Distress in the Financial Sector and Economic Activity

24 Pages Posted: 4 Nov 2010

See all articles by Mark A. Carlson

Mark A. Carlson

Board of Governors of the Federal Reserve System

Thomas B. King

Federal Reserve Bank of Chicago

Kurt F. Lewis

Board of Governors of the Federal Reserve System

Date Written: November 3, 2010

Abstract

This paper explores the relationship between the health of the financial sector and the rest of the economy. We develop an indicator of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. Our measure spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. We then use vector autoregressions to assess whether our indicator of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that our measure has a considerable impact. Moreover, we find that this financial channel amplifies changes in investment resulting from shocks to non-financial firm profitability.

Keywords: Bank Distress, Economic Activity, Financial Intermediation

JEL Classification: E44, E50, G20

Suggested Citation

Carlson, Mark A. and King, Thomas B. and Lewis, Kurt F., Distress in the Financial Sector and Economic Activity (November 3, 2010). FEDS Working Paper No. 2008-43. Available at SSRN: https://ssrn.com/abstract=1702316 or http://dx.doi.org/10.2139/ssrn.1702316

Mark A. Carlson

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
(202) 452-3987 (Phone)
(202) 452-2301 (Fax)

Thomas B. King (Contact Author)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

Kurt F. Lewis

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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