
*
t
¼ p
t
2p
*
t
þ
D
E
_ _
t
2
D
E
_ _
*
t
_ _
ð p 2r
B
Þ
t
2ð p 2r
B
Þ
*
t
_ _
ð4Þ
where the equity gap has three components:
(1) the house price gap p
t
2p
*
t
_ _
;
(2) the ?nancing gap ðD=EÞ
t
2ðD=EÞ
*
t
_ _
; and
(3) the incentive gap ð p 2r
B
Þ
t
2ð p 2r
B
Þ
*
t
_ _
.
While (1) is a measure of asset bubbles (2) is an indicator of excess leverage (3) a
measure of excessive incentives for mortgage ?nanced housing investments – or
stated differently, a measure of the incentives for speculation.
An augmented loss function for marginal crisis risk
Our extension to the loss function has the interest rate gap as its starting point.
The policy rate is an important factor both for the cost of capital and for the return to
investments. Focusing on the return to equity, we express it as a function of the policy
rate e ¼ eðiÞ where e
0
. 0:
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Without loss of generality we will in the following assume equality between the
equity gap e
t
2e
*
t
_ _
and the interest rate gap i
t
2i
*
t
_ _
. Substituting the former for
the latter we ?nd our augmented loss function as[10]:
L
t
¼ ðp
t
2p
*
Þ
2
þ l y
t
2y
*
t
_ _
2
þt
0
p
t
2p
*
t
_ _
2
þt
1
ðD
t
=E
t
2ðD=EÞ
*
Þ
2
þ t
3
½ð p 2r
B
Þ 2ð p 2r
B
Þ
*
?
2
ð5Þ
where t
i
are weights given to the various respective systemic risk components.
Our augmented loss function states that the central bank should care about housing
bubbles (through the house price gap), how households ?nance their housing
investments (through the ?nancing gap) and whether there are excessive incentive
gaps stimulating speculative investments.
An interest rate gap might fuel risk taking but to intervene according to this gap is
not necessarily suf?cient to hamper the build-up of ?nancial imbalances. A rental
equivalence strategy for instance, might create housing bubbles even if monetary
policy is leaning against the wind by considering an interest rate gap. If rents do not
mirror house prices, monetary policy might be unaffected by appreciations and only
responding indirectly through wealth effects on consumption. Higher appreciations
combined with unaffected mortgage rates, in fact there might not be any interest rate
gap, creates incentives for increasing leverage as the leverage gain is positively related
to the LTV ratio described earlier[11]. The increased incentives for mortgage ?nanced
housing that might develop, and which stimulates appreciations even further, should
result in a tighter monetary policy if aiming to lean against the wind. This even if the
interest rate gap is unaffected.
We argue that monetary policy should involve assessments of asset in?ation, on the
prevailing incentives to increase leverage and on the capital structure of investments,
irrespective of the interest rate gap. Our extension to the loss function will complicate
the reasoning about monetary policy and ?nancial stability, but at the same time make
it more realistic. The functioning of the ?nancial markets – as well as the interrelation
between the real side of the economy and the ?nancial market, are complex. It deserves
a more detailed approach to the marginal crisis risk is necessary than the interest rate
gap treating all risk inducing shifts as a result of exogenous shocks.
Summary and discussion
Even though many argue that macroprudential tools are better suited to ensure
?nancial stability (Eichengreen et al., 2011), there seems to be increased awareness of
the need to take ?nancial stability considerations in monetary policy. In fact, Woodford
(2012) argues that the balance between ?nancial stability objectives and price and
output stability is part of the choice when choosing between alternative short run paths
for monetary policy.
By taking a conventional approach to the capital structure of investments this paper
integrates asset in?ation, leverage and incentives for speculation into a central bank’s
loss function in a way that to the best of our knowledge is novel.
The capital structure allows us to extend the narrower, and more indirect, approach
of Norges Bank (2012) on how to incorporate ?nancial stability in a central bank’s loss
function to account for marginal crisis risk. Our augmented loss function includes
Perspectives
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a number of conventional ?nancial fragility indicators which shows scenarios for when
monetary policy should, for instance, respond to asset price in?ation in a ?nancial
fragility perspective, even if the interest rate gap is zero. The interest rate gap approach
ignores the role of the context speci?c monetary policy transmission mechanisms as all
risk increasing mechanisms are reduced to an external monetary policy shock.
