Financial Intermediation and Credit Policy in Business Cycle Analysis
Summary (7 min read)
1 Introduction
- Over the past few years the United States and much of the industrialized world have experienced the worst nancial crisis of the post-war.
- The authors goal is twofold: rst to illustrate how disruptions in nancial intermediation can induce a crisis that a¤ects real activity; and second, to illustrate how various credit market interventions by the central bank and the Treasury of the type the authors have seen recently, might work to mitigate the crisis.
- Along the way, there is mutual feedback between the nancial and real sectors.
- To the extent that the agency problem that limits an intermediary s ability to obtain funds from depositors also limits its ability to obtain funds from other nancial institutions and to the extent that non nancial rms can obtain funds only from a limited set of nancial intermediaries, disruptions of inter-bank markets are possible that can a¤ect real activity.
2 A Canonical Model of Financial Intermedi-
- Ation and Business Fluctuations Overall, the speci c business cycle model is a hybrid of Gertler and Karadi s (2009) framework that allows for nancial intermediation and Kiyotaki and Moore s (2008) framework that allows for liquidity risk.
- On the other hand, the authors also allow for some features prevalent in conventional quantitative macro models (such as Christiano, Eichenbaum and Evans (2005), Smets and Wouters (2007)) in order to get rough sense of the importance of the factors they introduce.
- For simplicity the authors restrict attention to a purely real model and only credit policies, as opposed to conventional monetary models.
- First, if the zero lower bound on the nominal interest is binding, the nancial market disruptions will have a larger e¤ect than otherwise.
- See, e.g., Gertler and Karadi (2009) and Del Negro, Ferrero, Eggertsson and Kiyotaki (2010) for an illustration of both of these points.
2.1 Physical Setup
- Before describing their economy with nancial frictions, the authors present the physical environment.
- Firms on investing islands acquire capital from capital goods producers who operate in a national market.
- The authors abstract from many frictions in the conventional DSGE framework (e.g. nominal price and wage rigidities, variable capital utilization, etc.).
- Suppose that, once capital is installed, capital is good-speci c and that each period a random fraction of goods become obsolete and are replaced by new goods.
- In what follows the authors will introduce banks that intermediate funds between households and non- nancial rms in a retail nancial market.
2.2 Households
- In their economy with credit frictions, households lend to non- nancial rms via nancial intermediaries.
- Following Gertler and Karadi (2009), the authors formulate the household sector in way that permits maintaining the tractability of the representative agent approach.
- Households may also hold riskless one period government debt which is a perfect substitute for bank deposits.
- It is critical, however, that the expected horizon is nite, in order to motivate payouts while the nancial constraints are still binding.
- Finally, because in equilibrium bankers will not be able to operate without any nancial resources, each new banker receives a "start up" transfer from the family as a small constant fraction of the total assets of entrepreneurs.
2.3 Banks
- To nance lending in each period, banks raise funds in a national nancial market.
- The authors allow for the possibility that bank may be constrained not only in obtaining funds from depositors but also in obtaining funds from other banks.
- The asset exchange between moving and staying banks described in the text accomplishes this arbitrage.
- The friction that constrains a banks ability to obtaining funds on the interbank market is the same as for the retail nancial market.
2.3.1 Case 1: Frictionless wholesale nancial market (! = 1)
- The perfect inter- bank market, further, implies that the marginal value of assets in terms of goods st Qt must equal the marginal cost of borrowing on the interbank market bt, st Qt = bt: (17) Because asset prices are equal across island types, the authors can drop the h superscript in this case.
- Accordingly, let t denote the excess value of a unit of assets relative to deposits, i.e., the marginal value of holding assets st Qt net the marginal cost of deposits t.
- It follows that the incentive constraint (16) in this case may expressed as Qtst bt = tnt (19) with t = t t : (20) Note that since interbank borrowing is frictionless, the constraint applies to assets intermediated minus interbank borrowing.
- How tightly the constraint binds depends positively on the fraction of net assets the bank can divert and negatively on the excess value of bank assets, given by t: Overall, a setting with a perfect interbank is isomorphic to one where banks do not face idiosyncratic liquidity risks.
