Financial Intermediation and Credit Policy
in
Business Cycle Analysis
Mark Gertler and Nobuhiro Kiyotaki
N.Y.U. and Princeton
October 2009
This version: Septemb er 2010
Abstract
We develop a canonical framework to think about credit market
frictions and aggregate economic activity in the context of the current
crisis. We use the framework to address two issues in particular: …rst,
how disruptions in …nancial intermediation can induce a crisis that
a¤ects real activity; and second, how various credit market interven-
tions by the central bank and the Treasury of the type we h ave seen
recently, might work to mitigate the crisis. We make use of earlier
literature to develop our framework and characterize how very recent
literature is incorporating insights from the crisis.
Prepared for the Handbook of Monetary Economics. Thanks to Michael Woodford,
David Andolfatto, Larry Christiano, Harris Dellas, Ian Dew-Becker, Giovanni Di Bar-
tolomeo, Chris Erceg, Simon Gilchrist, Arvind Krishnamurthy, Ramon Marimon and
Shinichi Nishiyama for helpful comments. Thanks also to Albert Queralto Olive for excel-
lent research assistance.
1
1 Introduction
To motivate interest in a paper on …nancial factors in business ‡uctuations
it use to be necessary to appeal either to the Great Depression or to the
experiences of many emerging market economies. This is no longer necessary.
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 global
recession that has followed also appears to have been the most severe of this
era. At the time of this writing there is evidence that the …nancial sector has
stabilized and the real economy has stopped contracting and output growth
has resumed. The path to full recovery, however, remains highly uncertain.
The timing of recent events, though, poses a challenge for writing a Hand-
book chapter on credit market frictions and aggregate economic activity. It
is true that over the last several decades there has been a robust literature
in this area. Bernanke, Gertler and Gilchrist (BGG, 1999) surveyed much
of the earlier work a decade ago in the Handbook of Macroeconomics. Since
the time of that survey, the literature has continued to grow. While much
of this work is relevant to the current situation, this literature obviously did
not anticipate all the key empirical phenomena that have played out during
the current crisis. A new literature that builds on the earlier work is rapidly
cropping up to address these issues. Most of these papers, though, are in
preliminary working paper form.
Our plan in this chapter is to look both forward and backward. We look
forward in the sense that we o¤er a canonical framework to think about credit
market frictions and aggregate economic activity in the context of the current
crisis. The framework is not meant as comprehensive description of recent
events but rather as a …rst pass at characterizing some of the key aspects and
at laying out issues for future research. We look backward by making use of
earlier literature to develop the particular framework we o¤er. In doing so,
we address how this literature may be relevant to the new issues that have
arisen. We also, as best we can, characterize how very recent literature is
incorporating insights from the crisis.
From our vantage, there are two broad aspects of the crisis that have not
been fully captured in work on …nancial factors in business cycles. First, by
all accounts, the current crisis has featured a signi…cant disruption of …nancial
2
intermediation.
1
Much of the earlier macroeconomics literature with …nancial
frictions emphasized credit market constraints on non-…nancial borrowers and
treated intermediaries largely as a veil (see, e.g. BGG). Second, to combat the
crisis, both the monetary and …scal authorities in many countries including
the US. have employed various unconventional policy measures that involve
some form of direct lending in credit markets.
From the standpoint of the Federal Reserve, these "credit" policies rep-
resent a signi…cant break from tradition. In the post war era, the Federal
Reserve scrupulously avoided any exposure to private sector credit risk. How-
ever, in the current crisis the central bank has acted to o¤set the disruption of
intermediation by making imperfectly secured loans to …nancial institutions
and by lending directly to high grade non-…nancial b orrowers. In addi-
tion, the …scal authority acting in conjunction with the central bank injected
equity into the major banks with the objective of improving credit ‡ows.
Though the issue is not without considerable controversy, many observers
argue that these interventions helped stabilized …nancial markets and, as
consequence, helped limit the decline of real activity. Since these policies are
relatively new, much of the existing literature is silent about them.
With this background in mind, we begin in the next section by developing
a baseline model that incorporates …nancial intermediation into an otherwise
frictionless business cycle framework. Our 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 we have seen recently, might
work to mitigate the crisis.
As in Bernanke and Gertler (1989), Kiyotaki and Moore (1997a) and
others, we endogenize …nancial market frictions by introducing an agency
problem between borrowers and lenders.
2
The agency problem works to in-
troduce a wedge between the cost of external …nance and the opportunity
1
For a description of the disruption of …nancial intermediation during the current re-
cession, see Brunnermeier (2009), Gorton (2010) an d Bernanke (2009). For a m ore general
description of …nancial crisis over the last several hundred years, see Reinhart an d Rogo¤
(2009).