Highlighting the period following the sub-prime crisis we frame our augmented loss
function in terms of housing markets and household behavior. We focus on housing
bubbles, household leverage and households risk taking. These have all, combined or
separately, been shown to indicate growing ?nancial imbalances in Norway during the
last century and should hence deserve monetary policy attention when aiming to lean
against the wind.
Being the ?rst to integrate internal (housing) market characteristics, as well as the
behavior of market participants to mitigate marginal crisis risk, our approach is
simplistic, but yet not without novelty. And – its general structure provides the basis
for a number of future extensions.
Notes
1. Whether monetary policy should take ?nancial stability considerations into account has
been a standing controversy since Borio and Lowe (2002) brought the issue to the table.
While some are in favor of the idea (see for instance Borio and White (2004), Curdia and
Woodford (2009) and Gambacota and Signoretti (2012)), others are still in opposition (see for
instance Eichengreen et al. (2011)). A general discussion regarding the lessons from asset
price in?ation for monetary policy is given by IMF (2009).
2. Woodford (2012) argues that the central bank should minimize a loss function where an
argument capturing ?nancial stability is included. The key assumption in the model is that
the probability of a crisis is endogenous and a function of leverage. The marginal crisis risk
measures the rate at which the expected loss from the occurrence of a ?nancial crisis
increases per unit of increase in leverage.
3. The ?nancial stability concern also includes increasing the weight on the output gap, as
higher resource utilization is assumed to correlate with increased leverage.
4. The relation between interest rates and risk taking is along the lines of Taylor (2007, 2009),
relating too low monetary policy rates to the credit boom and the housing bubble which
eventually lead to the sub-prime crisis.
5. For an interesting discussion on the monetary policy transmission mechanisms see
Boivin et al. (2010).
6. For households to increase risk taking in mortgage markets, their incentives to do so must be
matched by changed incentives among mortgagors. For a discussion on the relation between
mortgagor behavior and housing markets see for instance Goodhart and Hoffman (2008) or
Koetter and Poghosyan (2009).
7. See the theme box on pages 14-15 explaining the new loss function.
8. See MPR 3/11 pp. 15-16.
9. We abstract away from taxes.
10. For simplicity we suppress the interest rate gap component related to interest rate
smoothing. The expansion of equation (3) with respect to last periods interest rate can
however be expressed in a similar and straightforward manner:
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e
t
2e
t21
¼ p
t
2p
t21
þ
D
E
_ _
t
2
D
E
_ _
t21
_ _
½ð p 2r
B
Þ
t
2ð p 2r
B
Þ
t21
?;
11. A simple illustration using the RHE approach above can be useful: consider a dwelling with
a market value of 100,000 (¼V), where the LTV-ratio is 0.5 making the mortgage equal to
50,000 (¼D) and the applied equity equal to 50,000 (¼E). Let us assume that the excess return
to housing is 5 percent, as housing appreciations equals 8 percent and the mortgage rate is
3 percent. The RHE to this housing investment is now 13 percent. Another household, facing
the same appreciation and the same mortgage rate, but which has an LTV-ratio of 0.8, sees a
RHE of 33 percent. A higher RHE will stimulate households risk taking, through higher
LTV-ratios, and should be offset by monetary policy interventions. This also shows the
complementarity between monetary and macroprudential policy (See for instance Gelati and
Moessner (2012)).
References
Ahearne, A., Ammer, J., Doyle, B., Kole, L. and Martin, R. (2005), “House prices and monetary
policy: a cross-country study”, Board of Governors of the Federal Reserve System,
International Finance Discussion Papers No. 841.
Assenmacher-Wesche, K. and Gerlach, S. (2008), “Financial structure and the impact of monetary
policy on asset prices”, Swiss National Bank Working Paper 2008-16.
Boivin, J., Kiley, M.T. and Mishkin, F.S. (2010), “How has the monetary transmission mechanism
evolved over time?”, Finance and Economics Discussion Series 10-2012, Divisions of
Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, DC.
Borgersen, T.A. and Greibrokk, J. (2012), “Re?ections on LTV, risk and incentives in mortgage
markets”, Journal of European Real Estate Research, Vol. 5 No. 3, pp. 199-210.
Borio, C. and Lowe, P. (2002), “Asset prices, ?nancial and monetary stability: exploring the
nexus”, BIS Working Paper No. 114, Bank for International Settlements, Basel.
