Banks, Credi Marke Fricions, and Business Cycles Ali Dib Bank of Canada Join BIS/ECB Workshop on Moneary policy and financial sabiliy Sepember 10-11, 2009 Views expressed in his presenaion are hose of he auhor and do no necessary reflec hose of he Bank of Canada.
Inroducion The recen financial crisis demonsraes ha a breakdown in he banking sysem can severely disrup economic aciviy. Also, disurbances in he banking sysem can be a source of economic flucuaions. Financial condiions amplify and propagae he impac of real shocks o he economy.
Ouline Moivaion Modeling financial fricions Model Resuls Conclusion Fuure work
Moivaion Models used by policymakers ypically absrac from financial fricions (because of Modigliani-Miller heorem) In he lieraure, financial fricions inroduced focusing only on he demand of credi: Using BGG (1999) or Iacoviello (2005) [Chrisiano e al. 2009] Banks only play a passive role Few recen sudies inroduce banks in DSGE models: de Walque e al. (2008), Gerali e al. (2009), Gerler and Karadi (2009), and ohers.
Moivaion This paper proposes a fully micro-founded framework o incorporae an acive banking secor ino a DSGE model. We inroduce: demand- and supply-sides of credi markes an inerbank marke (o examine how ineracions beween banks affec credi supply) bank capial (o saisfy he bank capial requiremens, Basel II, capial regulaions) srucural financial shocks (originaing in he banking secor) and unconvenional moneary shocks
Modeling Financial Fricions
Modeling Financial Fricions Financial fricions are inroduced based on: 1. Corporae balance shee channel---financial acceleraor à la BGG (1999) -This is o model he demand-side of credi markes 2. Bank balance shee channel: shrinking balance shee resrains banks abiliy o make loans and affecs coss of producing loans (herefore, exernal financing coss) - This is o model he supply-side of credi markes
Corporae Balance Shee Channel Enrepreneurs are subjec o idiosyncraic shocks may defaul on loans Informaion asymmery and cosly sae verificaion imply an exernal finance premium, which depends on enrepreneurs ne worh Unlike BGG, in his paper: nominal deb conracs (o capure deb deflaion effecs) exernal financing coss depend on he prime lending rae se by banks (insead of policy rae)
Bank Balance Shee Channel The banking secor consiss of a coninuum of profimaximizing monopolisically compeiive banks To inroduce an inerbank marke, we assume wo ypes of banks ha inerac in he inerbank marke: savings banks lenders in he inerbank marke lending banks borrowers in he inerbank marke
Bank Balance Shee Channel Banks affec credi supply condiions hrough: Monopoly power when seing deposi and loan raes ime-varying spreads in reail raes Deposi rae se as a mark-down of he inerbank rae Loan rae se as a mark-up of marginal coss of producing loans Risk sharing wih households and enrepreneurs Banks help consumpion smoohing and efficien allocaion of savings o risky invesmen Endogenous (opimal) bank leverage raio poenial excess of bank capial holdings (capial buffer) lower raio implies lower coss of raising bank capial
Bank Balance Shee Channel Endogenous bank defauls (sraegic or mandaory), subjec o penalies (Goodhar e al. 2006) Opimal banks' porfolio composiion: spli deposis beween loans and holdings of risk-free asses
Quesions Wha is he role of acive banks in he U.S. business cycles: as an amplificaion and propagaion mechanism? Wha are real effecs of shocks originaing in he banking secor? Wha is he imporance of unconvenional moneary policies in reducing effecs of financial shocks?
