The role of bank capital in the propagation of shocks

Abstract

Recent events in financial markets have underlined the importance of analyzing the link between the financial health of banks and real economic activity. This paper contributes to this analysis by constructing a dynamic general equilibrium model in which the balance sheet of banks affects the propagation of shocks. We use the model to conduct quantitative experiments on the economy's response to technology and monetary policy shocks, as well as to disturbances originating within the banking sector, which we interpret as episodes of distress in financial markets. We show that, following adverse shocks, economies whose banking sectors remain well-capitalized experience smaller reductions in bank lending and less pronounced downturns. Bank capital thus increases an economy's ability to absorb shocks and, in doing so, affects the conduct of monetary policy. The model is also used to shed light on the ongoing debate over bank capital regulation. JEL classification: E44, E52, G21 Bank classification: Transmission of monetary policy; Financial institutions; Financial system regulation and policies; Economic models RésuméLes récents événements survenus sur les marchés financiers illustrent à quel point il est important d'analyser la relation entre la santé financière des banques et l'activité économique réelle. Les auteurs construisent pour ce faire un modèle dynamique d'équilibre général dans lequel le bilan des banques influe sur la propagation des chocs. À l'aide de ce modèle, ils mènent des simulations quantitatives concernant la réaction de l'économie à un choc technologique, à un choc de politique monétaire ainsi qu'à des perturbations émanant du secteur bancaire, qu'ils assimilent à des périodes de détresse sur les marchés financiers. Les auteurs montrent que, lors de chocs défavorables, les économies dont le secteur bancaire demeure bien doté en capital ne voient pas le crédit bancaire diminuer autant et connaissent un ralentissement moins marqué. La présence de banques au bilan solide aide donc l'économie à mieux absorber les chocs, ce qui a des répercussions sur la conduite de la politique monétaire. Le modèle utilisé apporte un éclairage intéressant au débat en cours sur la réglementation des fonds propres des banques.

Bank capital, the state contingency of banks’ assets and its role for the transmission of shocks

“…Banks' leverage constraint generally affects the business cycle and amplifies developments in a downturn. This is the reason why recent macroeconomic models heavily emphasize the role of bank capital as a propagation channel of shocks to the real economy (Chen, 2001;Gerali, Neri, Sessa, and Signoretti, 2010;Gertler and Karadi, 2011;Meh and Moran, 2010;Zeng, 2013). 1 Since bank capital is an important determinant of banks' leverage, which in turn affects how shocks are propagated through the banking sector to the real economy, it is also important to put the focus on the channels which determine the evolution of bank capital in a macroeconomic context.…”

Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults

“…These frictions indicate that the supply side of the credit market also contributes to shock propagation, affecting output dynamics in the economy. In Meh and Moran (2010), moral hazard arises, since the monitoring activities of banks are not publicly observable. Depositors are concerned that banks may not monitor entrepreneurs adequately and demand that banks invest their own net worth (bank capital) in the financing of entrepreneurial projects.…”

Japan's financial crises and lost decades

“…The …rst is the Non-FA model, in which no …nancial accelerator mechanism is incorporated. The equilibrium conditions under this model are given by equations (16), (17), (20), (21), (22), (23), (24), (30), (31), (32), (34), (35), (36), (37), and (47), and by the following equations instead of equations (33) and (36), respectively, under the benchmark model, :…”

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