Borio, C. and White, W. (2004), “Whiter monetary policy and ?nancial stability? The implications
of evolving policy Regimes”, BIS Working Paper No. 147, Bank for International
Settlements, Basel.
Calza, A., Monacelli, T. and Stracca, L. (2009), “Housing ?nance and monetary policy”,
ECB Working Paper Series No. 1069.
Curdia, V. and Woodford, M. (2009), “Credit spreads and monetary policy”, Federal Reserve Bank
of New York Staff Report No. 385.
Davies, E.P. and Stone, M.R. (2004), “Corporate ?nancial structure and ?nancial stability”,
IMF Working Paper, 04/124.
Diamond, D.W. and Rajan, R. (2009), “The credit crisis: conjectures about causes and remedies”,
NBER Working Paper No. 14739.
Duca, J.V., Muellbauer, J. and Murphy, A. (2010), “Housing markets and the ?nancial crisis of
2007-2009: lessons for the future”, Journal of Financial Stability, Vol. 6, pp. 203-217.
Ehrmann, M., Gambacorta, L., Martinez-Pages, J., Sevestre, P. and Worms, A. (2001), “Financial
systems and the role of banks in the monetary policy transmission mechanisms in the
Euro area”, ECB Working Paper No. 105.
Eichengreen, B., El-Erian, M., Fraga, A., Ito, T., Pisani-Ferry, J., Prasad, E., Rajan, R., Ramos, M.,
Reinhardt, C., Rey, H., Rodrik, D., Rogoff, K., Sin, H.S., Velasco, A., Weder di Mauro, B.
and Yo, Y. (2011), Rethinking Central Banking, Committee on International Economic
Policy and Reform, Brookings Institution, Washington, DC.
Perspectives
on “marginal
crisis risk”
279
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Evjen, S. and Kloster, T.B. (2012), “Norges Bank’s new monetary policy loss function – further
discussion”, Norges Bank Staff Memo 11/2012, available at: www.norges-bank.no/no/om/
publisert/publikasjoner/staff-memo/2012/11/
Gambacota, L. and Signoretti, F.M. (2012), “Should monetary policy lean against the wind? An
analysis based on a DSGE model with banking”, paper presented at BOK-BIS-IMF
Conference on Macro?nancial Linkages: Implications for Monetary and Financial Stability
Policies, BIS, 10 April 2012, available at: www.bis.org/events/bokbisimf2012/session7_
should_monetary_policy_lean.pdf
Gelati, G. and Moessner, R. (2012), “Macroprudential policy – a literature review”, Journal of
Economic Surveys, available at: http://onlinelibrary.wiley.com/doi/10.1111/j.1467-6419.
2012.00729.x/abstract
Gerdrup, K. (2003), “Three episodes of ?nancial fragility in Norway since the 1890s”,
BIS Working Paper No 142, available at: www.bis.org/publ/work142.pdf
Goodhart, C. and Hoffman, B. (2008), “House prices, money, credit, and the macroeconomy”,
Oxford Review of Economic Policy, Vol. 24 No. 1, pp. 180-205.
IMF (2009), “Lessons for monetary policy from asset price in?ation”, World Economic Outlook,
Chapter 3, International Monetary Fund, Washington, DC, September.
IMF (2011), “Housing ?nance and ?nancial stability – back to basics?”, World Economic Outlook,
Chapter 3, International Monetary Fund, Washington, DC, September.
Kiyotaki, N. and Moore, J. (1997), “Credit cycles”, Journal of Political Economy, Vol. 105 No. 3,
pp. 211-248.
Koetter, M. and Poghosyan, T. (2009), “Real estate prices and bank stability”, Journal of Banking
and Finance, Vol. 34, pp. 1129-1138.
Modiglianai, F. and Miller, M.H. (1958), “The cost of capital, corporation ?nance and the theory of
investment”, The American Economic Review, Vol. 48 No. 3, pp. 261-297.
Norges Bank (2012), Monetary Policy Report 1-2012, available at: www.norges-bank.no/pages/
88292/MPR_1_12.pdf
Rajan, R.G. (2005), “Has ?nancial developments made the world riskier?”, NBER Working Paper
Series No. 11728.
Taylor, J.B. (2007), “Housing and monetary policy”, NBER Working Paper Series No. 13682.
Taylor, J.B. (2009), “The ?nancial crisis and the policy responses: an empirical analysis of what
went wrong”, NBER Working Paper Series No. 14631.