Main findings The model shows ha : An acive banking secor amplifies and propagaes impacs of real shocks o he economy Bank leverage is procyclical Shocks originaing in he banking secor can generae recessions Unconvenional moneary policy has modes effecs on he real economy
The Model
The Model A New Keynesian model for a closed economy buil on BGG (1999) Real rigidiy: - Habi formaion on consumpion - Bank capial adjusmen coss - Invesmen adjusmen coss Nominal rigidiy: - Sicky prices à la Calvo-Yun conracs - Adjusmen coss of changing deposi and prime lending raes (as in Gerali e al. 2009)
Srucure of he BGG model Transfer Cenral Bank Ses policy rae, R Households Exernal financing cos depends on policy rae (R) and risk premium (rp) Deposis Passive Banking Secor (Financial Inermediaries) Deposis = Loans f ( R, rp) Loans Enrepreneurs Banks play a passive role
Srucure of he model Households (Workers) Transfer Cenral Bank Ses policy rae, R Injecs liquidiy Swaps risky asses Households (Bankers) Deposis Gov. Bonds Acive Banking Secor (coninuum of opimizing banks) Deposis Loans Bank capial Loans Governmen Banks maximize profis Enrepreneurs
Consume, work, hold cash, and make deposis Transfer Households (Workers) Srucure of he model Cenral Bank bank capial Liquidiy injecion Asse swapping Own Ses policy banks, rae, consume, R hold gov. bonds, and accumulae Households (Bankers) Deposis Gov. Bonds Acive Banking Secor Deposis Loans Bank capial Loans (risky asses) Governmen Manage firms, borrow o finance par of invesmen, subjec o idiosyncraic shocks, and may defaul Enrepreneurs
Srucure of he model Demand shocks Transfer Households (Workers) Cenral Bank Liquidiy injecion Policy shocks Asse swapping Unconvenional shocks Demand shocks Households (Bankers) Deposis Gov. Bonds Acive (opimizing) Banks Deposis Loans Bank capial Loans Governmen Financial inermediaion shocks Enrepreneurs Demand shocks Supply shocks Riskiness shocks Riskiness: shock o sd, of disribuion, agency cos, or defaul hreshold
Srucure of he model Transfer Cenral Bank Households (Workers) Liquidiy injecion Asse swapping Households (Bankers) Deposis Gov. Bonds Savings Banks Inerbank lending Lending Banks Bank capial Loans Inerbank marke Governmen Enrepreneurs Lenders in he inerbank marke Borrowers in he inerbank marke
Srucure of he model Households (Workers) Transfer Deposis fully insured Cenral Defaul on Bank inerbank Liquidiy injecion borrowing Asse swapping Households (Bankers) Deposis R D Gov. bonds Savings Banks Inerbank lending Lending Banks Bank capial Loans Inerbank marke Governmen Enrepreneurs
Se deposi rae R D, Spli deposis Transfer beween inerbank lending, sd, and Households holdings of gov. bonds, (1-s)D (Workers) Srucure of he model Cenral Bank Liquidiy injecion Asse swapping Households (Bankers) Deposis R D Gov. bonds (1-s)D Governmen Savings Banks Inerbank lending sd Inerbank marke s decreasing in defaul on inerbank borrowing Lending Banks Bank capial Loans Enrepreneurs
Households (Workers) Transfer Srucure of he model Defaul on Cenral bank capial Bank R Z risky reurn on Liquidiy injecion bank capial, Asse swapping increasing in defaul Households (Bankers) Deposis Gov. bonds Savings Banks Inerbank lending Lending Banks Bank capial R Z Loans Inerbank marke Governmen Enrepreneurs
Srucure of he model Households (Workers) Transfer Cenral Lending Bankbanks use inerbank borrowing Liquidiy injecion and bank capial o Asse swapping produce loans Households (Bankers) Governmen Deposis Gov. bonds Savings Banks Inerbank lending Inerbank marke Informaion asymmery implies an exernal risk premium (rp) Lending Banks Bank capial R Z Loans L f ( R, rp) Enrepreneurs
Srucure of he model Households (Workers) Cenral Transfer Se R L, choose leverage Bank raio, and decide defauls on inerbank Liquidiy injecion lending and bank capial Asse swapping Households (Bankers) Deposis Gov. bonds Savings Banks Inerbank lending Inerbank marke Lending Banks Bank capial R Z Loans L f ( R, rp) Governmen Enrepreneurs