2.3.2 Case 2: Symmetric frictions in wholesale and retail nancial
- Markets (! = 0) In this instance the bank s ability to divert funds is independent of whether the funds are obtained in either the retail or wholesale nancial markets.
- Here, even if banks on investing islands are nancially constrained, banks on non-investing islands may or may not be.
- With an imperfect inter-bank market, a crisis is associated with both a rise in the excess return for banks on investing islands and increase in the dispersion of returns between island types.
- For the case where the interbank market is imperfect but operates with less friction than the retail deposit market (i.e., 0 < ! < 1), the interbank rate will lie between the return on loans and the deposit rates.the authors.
2.4 Evolution of Bank Net Worth
- Nht , equal the sum of the net worth of existing bankers.
- Net worth of existing bankers equals earnings on assets net debt payments made in the previous period, multiplied by the fraction that survive until the current period, : Nhot = hf[Zt + (1 )Qht ] tSt 1 RtDt 1g: (35) Because the arrival of investment opportunity is independent across time, the interbank loans are net out in the aggregate here.
- Further, the higher the leverage of the bank is, the larger will be the percentage impact of return uctuations on net worth.
- Note also that a 20 deterioration of capital quality (a decline in t) directly reduces net worth.
- As the authors will show, there will also be a second round e¤ect, as the decline in net worth induces a re sale of assets, depressing asset prices and thus further depressing bank net worth.
2.5.1 Goods Producer
- Competitive goods producers on di¤erent islands operate a constant returns to scale technology with capital and labor inputs, given by equation (1).
- A goods producer with an opportunity to invest obtains funds from an intermediary by issuing new state-contingent securities at the price Qit .
- The producer then uses the funds to buy new capital goods from capital goods producers.
- Note that given constant returns and perfect labor mobility, the authors do not have keep track of the distribution of capital across islands.
- As in the standard competitive model with constant returns, the size distribution of rms is indeterminate.
2.6 Capital Goods Producers
- Capital producers operate in a national market.
- They make new capital using input of nal output and subject to adjustment costs, as described in section 2.1.
- They sell new capital to rms on investing islands at the price Qit: Given that households own capital producers, the objective of a capital producer is to choose.
2.7 Equilibrium
- To close the model (in the case without government policy), the authors require market clearing in both the market for securities and the labor market.
- Observe rst that the market price of capital on each island type will in general depend on the nancial condition of the associated banks.
- For the more general case of imperfect interbank market, the condition that labor demand equals labor supply requires that (1 )Yt Lt EtuCt = L"t (42) Because of Walras Law, once the market for goods, labor, securities, and interbank loans is cleared, the market for riskless debt will be cleared automatically:.
- With highly leveraged banks, a substantial percentage drop in bank equity may arise, leading to a signi cant disruption of credit ows.
3 Credit Policies
- During the crisis the various central banks, including the US.
- There is some evidence that these types of policies were e¤ective in stabilizing the nancial system.
- Though not without controversy, the equity injections appeared to reduce stress in banking markets.
- As the authors showed in the previous section, within the context of their model, the nancial market frictions open the possibility of periods of distress where excess returns on assets are abnormally high.
- 24 the point of the Federal Reserve s various credit programs as facilitating this arbitrage in times of crisis.
3.1 Lending Facilities (Direct Lending)
- The authors characterize direct lending broadly as the facilities the Federal Reserve set up for direct acquisition of high quality private securities.
- The advantage is that unlike private intermediaries, the central bank is not balance sheet constrained (at least in the same way).
- It is true that the interest rate on reserves fell to zero as the Federal Funds rate reached its lower bound, giving these reserves the appearance of money.
- As originally noted by Wallace (1980), unless there is something special about government liabilities, the Miller-Modigliani theorem applies to government nance.
- Only when private intermediaries are nancially constrained does central bank intermediation expand the overall supply of credit.
3.2 Liquidity Facilities (Discount Window Lending)
- With liquidity facilities, the central bank uses the discount window to lend funds to banks that in turn lend them out to non nancial borrowers.
- The authors suppose the central bank o¤ers discount window credit at the noncontingent interest rateRmt+1 to banks who borrow on the inter-bank market.