Woodford, M. (2012), “In?ation targeting and ?nancial stability”, Sveriges Riksbank Economic
Review, Vol. 1, pp. 7-33, available at: www.riksbank.se/Documents/Rapporter/POV/2012/
rap_pov_120210_eng.pdf
Further reading
Lund, K. and Robstad, Ø. (2012), “Effects of a new loss function in NEMO”, Norges Banks
Staff Memo 10/2012, available at:www.norges-bank.no/no/om/publisert/publikasjoner/
staff-memo/2012/12/
Corresponding author
Trond Arne Borgersen can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
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doc_990649225.pdf
The purpose of this paper is to relate the marginal crisis risk of Woodford to a number of
financial fragility indicators. The paper expands the interest rate gap approach by considering the
capital structure of investments and systemic risk, dating back to Modigliani-Miller. The model allows
for distinct impacts from asset inflation, leverage as well as incentives for speculative investments for
a central bank that aims to lean against the wind.
Journal of Financial Economic Policy
Perspectives on “marginal crisis risk” and “leaning against the wind” from the capital
structure of housing investments
Trond Arne Borgersen
Article information:
To cite this document:
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Perspectives on “marginal
crisis risk” and “leaning against
the wind” from the capital
structure of housing investments
Trond Arne Borgersen
Department of Economics and Social Sciences, Østfold University College,
Halden, Østfold, Norway
Abstract
Purpose – The purpose of this paper is to relate the marginal crisis risk of Woodford to a number of
?nancial fragility indicators. The paper expands the interest rate gap approach by considering the
capital structure of investments and systemic risk, dating back to Modigliani-Miller. The model allows
for distinct impacts from asset in?ation, leverage as well as incentives for speculative investments for
a central bank that aims to lean against the wind.
Design/methodology/approach – Framed in terms of the housing market and household
behaviour, the paper sets out an augmented loss function which takes a number of ?nancial
fragility indicators into account. By moving beyond the case where all risk increasing mechanisms are
driven by external monetary policy shocks, the approach shows why a central bank should be inclined
to lean against the wind even in the absence of interest rate gaps.
Findings – Taking the return to equity into account, and moving beyond the case where all risk
increasing mechanisms are related to external monetary policy shocks, the paper shows why a central
bank might be inclined to lean against the wind even in the absence of interest rate gaps. The
context-speci?c nature of the monetary transmission mechanism in general, and the structure of
the risk taking channel more speci?cally, calls for both internal ?nancial market features as well as the
link between ?nancial markets and the real economy to impact on how and when to lean.
Originality/value – There seems to be increased awareness of the need to take ?nancial stability
considerations in monetary policy. In fact, Woodford argues that the balance between ?nancial stability
objectives and price and output stability is part of the choice when choosing between alternative short
run paths for monetary policy. By taking a conventional approach to the capital structure of
investments, this paper integrates asset in?ation, leverage and incentives for speculation into a central
bank’s loss function in a way that to the best of the author’s knowledge is novel.
Keywords Household, Fiscal policies and behaviour of economic agents, Public economics,
Monetary policy, Central banking and the supply of money and credit,
Macroeconomics and monetary economics, Central banks and their policies, Central banks, Fiscal policy,
Housing
Paper type Research paper
Introduction
Despite a long lasting controversy regarding whether ?nancial stability should be
taken into account[1], Woodford (2012) argues that monetary policy should consider
other objectives than in?ation and the output gap when there is a risk that ?nancial
imbalances are building. The paper shows how the ?rst-order condition for optimal
monetary policy does not depend solely on the paths of prices and the output gap,
but is also related to what Woodford refers to as the “marginal crisis risk”[2].
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
Journal of Financial Economic Policy
Vol. 5 No. 3, 2013
pp. 272-280
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-01-2013-0001
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Norges Bank (2012) incorporates ?nancial stability in its monetary policy framework
by inserting an interest rate gap – between the current and the equilibriuminterest rate,
as well as between the current and the last period’s interest rate – in its loss function[3].
The motivation for the interest rate gap is found in the argument relating a prolonged
period of time with a too low interest rate with increased risk taking and a higher
probability of ?nancial instability – stimulating the marginal crisis risk[4].
