Unexpected loan losses and bank capital in an estimated DSGE model of the euro area

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. We develop a stylized DSGE model in which banks face capital regulation and their loan portfolios are subject to non-diversifiable losses due to aggregate shocks. The framework is used to explore the importance of the interaction between macroeconomic conditions, credit default and bank capitalization for the transmission of macroeconomic shocks. We fit the model to euro area data. Impulse response analysis shows that the aforementioned interaction substantially magnifies the responsiveness of the economy to real and nominal demand side disturbances. The amplification is especially strong with respect to government spending shocks. The model is further capable of replicating two financial market characteristics that are documented in the empirical literature, i.e. the pro-cyclicality of bank profitability and the counter-cyclical response of firm default rates and credit spreads to monetary policy shocks. Terms of use: Documents inJEL-Codes: E440, E510, G210, G330.

Financial shocks and inflation dynamics

“…Contractionary aggregate demand shocks lead to a decline in real GDP, credit, inflation and the policy rate, and raise the credit-to-GDP ratio. This last restriction disentangles financial and aggregate demand shocks, and is for instance consistent with the effects of a preference shock in Iacoviello (2015), Hristov and Huelsewig (2017) and Gelain et al (2017), or with the effects of a fiscal shock in Hristov and Huelsewig (2017). Contractionary aggregate supply shocks lead to a decline 18 Relaxing the conditional restriction on the policy rate produces the same qualitative results, but increases the model uncertainty associated with the sign restrictions.…”

“…Economic Journal 17( 519 Tables Table 1: Theoretical responses of inflation to contractionary financial shocks implied by different models: An increase (decrease) is denoted with a + (-) sign. ft refers to De Fiore and Tristani (2013); mm refers to Meh and Moran (2010); gnss refers to Gerali et al (2010); gssz refers to Gilchrist et al (2017); gk refers to Gertler and Karadi (2011); cw refers to Curdia and Woodford (2010); hh refers to Hristov and Huelsewig (2017); gln refers to Gelain et al (2017); cmr refers to Christiano et al (2010).…”

“…The relative restriction on credit growth and GDP is consistent with DSGE models featuring an active financial sector and shocks that directly affect banks' balance sheets. Examples of these models include Covas and Driscoll (2013), Curdia and Woodford (2010), Gelain et al (2017), Gerali et al (2010, Gertler and Karadi (2011), Hristov and Huelsewig (2017), Iacoviello (2015) and Meh and Moran (2010). 14 Key to this credit-to-GDP response is a realistic banking sector that is subject to endogenous bank balance-sheet constraints due to financial frictions.…”

“…The effect arises on impact and is 2 The models do not allow to associate specific characteristics of financial shocks to a specific inflation response. For example, Gerali et al (2010), Gertler and Karadi (2011) and Hristov and Huelsewig (2017) consider shocks to bank capital, but inflation responses differ (cf. Table 1).…”

The Impact of Basel III Capital Regulation on Profitability: A Hybrid Model

“…Hogan (2015) used CAR to compares the RBC ratio to the standard capital ratio of equity over assets of US holding companies from 1999 through 2010. Hristov and Hülsewig (2017) used CAR to study the importance of the endogenous interaction between private debtors' default, aggregate loan losses and the bank capital regulation for the transmission of macroeconomic shocks using euro area data over the period 2000-2015.…”