- Here the authors suppose that the central bank is better able to enforce repayment than private lenders.
- With a capacity constraint on discount window lending (secured by private credit) the central bank may need to use other tools such as direct lending or equity injections during crisis periods of high excess returns.
3.3 Equity Injections.
- With equity injections, the scal authority coordinates with the monetary authority to acquire ownership positions in banks.
- The government may hold the equity stake until the bank exits and then receive the liquidation value of its assets, equal to 30 Z + (1 )Q per unit of capital times the number of units of capital its shares are worth.
- To acquire equity, the government may pay a price Qgt that is above Qt.
- One rationale for the government paying a premium is that the market price is below its normal value due to nancial distress.
- For high grade instruments like commercial paper, agency debt and mortgage backed securities it is reasonable to suppose the costs of central bank intermediation are not large.
- In a period of crisis, equity injections that enhance the ability of private banks to make these kinds of loans would seem desirable, (if the e¢ ciency cost of government equity injection is not too large.).
3.4 Government Expenditures and Budget Constraint
- Here government consumption Let Shgt be total securities of type h = i; n acquired via direct central bank lending and Sget securities acquired via equity injections.
- Gt is given by Gt = G+ eSget + X h=i;n Shgt (60) Putting together scal and monetary authority, government expenditures are nanced by lump sum taxes.
- As the authors discussed earlier, the price the government pays for equity, Qgt; could exceed the market price.
- Note that the during the crisis the government will earn extra returns on its portfolio, since excess private returns in the market are positive, but private intermediaries are constrained from exploiting this.
- Here the authors assume that lump sum taxes adjust to nance the losses.
4 Crisis Simulations and Policy Experiments
- In this section the authors present some numerical experiments designed to illustrate how the model may capture some key features of a nancial crisis and also how credit policy might work to mitigate the crisis.
- Their aim is to show how vulnerability of the nancial system might propagate the e¤ects of a disturbance to asset values and aggregate production that might otherwise have a relatively modest e¤ect on the economy.
- The authors start with the calibration and then turn to a "crisis" simulation.
- After examining how the crisis plays out in the absence of any kind of policy response, the authors analyze how credit policy might work to mitigate the crisis.
- Though, the authors do not report the results here, the other policies ultimately a¤ect the economy in a similar fashion.
4.1 Calibration
- There are eleven parameters for which the authors need to assign values.
- The one exception involves the labor supply elasticity:.
- The rst is the probability of an investment opportunity, i: The last three are the nancial sector parameters: the quarterly survival probability of bankers; the 34 transfer parameter for new bankers, and the fraction of gross assets the banker can divert.
- The authors base the steady state target for the spread on the pre-2007 spreads as a rough average of the following spreads: mortgage rates versus government bond rates, BAA corporate bond rates versus government bonds, and commercial paper rates versus T-Bill rates.
- With an imperfect inter-bank market, under their calibration only banks on investing islands are constrained (within a local region of the steady-state).
4.2.1 No Policy Response
- Broadly speaking, what triggered the recent nancial crisis was a decline in real estate values that precipitated a wave of losses on mortgage backed securities held by nancial intermediaries.
- First, because banks are leveraged, the e¤ect of decline in assets values on bank net worth is enhanced by a factor equal to the leverage ratio.
- Note rst that the negative disturbance produces only a modest downturn in the frictionless model.
- The loss of capital initially produces a drop 17What is critical for their crisis experiment is that the initiating disturbance lead to a decline in the market prices of intermediary assets.
- Next the authors turn to the case with the imperfect inter-bank market in Figure 2.
4.2.2 Credit Policy Response
- Symptomatic of the nancial distress in the simulated crisis is a large increase in the spread between the expected return on capital on investing islands and the riskless interest rate.
- Figure 3 reports the impulses for this case.
- The credit policy similarly works to dampen the output decline by mitigating the increase in the spread.
- Interestingly, the policy is more e¤ective at containing the crisis in this case.
- By directly facilitating credit ows in investing regions, a given level of central bank intermediation can be more e¤ective in relaxing nancial constraints.