While the interest rate arguably is important for risk taking, both through
search-for-yield (see Rajan (2005) and through asset appreciation and the resulting
wealth effects (see for instance Diamond and Rajan (2009)) the relation might differ
between systems. Assenmacher-Wesche and Gerlach (2008) analyses the relation
between ?nancial structure and the impact of monetary policy on asset prices in
general, while Ahearne et al. (2005) and Calza et al. (2009) discuss the impact on house
prices more speci?cally. The distinct monetary transmission mechanisms in the USA
and in the Euro area were shown already by Ehrmann et al. (2001).
Over time one has acknowledged that the monetary transmission mechanism, when
working its way through the ?nancial market, might take a number of different
routes[5]. Changes in monetary policy might either through Tobin’s q, the bank lending-
or bank balance sheet channel, the cash ?owchannel or through wealth effects – impact
on a number different ?nancial fragility indicators.
The paper provides an extension to the interest rate gap approach by taking into
account the capital structure of investments, a frame of reasoning dating back to
Modiglianai and Miller (1958). Separating between asset in?ation, leverage and incentives
for speculative investments we integrate ?nancial fragility indicators into the loss
function. We take the case for “leaning against the wind” as given and, by taking internal
?nancial market characteristics into account in the formulation of the loss-function, allow
for endogenous systemic risk along the lines of Woodford (2012). This also avoids the
undesirable aspect related to having the policy rate in a central bank’s loss function.
The policy rate is exogenous to ?nancial markets and impacts both on the return to
investments and the cost of borrowing, which in the absence of transaction costs will be
equal. Relating the policy rate to the return to equity and we include a conventional
capital structure approach to systemic risk, and separate between asset bubbles, excess
leverage and too strong incentives for speculation within the loss function, indicators
frequently used for analyzing ?nancial imbalances. In fact, analyzing ?nancial fragility
in Norway since the 1890s, Gerdrup (2003) de?nes indicators of ?nancial fragility in
close conformity with these three.
The relation between ?nancial structure and ?nancial stability is highlighted by
Davies and Stone (2004). Analyzing the impact of ?nancial crises on corporate ?nancial
structures the paper draws on several different theory camps relating ?nancial and
economic structures. We frame our extension of the loss function in terms of housing
investments, household behavior and the housing market. The housing market is
considered crucial for the current crisis (see for instance, Duca et al. (2010) and
IMF (2011). In Norway, is household behavior towards mortgage and housing markets
argued to be a relevant framework for understanding the risk taking channel of
monetary policy by Evjen and Kloster (2012)[6].
Our approach draws explicitly on Borgersen and Greibrokk (2012) highlighting
the capital structure of housing investments. The paper relates ?nancial fragility in the
household sector to the excess return to housing as incentives for increasing loan
Perspectives
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to value (LTV) ratios develops among both mortgagees and mortgagors when there is
short-sightedness on both sides of the mortgage market. The capital structure approach
to housing divides the return to home equity (RHE) between a price gain and a leverage
gain – where the latter is related to the excess return to housing and how housing
investments are ?nanced. In fact, excess return to housing creates stimulates risk
taking and increases ?nancial fragility. Hence, taking the relation between the policy
rate and the return to equity into account, the paper integrates ?nancial fragility
indicators directly into the central bank’s loss function in a way which the best of our
knowledge is novel. Extending the interest rate gap by a combination of a house
price gap, a leverage gap and an incentive gap allows us to take both internal ?nancial
market characteristics as well as the context speci?c relation between the ?nancial
market and the real economy into account when deciding to lean against the wind.
The rest of the paper is structure as follows. In the next section we brie?y introduce
the interest rate gap approach of Norges Bank and the marginal risk approach of
Woodford (2012). We also discuss some aspects of the monetary policy transmission
channels. The third part presents the capital structure approach to housing investments
and introduces our ?nancial fragility indicators. The fourth part introduces our
augmented loss function. The last part concludes.
Marginal crisis risk and a central bank’s loss function
We start out by introducing the loss-function given by Norges Bank (2012):
L
t
¼ ðp
t
2p
*
Þ
2
þ l y
t
2y
*
t
_ _
2
þg ði
t
2i
t21
Þ
2
þ t i
t
2i
*
t
_ _
2
ð1Þ
The ?rst component measures the weight given to the deviation between actual
in?ation p and the in?ation target p
*
, the second component allows for more ?exible
in?ation targeting by giving a weight l to the output gap (Y 2 Y
*
) the third
component ensures interest rate smoothing (i
t
2 i
t21
) and the fourth i
i
2i
*
t21
_ _
is to
include an interest rate gap where the central bank’s loss increases as the interest rate
deviates from a normal level.
