When Banks Punch Back: Macrofinancial Feedback Loops in Stress Tests
66 Pages Posted: 30 Jun 2020
Date Written: May 2020
In the presence of adverse macroeconomic shocks, simultaneous capital losses in multiple banks can prompt them to contract their balance sheets. These bank responses generate externalities that propagate in the form of macro-financial feedback loops. This paper develops a credit response and externalities analysis model (CREAM) that integrates a disaggregated banking sector into an otherwise standard macroeconomic structural vector autoregressive model. It shows that accounting for macro-financial feedback loops can significantly affect macroeconomic outcomes and bank-specific stress tests results. The heterogeneity in bank lending responses matters: it determines how each bank fares under adverse conditions and the external effects that banks impose on each other and on economic activity. The model can thus be used to assess the contributions of individual banks to systemic risk along the time dimension.
Keywords: Financial crises, Bank credit, Interest rates on loans, Market interest rates, Interest rate differential, Stress tests, macroeconomic shocks, banking sector, modeling, WP, quasi-static, lend rate, individual bank, externality, systemic risk
JEL Classification: E44, G21, E01, E52, O24, G12
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