Srucure of he model Households (Workers) Cenral Transfer Bank Exernal financing coss depend Liquidiy injecion on loan prime rae (R Asse L ) and rp swapping Households (Bankers) Deposis Gov. bonds Savings Banks Inerbank lending Inerbank marke Lending Banks Bank capial R Z Loans L f ( R, rp) Governmen R L depends on marginal cos of producing loans (R, R Z, and banks leverage raio) Enrepreneurs
Banks
Savings banks Collec deposis from households (workers) Lend in he inerbank marke Se deposi raes as mark-down of he inerbank rae Opimally choose he composiion of heir porfolio: inerbank lending and holdings of risk-free asses Face defaul on heir inerbank lending
Savings banks Savings banks balance shee Asses Gov. bonds: (1-s)D Inerbank lending: sd Deposis: D Liabiliies
Lending banks Receive bank capial from households (bankers) Borrow on he inerbank marke Opimally choose heir leverage raio Se prime lending rae as mark-up of he marginal cos of producing loans Marginal cos depends on he inerbank rae and he marginal cos of raising bank capial, which is increasing in he bank leverage raio Opimally decide o defaul on inerbank borrowing and/or bank capial
Lending banks Produce loans using inerbank borrowing and bank capial according o: L { ( )} s D + m Q Z Z + x Γ = min, κ Loans Risky asses Inerbank borrowing 0 s 1 D = deposis Bank capial value Z=claims on bank capial Q Z = price of bank capial
Lending banks Produce loans using inerbank borrowing and bank capial according o: L { ( )} s D + m Q Z Z + x Γ = min, κ Maximum imposed leverage raio Leverage raio subjec o κ κ and gains of holdings of 2 bank capial in excess: χ κ κ 2 κ Q Z Z
Lending banks Produce loans using inerbank borrowing and bank capial according o: L { ( )} s D + m Q Z Z + x Γ = min, κ Liquidiy injecions Asse swapping Financial inermediaion shocks: -Risk percepion -Fin. innovaion -Banking ech. -Off-bal. shee operaions
Lending banks Prime lending rae: Marginal cos of producing loans ] [ 1 +1 + = L L L j Ad E Ad j R β ζ ϑ ϑ + Γ = + κ κ κ κ ζ L Z Z R R R Q R ) 1 ( 1 1 1
Lending banks Prime lending rae: Marginal cos of producing loans ] [ 1 +1 + = L L L j Ad E Ad j R β ζ ϑ ϑ + Γ = + κ κ κ κ ζ L Z Z R R R Q R ) 1 ( 1 1 1 Cos of inerbank borrowing
Lending banks Prime lending rae: Marginal cos of producing loans ] [ 1 +1 + = L L L j Ad E Ad j R β ζ ϑ ϑ + Γ = + κ κ κ κ ζ L Z Z R R R Q R ) 1 ( 1 1 1 Cos of bank capial is increasing in leverage raio Cos of inerbank borrowing
Lending banks Prime lending rae: Marginal cos of producing loans ] [ 1 +1 + = L L L j Ad E Ad j R β ζ ϑ ϑ + Γ = + κ κ κ κ ζ L Z Z R R R Q R ) 1 ( 1 1 1 Marginal gain of holding bank capial in excess is decreasing in leverage raio Cos of bank capial is increasing in leverage raio Cos of inerbank borrowing
Lending banks Lending banks balance shee Asses Gov. bonds: Q Z Z +x Loans: L-x (L= sd+m) Liabiliies Bank capial: Q Z Z Inerbank borrowing: sd Liquidiy injecion: m Ohers: (Γ-1)(sD+m) x = qualiaive (credi) easing shock (swap a fracion of banks risky asses for risk-free asses) m = quaniaive easing shock (liquidiy injecions ha expend balance shees)
Simulaion Resuls
Simulaion resuls Two versions of he model have been simulaed: Baseline model: he model wih he banking secor and he financial acceleraor FA model: he model wih only he financial acceleraor (wihou he banking secor)
Simulaion resuls Table 1: Volailiies (Daa 80:1-08:4) Variables Daa Baseline FA Lower volailiies compared o FA, excep for loans A. Sandard deviaions in % Oupu 1.27 1.48 2.21 Invesmen 6.15 7.20 9.64 Consumpion Loans Risk premium 1.06 4.21 0.38 1.26 4.80 0.44 1.61 4.24 0.51 Calibraed o reproduce relaive volailiies B. Relaive volailiies Oupu 1 1 1 Invesmen 4.84 4.86 4.36 Consumpion 0.83 0.85 0.73 Loans 3.31 3.25 1.91 Risk premium 0.30 0.30 0.23
Simulaion resuls Table 2: Correlaions wih oupu (Daa 80:1-08:4) Variables Daa Baseline FA Counercyclical Oupu Invesmen Consumpion 1 0.87 0.84 1 0.79 0.53 1 0.87 0.43 Loans Risk premium Share of iner. lending Bank leverage Defaul on iner. lending Defaul on bank capial 0.20-0.30 + + - - 0.30-0.28 0.34 0.51-0.35-0.27 0.17-0.55.... procyclical inerbank lending and bank leverage counercyclical defauls