The three latter components of the loss function are all related to the latest
amendment to Norges Banks criteria for an appropriate interest rate path – that
monetary policy is robust. The explanation for this criterion was given in Monetary
Policy Report (1/2012)[7]:
[. . .] interest rates should be set so that monetary policy mitigates the risk of a buildup of
?nancial imbalances, and so that acceptable developments in in?ation and output are also
likely under alternative assumptions concerning the functioning of the economy.
Evjen and Kloster (2012) argue that these amendments to the loss function could be
interpreted as representing the marginal crisis risk aspect of Woodford (2012).
Norges Bank (2012) states further that:
[. . .] monetary policy is robust, is covered by the second, third and fourth segments.
Experience shows that ?nancial imbalances often buildup in periods of high capacity
utilisation. For that reason, increasing the weight l of the output gap in the loss function may
reduce the risk of a build-up of such imbalances. [. . .]
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The last segment states that the loss increases when the interest rate deviates substantially
from a normal level it
*
. This consideration can help to mitigate the risk of a build-up of
?nancial imbalances – even in periods when capacity utilisation is not particularly high.
Over time, income level, saving behaviour, the tax system and the structure of ?nancial
markets determine the level of household and corporate indebtedness. Low interest rates for
extended periods can increase the risk that debt and asset prices will move up and remain
higher than what is sustainable over the economic cycle. In addition, banks may ease credit
standards and ?nancial market participants may increase risk taking. High debt levels make
borrowers more vulnerable and increase the risk of long-term instability in the real economy.
A sudden, unexpected drop in incomes, higher unemployment or other macroeconomic
shocks may result in a fall in property prices, creating imbalances between borrowers’ debts
and the value of leveraged assets[8].
By incorporating the interest rate level in the loss function, the Bank is seeking to counter the
build-up of such imbalances. This does not imply that the interest rate becomes an
independent objective of monetary policy. Rather, the purpose is to overcome ?aws in our
analytical tools related to the effects of low interest rates.
Norges Bank admits that the step of including the interest rate in the loss function re?ects
a ?awin its analytical tools. Being a ?rst approach, the simplistic and easy-to-understand
framework anchored in a well-established driver of ?nancial instability, is
understandable. The approach also ?ts with arguments about realistic macro?nancial
stability expectations for monetary policy (see again IMF (2009)). However, a framework
for leaning against the wind should not be too simplistic, if only to ensure that one not gets
the impression of correcting ?nancial instability as “a quick ?x”.
To make the framework for expressing ?nancial stability concerns within a
conventional monetary policy framework more related to the ?nancial fragility
approach we could start by taking common knowledge into account. Since Modiglianai
and Miller (1958) systemic risk, ?nancial fragility and the capital structure of
investments have been on the table. If monetary policy is to take systemic risk and
?nancial stability into account, these relations between ?nancial fragility and system
risk is a natural starting point.
Financial fragility indicators and the capital structure of housing
investment
Borgersen and Greibrokk (2012) start by assuming a dwelling with a market value, V.
The purchase of the dwelling is ?nanced by equity, E, and a mortgage, D. The total
(expected) return to housing investments is given by the house price growth, p.
The total return must compensate creditors and provide a return for home equity.
The former is determined by an exogenous mortgage rate, r
B
. The RHE, expressing the
wealth effect for home owners, is denoted e. We introduce two ratios, LTV, D/V, and
equity-?nanced housing, E/V. From standard investment theory we know that:
p ¼ e
E
V
þ
D
V
r
B
ð2Þ
which, by rearranging, can be expressed as:
e ¼ p þ
D
E
ð p 2r
B
Þ; ð3Þ
Perspectives
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crisis risk”
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Expression (3) shows how RHE is endogenously determined by the interaction between
the mortgage and the housing market. RHE is divided between a price gain, p, and a
leverage gain, (D/E) ( p 2 r
B
). The leverage gain increases with the mortgage-to-equity
ratio (D/E) and the difference between the rate of appreciation and the mortgage rate-
referred to as the excess return to housing[9]. The excess return to housing creates
incentives for increasing leverage among short-sighted market players.
The relation between RHE and the excess return to housing given above abstracts
away from the endogenous relation between collateral values and credit, as discussed
by for instance Kiyotaki and Moore (1997). Over time it is reasonable to assume that
higher leverage stimulates appreciation, and RHE, at the same time as the increased
risk associated with higher leverage might materialize. Expression (3) can be
interpreted as the short run expression for the relation between RHE, housing
appreciations and LTV-ratios.
