The real consequences of financial stress

Abstract

We introduce a dynamic banking-macro model, which abstains from conventional meanreversion assumptions and in which-similar to Brunnermeier and Sannikov (2010)-adverse asset-price movements and their impact on risk premia and credit spreads can induce instabilities in the banking sector. To assess such phenomena empirically, we employ a multi-regime vector autoregression (MRVAR) approach rather than conventional linear vector autoregressions. We conduct bivariate empirical analyses, using country-specific financial-stress indices and industrial production, for the U.S., the UK and the four large euro-area countries. Our MRVAR-based impulse-response studies demonstrate that, compared to a linear specification, response profiles are dependent on the current state of the economy as well as the sign and size of shocks. Previous multi-regime-based studies, focusing solely on the regime-dependence of responses, conclude that, during a high-stress period, stress-increasing shocks have more dramatic consequences for economic activity than during low stress. Conducting size-dependent response analysis, we find that this holds only for small shocks and reverses when shocks become sufficiently large to induce immediate regime switches. Our findings also suggest that, in states of high financial stress, large negative shocks to financial-stress have sizeable positive effects on real activity and support the idea of "unconventional" monetary policy measures in cases of extreme financial stress.

The perils of debt deflation in the Euro area: a multi regime model

“…Empirical evidence can be found in similar studies (e.g. Mittnik and Semmler 2013;Semmler and Chen 2014), where it is shown that the state of financial markets plays a crucial role with respect to the propagation of shocks. Similarly Schleer et al (2014) develop an index of optimal leverage for 40 banks in Europe and show that credit and output contractions due to a lending shock are more severe during a period of overleveraging than during "normal times".…”

A financially stressed euro area

“…In particular, some of these extra variables, namely the annual growth rate of assets over liabilities, the ratio of short over long-term debt securities issued by banks, and the annual growth rate of bank lending to the private sector, reflect dynamics of the theoretical models recently developed as response to the financial crisis (see, for instance, Brunnermeier andSannikov, 2014 andMittnik and. Their macro-finance models have shown a critical impact of the banking sector on the real economy, such that the balance sheet structure of banks, credit conditions or credit constraints should be prominently considered in a financial sector data set.…”

“…Frictions can then translate into financially distressed economies. Specifically, credit conditions and the balance sheet structure of banks relate to the recent non-neoclassical channel introduced by Brunnermeier and Sannikov (2014) and Mittnik and Semmler (2013). 6 Variables related to the money and interbank market express the liquidity and confidence situation in the banking-sector.…”

“…The balance sheet structure of banks gains increasingly importance in the literature as a potential financial market stress channel (Brunnermeier andSannikov, 2014 andMittnik and. Asset price losses or a decline in credit quality lead to a reduction in the value of bank assets.…”

Macroeconomic Policy in DSGE and Agent-Based Models Redux: New Developments and Challenges Ahead

“…Auerbach and Gorodnichenko, 2012) and financial markets (Mittnik and Semmler, 2013;Ferraresi et al, 2014). In DSGE models, the effects of monetary and fiscal policies are time invariant, even if the economy is trapped in a depression.…”