Impulse Responses
Impulse Response Funcions Propagaion of sandard shocks Technology shock Srucural financial shocks Riskiness shock Financial inermediaion shock Unconvenional moneary policy shocks Liquidiy injecion (quaniaive moneary easing)
Technology shocks
Figure 1: Responses o echnology shocks
Figure 1: Responses o echnology shocks Banks amplify and propagae effecs on oupu, invesmen and consumpion Banks dampen effecs on inflaion and he policy rae
Figure 1: Responses o echnology shocks Ne worh decreases because of deb deflaion and increase in lending rae on impac Risk premium increases and is higher wih banks, because of larger drop of ne worh
Figure 1: Responses o echnology shocks Loans increase furher in model wih banks, because of he larger drop in ne worh and increase in inpu used o produce loans: value of capial and inerbank lending Leverage raio increases, so bank exend Loans during booms
Figure 1: Responses o echnology shocks Ineres rae sickiness implies gradual responses, so moving and persisen spreads Prime lending increases on impac because of he increase in bank capial prices.
Figure 1: Responses o echnology shocks Boh defauls fall, because of increase in bank capial and expansion in oupu
Financial shocks
Figure 2: Responses o Riskiness shocks
Figure 2: Responses o Riskiness shocks 10% increase in he riskiness shock (shock o he elasiciy of risk premium). I may be shocks o sd of enrepreneurial disribuion, agency cos, or defaul hreshold Banks are unable o discriminae beween good and bad projecs Higher risk premium for all borrowers
Figure 2: Responses o Riskiness shocks Higher risk premium lowers ne worh. Thus, invesmen and oupu Drops are lower in he model wih banks. Loans drop in shor erms, hen increase, because firms need loans o finance heir invesmen
Figure 2: Responses o Riskiness shocks Leverage raio increases because drop of bank capial is larger han ha of loans. Banks expand loans. Drop of inerbank borrowing because banks make less loans Defauls increase.
Figure 3: Financial Inermediaion Shocks
Figure 3: Financial Inermediaion Shocks Oupu increases, inflaion and policy rae fall (i is a supply shock) Loans increase on impac, hen decrease because increase in ne worh and fall in marginal produciviy of capial
Figure 3: Financial Inermediaion Shocks Invesmen gradually increases. Higher ne worh. Higher leverage raio, since bank capial value falls Loan prime falls o accommodae he shock. Bank capial and inerb. borrowing fall. Banks need less inpus
Figure 3: Financial Inermediaion Shocks Exogenous expansion of loans increases probabiliies of defauls. Bank become fragile
Unconvenional moneary policy shocks
Figure 4: Moneary Injecion Shocks
Figure 4: Moneary Injecion Shocks Ne worh increases, while risk premium decreases Oupu and invesmen increase
Figure 4: Moneary Injecion Shocks Bank capial and inerbank borrowing decrease Leverage raio increases while loans fall one period laer. This is due o he increase in ne worh. Loan prime decreases because he decrease in he marginal cos of producing loans
Figure 4: Moneary Injecion Shocks Defauls increase because of he fall of bank capial and in he marginal reurn of loans
Conclusion We propose a micro-founded framework o model acive banks and an inerbank marke: new sources of flucuaions and propagaion mechanisms We examine he role of banks and financial shocks in he US business cycles Main findings are ha: The banking secor affecs he propagaion of real shocks Financial shocks largely accoun for US business cycles Bank leverage raio is procyclical unconvenional moneary policies have modes impacs
Fuure Work Esimaion he model Incorporaing credi o households Exending he approach o he inernaional inerbank marke Addressing differen moneary policy and financial sabiliy issues: such as bank capial regulaion (couner-cyclicaliy of bank leverage)