5 Issues and Extensions
- The authors now discuss some key issues in the literature that their baseline model does not consider.
- The authors also characterize how one might extend their framework to address these issues.
5.1 Tightening Margins
- Within their baseline model, nancial distress is a product of deteriorating intermediary balance sheets:.
- In the context of their model, any factor that might reduce the fraction of assets that lenders can expect to recover in a default will induce a tightening of margins.
- Kiyotaki and Moore (2008), Del Negro, Eggertsson, Ferrero and Kiyotaki (2010) and Jermann and Quadrini (2009) use essentially this kind of mechanism to motivate a disruption of nancial markets.
- If the recovery problem is concentrated in the inter-bank market, then the deterioration in asset quality might induce a reduction in !t, causing the interbank market to contract.
- Banks always hold the maximum level of assets that their respective net worth permits.
5.2 Regulatory Arbitrage and Securitized Lending
- Because the authors are interested in capturing the interaction between banking and the macroeconomic conditions their representation of the nancial intermediary sector is quite parsimonious.
- At the same time, their framework captures three basic aspects of banking that have been emphasized in the literature.
- Think of the overall entity that the banker runs as a universal bank with the commercial bank and the SPV as separate entities.
- Now suppose that the maximum regulatory leverage on the commercial bank b is lower than the privately determined value t.
5.3 Outside Equity, Externalities and Moral Hazard
- The authors baseline presumes that the only type of liability the bank can issue to raise funds is short term non-contingent debt.
- The left side then implies that for banks to be issuing both deposits and outside equity, the discounted cost of the outside equity, Et t;t+1 t+1Ret+1, must be less than that of that of deposits..
- The introduction of an endogenous choice of equity also raises the issue of moral hazard from the anticipation of policy interventions.
- Doing so, however, reduces the banks incentive to resort to outside equity nancing.
6 Concluding Remarks
- If nothing else, the authors hope that their Handbook chapter helps dispel the notion that macroeconomists have not paid attention to the nancial sector.
- As the authors have seen, over the past twenty years there has been a steady stream of research that incorporates nancial frictions into macroeconomic analysis.
- The crisis, of course, has precipitated an uptick in the pace of this research and o¤ered many new issues to study.
- One di¤erence between research over the past decade as compared to earlier has been an emphasis on developing frameworks suitable for quantitative analysis.
- The authors view this as a welcome development since many of the issues involving the role of nancial factors in the business cycle and the implications for both credit and regulatory policies ultimately involve quantitative considerations.
Did you find this useful? Give us your feedback
Citations
2,158 citations
Cites background from "Financial Intermediation and Credit..."
...See Gertler and Kiyotaki (2010) for a formal characterization of the different types of credit market interventions that the Federal Reserve and Treasury pursued in the current crisis. where ft is the leverage ratio for privately intermediated funds (see Eqs....
[...]
...4 See Justiniano et al. (2010a, 2010b) for evidence that this premium is highly countercyclical and in fact opened up widely during the 2007–2009 recession....
[...]
...In this literature, 13 See Gertler et al. (2010) for an attempt along these lines. the disaster is taken as a purely exogenous event....
[...]
...See Acharya et al. (2010) and the references therein....
[...]
1,585 citations
1,365 citations
1,124 citations
1,107 citations
References
9,099 citations
"Financial Intermediation and Credit..." refers background in this paper
...Next, from (25, 26, 29, 30), we learn that the returns obey...
[...]
7,982 citations
"Financial Intermediation and Credit..." refers background in this paper
...Accordingly, equation (14) implies that the marginal cost of interbank borrowing is equal to the marginal cost of deposits bt = t: (25)...
[...]
...Next, from (25, 26, 29, 30), we learn that the returns obey...
[...]
6,294 citations
"Financial Intermediation and Credit..." refers background in this paper
...Finally, the condition that labor demand equals labor supply requires that (1 )t Lt Et(uCt) = L ' t (42)...
[...]
5,370 citations
4,595 citations
"Financial Intermediation and Credit..." refers methods in this paper
...We keep the core macro model simple in order to see clearly the role of intermediation and 5 liquidity....
[...]