Expression (3) incorporates two of the indicators de?ned by Gerdrup (2003) when
analyzing ?nancial fragility in Norway:
(1) asset price in?ation; and
(2) non-?nancial sector indebtedness.
The third component, excess return to housing, can also be argued to have a strong
relation to the last of the indicators used by Gerdrup (2003), tough competition among
credit institutions. This tougher competition might on one hand reduce the borrowing
rate for households and simultaneously stimulate the rate of appreciation. Hence,
tougher competition among credit institutions is closely correlated with the excess
return to housing.
To bring the ?nancial fragility indicators in conformity with the approach used to
express the preferences of a central bank we expand (3) from its equilibrium:
e
t
2e
*
t
¼ p
t
2p
*
t
þ
D
E
_ _
t
2
D
E
_ _
*
t
_ _
ð p 2r
B
Þ
t
2ð p 2r
B
Þ
*
t
_ _
ð4Þ
where the equity gap has three components:
(1) the house price gap p
t
2p
*
t
_ _
;
(2) the ?nancing gap ðD=EÞ
t
2ðD=EÞ
*
t
_ _
; and
(3) the incentive gap ð p 2r
B
Þ
t
2ð p 2r
B
Þ
*
t
_ _
.
While (1) is a measure of asset bubbles (2) is an indicator of excess leverage (3) a
measure of excessive incentives for mortgage ?nanced housing investments – or
stated differently, a measure of the incentives for speculation.
An augmented loss function for marginal crisis risk
Our extension to the loss function has the interest rate gap as its starting point.
The policy rate is an important factor both for the cost of capital and for the return to
investments. Focusing on the return to equity, we express it as a function of the policy
rate e ¼ eðiÞ where e
0
. 0:
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Without loss of generality we will in the following assume equality between the
equity gap e
t
2e
*
t
_ _
and the interest rate gap i
t
2i
*
t
_ _
. Substituting the former for
the latter we ?nd our augmented loss function as[10]:
L
t
¼ ðp
t
2p
*
Þ
2
þ l y
t
2y
*
t
_ _
2
þt
0
p
t
2p
*
t
_ _
2
þt
1
ðD
t
=E
t
2ðD=EÞ
*
Þ
2
þ t
3
½ð p 2r
B
Þ 2ð p 2r
B
Þ
*
?
2
ð5Þ
where t
i
are weights given to the various respective systemic risk components.
Our augmented loss function states that the central bank should care about housing
bubbles (through the house price gap), how households ?nance their housing
investments (through the ?nancing gap) and whether there are excessive incentive
gaps stimulating speculative investments.
An interest rate gap might fuel risk taking but to intervene according to this gap is
not necessarily suf?cient to hamper the build-up of ?nancial imbalances. A rental
equivalence strategy for instance, might create housing bubbles even if monetary
policy is leaning against the wind by considering an interest rate gap. If rents do not
mirror house prices, monetary policy might be unaffected by appreciations and only
responding indirectly through wealth effects on consumption. Higher appreciations
combined with unaffected mortgage rates, in fact there might not be any interest rate
gap, creates incentives for increasing leverage as the leverage gain is positively related
to the LTV ratio described earlier[11]. The increased incentives for mortgage ?nanced
housing that might develop, and which stimulates appreciations even further, should
result in a tighter monetary policy if aiming to lean against the wind. This even if the
interest rate gap is unaffected.
We argue that monetary policy should involve assessments of asset in?ation, on the
prevailing incentives to increase leverage and on the capital structure of investments,
irrespective of the interest rate gap. Our extension to the loss function will complicate
the reasoning about monetary policy and ?nancial stability, but at the same time make
it more realistic. The functioning of the ?nancial markets – as well as the interrelation
between the real side of the economy and the ?nancial market, are complex. It deserves
a more detailed approach to the marginal crisis risk is necessary than the interest rate
gap treating all risk inducing shifts as a result of exogenous shocks.
Summary and discussion
Even though many argue that macroprudential tools are better suited to ensure
?nancial stability (Eichengreen et al., 2011), there seems to be increased awareness of
the need to take ?nancial stability considerations in monetary policy. In fact, Woodford
(2012) argues that the balance between ?nancial stability objectives and price and
output stability is part of the choice when choosing between alternative short run paths
for monetary policy.
