The financial turmoil which originated with the collapse of the subprime mortgage market in the US and spread through the globe has claimed more than US$ 600 bn. in losses to financial firms and a significant contraction in bank lending standards.
More recently, the US Congress passed a bailout package to alleviate capital-constrained financial institutions in a market intervention not seen since Franklin Roosevelt’s New Deal, aimed at avoiding the potentially catastrophic consequences of a severe and protracted credit crunch. This paper contributes with a model to study credit crunches, which can be used as a laboratory to explore policy options. It belong to the growing literature on the linkages between real and financial factors.
The link between financial factors and the real economy relies on the breakdown of the Modigliani and Miller (1958) theorem. By now, there is significant empirical evidence suggesting the failure of the Modigliani and Miller (1958) theorem–see for instance Bernanke, Gertler, and Gilchrist (1996)–and substantial theoretical work modeling the dynamic interaction between borrowers’ access to credit and the value of collateral, to show that credit market imperfections amplify and propagate shocks to the economy.
Important contributions along these lines include Bernanke and Gertler (1989, 1990), Kiyotaki and Moore (1997), Gertler (1992), Greenwald and Stiglitz (1993), Fuerst (1995), Carlstrom and Fuerst (1997, 2001), and Bernanke, Gertler, and Gilchrist (1999); Chari, Kehoe, and McGrattan (2006) argue that such frictions are not important once time-variation in other factors such as efficiency and labor wedges are taken into account. However, they potentially understate the importance of credit market frictions by ignoring their interactions with other efficiency wedges, as suggested by Christiano and Davis (2006). Levin, Natalucci, and Zakrajsek (2004) estimate the magnitude and cyclical behavior of financial frictions using publicly traded debt in a sample of U.S. firms and find that they are statistically significant and economically important.
There are also a number of empirical studies providing evidence in rejection of the Modigliani and Miller (1958) theorem in the context of banks. Bernanke and Lown (1991), Peek and Rosengren (1994, 1995), Hancock and Wilcox (1994), Kashyap and Stein (1995, 2000) are examples of studies showing that banks’ lending decisions depend on their balance sheet structure. Moreover, Bernanke (1983), Dell’Ariccia, Detragiache, and Rajan (2005), Gibson (1995, 1997), Klein, Peek, and Rosengren (2002), Peek, Rosengren, and Tootell (2003), Peek and Rosengren (1997, 1999, 2000) and others have provided evidence suggesting the detrimental economic effects of financial distress in the banking industry. More recently, Adrian and Shin (2008a and 2008b) argue that marked-to-market leverage of financial firms is strongly procyclical and constitutes an important amplification mechanism during the ongoing crisis.
The key contribution of this paper is the development of a tractable framework to analyze banks’ intertemporal decisions in a world of imperfect capital markets, in line with existing empirical work. Two of its key advantages over existing bank models are its infinite-horizon feature and non-linear solution. Models that include a bank, such as Bernanke and Gertler (1987), Holmstrom and Tirole (1997), Chen (2001), Meh and Moran (2004), and Christiano, Motto, and Rostagno (2004) have been developed in general equilibrium framework. However, in the cases where they have a dynamic nature, the solution arises from linearized versions of the first order conditions, eliminating thus important aspects of banks’ behavior such as their precautionary motive. Other models such as Stein (1998), Diamond and Dybvig (1983), and Diamond and Rajan (2001, 2003a, b) offer important insights about equilibrium outcomes; however, their static or short-horizon nature–as it is also the case for Holmstrom and Tirole (1997)–do not permit exploring the dynamic adjustment towards equilibrium. Models closely related to the one presented in this paper are Van Den Heuvel
(2002), which examines the role of regulatory constraints on bank behavior, and Geiregat
(2001), which models the bank in a social planner setup.
The model developed in this paper has two key set of players: borrowers and a monopolistic bank. The borrower-bank relationship is modeled as a risky debt contract subject to information problems. In order to focus the attention entirely on the bank’s optimal decisions, borrowers’ creditworthiness is constant over time–that is, the Bernanke, Gertler, and Gilchrist (1999)’s financial accelerator is shut down.
The bank faces constraints in raising funds, as a result of credit market imperfections, implying that its funding costs increase when solvency declines. This setup generates an optimal financial structure and permits examining how the bank adjusts to deviations from it. For instance, when a negative shock deteriorates bank capital, it is optimal for the bank to reduce dividends in order to restore solvency to its optimal level. If such strategy is not enough to restore equilibrium, the bank reduces lending, triggering a credit crunch. This credit crunch can be quite persistent because the bank restores solvency only gradually through retained earnings. This result is crucial because the persistent credit crunch arises even when the original impulse is a transitory, one-period i.e. interest rate or productivity shock. Another interesting feature of the model is that the bank exhibits a precautionary motive: when credit risk increases, the optimal level of capital and hence solvency is higher.
The results obtained from numerical simulations of the model suggest that the financial health of the banking system may be a significant contributor to the propagation of economic shocks, especially negative ones. Banks’ precautionary motive insulates lending from shocks up to some size, but for larger shocks the economic consequences of the ensuing credit crunch may be significant. In this context, the results suggest that government bailouts of distressed banks--in the form of recapitalization policies--may be a reasonable responseduring episodes of systemic financial pressures.
This paper is organized as follows: the next section provides a review of the literature on the real effects of financial distress; section 3 presents the model; section 4 discusses some quantitative experiments; section 5 discusses bank recapitalization in the context of the model; and section 6 concludes.
Contents
I. Introduction
II. Banks and the Real Economy
III. The Model
- A. The Loan Contract
B. The Bank’s Optimization Problem
C. Solution
D. Risk and the Target Level of Solvency
IV. Quantitative Experiments
V. Bank Recapitalization
VI. Conclusions
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