Commercial banks are distinguished from other financial institutions by their accepting deposits and provision of loans. The Federal Reserve classifies bank loans into several categories: real estate loan, agricultural loan, commercial and industrial loan (C&I), loan to depository institutions, consumer loan, obligations to state and political subdivision, and foreign loan (Saunders, 2008). Loans are the basic source of revenue and a major part of asset for banks. Loan portfolio problems have historically been a major cause of bank failure (Comptroller’s Handbook, 1998). Loans are associated with default risk in addition to the inherent risk of individual loans. Thus, according to the Modern Portfolio Theory the objective of the bank manager is to choose a loan portfolio that minimizes risk given the expected return of the portfolio.
The recent financial crisis of 2008 had severe consequences for commercial banks. According to the Federal Deposit Insurance Corporation (FDIC) 25 commercial banks failed and several others declared bankruptcy during 2008. These failures are likely to cause a decline in confidence that would make commercial banks reluctant to lend money amongst themselves or to others.
It is generally considered all too obvious that the world's financial markets have become continuously, dramatically and unprecedentedly open in the years since the end of World War II. And often in the same breath, the equally obvious explanation is provided that these facts are the consequences of advances in computers and high-speed communications.
Given the on-going financial crisis precipitated by the sub-prime loan problem in the U.S. financial sector, there has been an increased interest in the linkage between financial activity and real economic activity. In particular, there is a heightened interest in how the shock occurring in direct and/or indirect financial market can affect the real economic activity. Although the Canadian banking sector seems to be weathering the current financial crisis (Northcott et al. (2009)) or have not experienced a major financial turmoil in recent decades, there is no guarantee that the Canadian economy will be free from a large shock in the financial sector in a near future. In order to help the policy makers to understand the consequences of such contingency and to facilitate them in forming a counter-measure, it is crucial to assess how vulnerable (or robust) is the Canadian economy to the shocks originating in the financial sector. As such, we ask the following question in this paper; how important are financial shocks for the Canadian business cycle?
To answer the above question, we need to decide how to model the financial friction and financial shocks. In modeling the financial friction in a general equilibrium setting, there are mainly two approaches. One way is to impose collateral constraint as in Kiyotaki and Moore (1997). This collateral constraint approach is becoming a popular choice, especially when modelling the financial friction in mortgage loan market where residential asset is customary withheld as a collateral until the mortgage loan is repaid in full. Another approach is to model external finance premium as in Bernanke and Gertler (1989), Carlstrom and Fuerst (1997), and Bernanke, Gertler, and Gilchrist (1999). This approach proved extremely useful in modelling the standard debt contract between the corporate sector and financial intermediary which allows us to analyze the relationship between business fixed investment and external financing cost. Both types of financial friction — collateral constraint and external finance premium — are useful in addressing the linkage between financial market and real economic activity such as financial acceleration mechanism in residential investment and business fixed investment. However, since we are more interested in the fluctuation of the business fixed investment — the most important factor in output fluctuation, we will be adopting the external finance premium as the choice of financial friction mechanism in this paper. In particular, we construct a medium-scale dynamic stochastic general equilibrium (denoted DSGE, hereafter) model with financial friction ? la Bernanke, Gertler, and Gilchrist (1999) (denoted BGG, hereafter). Further, reflecting the Canadian context, we extend the model to incorporate the small-open economy feature.