By taking a conventional approach to the capital structure of investments this paper
integrates asset in?ation, leverage and incentives for speculation into a central bank’s
loss function in a way that to the best of our knowledge is novel.
The capital structure allows us to extend the narrower, and more indirect, approach
of Norges Bank (2012) on how to incorporate ?nancial stability in a central bank’s loss
function to account for marginal crisis risk. Our augmented loss function includes
Perspectives
on “marginal
crisis risk”
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a number of conventional ?nancial fragility indicators which shows scenarios for when
monetary policy should, for instance, respond to asset price in?ation in a ?nancial
fragility perspective, even if the interest rate gap is zero. The interest rate gap approach
ignores the role of the context speci?c monetary policy transmission mechanisms as all
risk increasing mechanisms are reduced to an external monetary policy shock.
Highlighting the period following the sub-prime crisis we frame our augmented loss
function in terms of housing markets and household behavior. We focus on housing
bubbles, household leverage and households risk taking. These have all, combined or
separately, been shown to indicate growing ?nancial imbalances in Norway during the
last century and should hence deserve monetary policy attention when aiming to lean
against the wind.
Being the ?rst to integrate internal (housing) market characteristics, as well as the
behavior of market participants to mitigate marginal crisis risk, our approach is
simplistic, but yet not without novelty. And – its general structure provides the basis
for a number of future extensions.
Notes
1. Whether monetary policy should take ?nancial stability considerations into account has
been a standing controversy since Borio and Lowe (2002) brought the issue to the table.
While some are in favor of the idea (see for instance Borio and White (2004), Curdia and
Woodford (2009) and Gambacota and Signoretti (2012)), others are still in opposition (see for
instance Eichengreen et al. (2011)). A general discussion regarding the lessons from asset
price in?ation for monetary policy is given by IMF (2009).
2. Woodford (2012) argues that the central bank should minimize a loss function where an
argument capturing ?nancial stability is included. The key assumption in the model is that
the probability of a crisis is endogenous and a function of leverage. The marginal crisis risk
measures the rate at which the expected loss from the occurrence of a ?nancial crisis
increases per unit of increase in leverage.
3. The ?nancial stability concern also includes increasing the weight on the output gap, as
higher resource utilization is assumed to correlate with increased leverage.
4. The relation between interest rates and risk taking is along the lines of Taylor (2007, 2009),
relating too low monetary policy rates to the credit boom and the housing bubble which
eventually lead to the sub-prime crisis.
5. For an interesting discussion on the monetary policy transmission mechanisms see
Boivin et al. (2010).
6. For households to increase risk taking in mortgage markets, their incentives to do so must be
matched by changed incentives among mortgagors. For a discussion on the relation between
mortgagor behavior and housing markets see for instance Goodhart and Hoffman (2008) or
Koetter and Poghosyan (2009).
7. See the theme box on pages 14-15 explaining the new loss function.
8. See MPR 3/11 pp. 15-16.
9. We abstract away from taxes.
10. For simplicity we suppress the interest rate gap component related to interest rate
smoothing. The expansion of equation (3) with respect to last periods interest rate can
however be expressed in a similar and straightforward manner:
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e
t
2e
t21
¼ p
t
2p
t21
þ
D
E
_ _
t
2
D
E
_ _
t21
_ _
½ð p 2r
B
Þ
t
2ð p 2r
B
Þ
t21
?;
11. A simple illustration using the RHE approach above can be useful: consider a dwelling with
a market value of 100,000 (¼V), where the LTV-ratio is 0.5 making the mortgage equal to
50,000 (¼D) and the applied equity equal to 50,000 (¼E). Let us assume that the excess return
to housing is 5 percent, as housing appreciations equals 8 percent and the mortgage rate is
3 percent. The RHE to this housing investment is now 13 percent. Another household, facing
the same appreciation and the same mortgage rate, but which has an LTV-ratio of 0.8, sees a
RHE of 33 percent. A higher RHE will stimulate households risk taking, through higher
LTV-ratios, and should be offset by monetary policy interventions. This also shows the
complementarity between monetary and macroprudential policy (See for instance Gelati and
Moessner (2012)).
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Further reading
Lund, K. and Robstad, Ø. (2012), “Effects of a new loss function in NEMO”, Norges Banks
Staff Memo 10/2012, available at:www.norges-bank.no/no/om/publisert/publikasjoner/
staff-memo/2012/12/
Corresponding author
Trond Arne Borgersen can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
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