2
A partial of other macro models with …nancial frictions in this vein includes,
Williamson (1987), Kehoe and Livene (1993), Holmstrom and Tirole (1998), Carlstrom
and Fuerst (1997), Caballero and Kristhnamurthy (2001), Kristhnamurthy (2003), Chris-
tiano, Motto and Rostagno (2005), Lorenzoni (2008), Fostel and Geanakoplos (2009), and
Brunnermeir and Sannikov (2009).
3
cost of internal …nance, which adds to the overall cost of credit that a bor-
rower faces. The size of the external …nance premium, further, depends on
the condition of borrower balance sheets. Roughly speaking, as a borrower’s
percentage stake in the outcome of an investment project increases, his or
her incentive to deviate from the interests of lenders’declines. The external
…nance premium then declines as a result.
In general equilibrium, a "…nancial accelerator" emerges. As balance
sheets strengthen with improved economics conditions, the external …nance
problem declines, which works to enhance borrower spending, thus enhancing
the boom. Along the way, there is mutual feedback between the …nancial and
real sectors. In this framework, a crisis is a situation where balance sheets of
borrowers deteriorate sharply, possibly associated with a sharp deterioration
in asset prices, causing the external …nance premium to jump. The impact
of the …nancial distress on the cost of credit then depresses real activity.
3
Bernanke and Gertler (1989), Kiyotaki and Moore (1997a) and others
focus on credit constraints faced by non-…nancial borrowers.
4
As we noted
earlier, however, the evidence suggests that disruption of …nancial interme-
diation is a key feature of both recent and historical crises. Thus we focus
our attention here on …nancial intermediation.
We begin by supposing that …nancial intermediaries have skills in evaluat-
ing and monitoring borrowers, which makes it e¢ cient for credit to ‡ow from
lenders to non-…nancial borrowers through the intermediaries. In particular,
we assume that households deposit funds in …nancial intermediaries that in
turn lend funds to non-…nancial …rms. We then introduce an agency problem
that potentially constrains the ability of intermediaries to obtain funds from
depositors. When the constraint is binding (or there is some chance it may
bind), the intermediary’s balance sheet limits its ability to obtain deposits.
In this instance, the constraint e¤ectively introduces a wedge between the
loan and deposit rates. During a crisis, this spread widens substantially,
which in turn sharply raises the cost of credit that non-…nancial borrowers
face.
As recent events suggest, however, in a crisis, …nancial institutions face
3
Most of the models focus on the impact of borrower constraints on producer durable
spending. See Monacelli (2009) and Iacoviello (2005) for extensions to consumer durables
and housing. Jermann and Quadrini (2009), amongst others, focus on borrowing con-
straints on employment.
4
An exception is Holmstrom and Tirole (1997). More recent work includes see He and
Kristhnamurthy (2009), and Angeloni and Faia (2009).
4
di¢ culty not only in obtaining depositor funds in retail …nancial markets
but also in obtaining funds from one another in wholesale ("inter-bank")
markets. Indeed, the …rst signals of a crisis are often strains in the interbank
market. We capture this phenomenon by subjecting …nancial institutions to
idiosyncratic "liquidity" sho cks, which have the e¤ect of creating surplus and
de…cits of funds across …nancial institutions. If the interbank market works
perfectly, then funds ‡ow smoothly from institutions with surplus funds to
those in need. In this case, loan rates are thus equalized across di¤erent
…nancial institutions. Aggregate behavior in this instance resembles the case
of homogeneous intermediaries.
However, to the extent that the agency problem that limits an intermedi-
ary’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.
In this instance, intermediaries with de…cit funds o¤er higher loan rates to
non…nancial …rms than intermediaries with surplus funds. In a crisis this gap
widens. Financial markets e¤ectively become segmented and sclerotic. As
we show, the ine¢ cient allocation of funds across intermediaries can further
depress aggregate activity.
In section 3 we incorporate credit policies within the formal framework.
In practice the central bank employed three broad types of policies. The …rst,
which was introduced early in the crisis, was to permit discount window lend-
ing to banks secured by private credit. The second, introduced in the wake
of the Lehman default was to lend directly in relatively high grade credit
markets, including markets in commercial paper, agency debt and mortgage-
backed securities. The third (and most controversial) involved direct assis-
tance to large …nancial institutions, including the equity injections and debt
guarantees under the Troubled Assets Relief Program (TARP) as well as the
emergency loans to JP Morgan Chase (who took over Bear Stearns) and AIG.
We stress that within our framework, the net bene…ts from these various
credit market interventions are increasing in the severity of the crisis. This
helps account for why it makes sense to employ them only in crisis situations.
In section 4, we use the model to simulate numerically a crisis that has
some key features of the current crisis. Absent credit market frictions, the
disturbance initiating the crisis induces only a mild recession. With credit
frictions (especially those in interbank market), however, an endogenous dis-
ruption of …nancial intermediation works to magnify the downturn. We then
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