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The current financial crisis and the contemporaneous contractions in output, investment, and employment indicate that credit markets disruptions have important effects on economic activity. Central banks round the world have responded with aggressive reductions in their interest rates what suggests that monetary authorities believe that they can partially offset these negative credit market shocks. In this paper I explore the importance of credit market shocks for economic fluctuations and I asses if monetary policy could stabilize shocks that originate in credit markets. To provide quantitative answers for the U.S. economy I use Bayesian maximum likelihood methods to estimate an extended version of the Bernanke, Gertler, Gilchrist (1999) (henceforth BGG) financial accelerator model using real and financial data.
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.
The size and book-to-market effects are two of the most frequently studied phenomena of stock returns. They were first documented in the early 1980s and were later made famous by Fama and French (1992). These two firm-specific variables have been found to be the strongest among all variables that have explanatory power for cross-sectional stock returns, subduing the market beta, earnings-price ratio, and other variables previously found useful in explaining average returns.
