Charge-offs, Defaults and the Financial Accelerator

McMaster University Department of Economics Working Paper No. 2020-17

57 Pages Posted: 2 Dec 2020

See all articles by Christopher Gunn

Christopher Gunn

Carleton University - Department of Economics

Alok Johri

McMaster University - Department of Economics

Marc-André Letendre

McMaster University - Department of Economics

Date Written: October 14, 2020

Abstract

We uncover new facts: U.S. banks countercyclically vary the ratio of charge-offs to defaulted loans (COD). The variance of this ratio is roughly 15 times larger than that of GDP. Canonical financial accelerator models cannot explain this variance. We develop an expression for the wedge between charge-offs and defaults in the model and show that introducing stochastic default costs as in Gunn and Johri (2013a) and stochastic risk as in Christiano et al. (2014) into the canonical theoretical model can potentially resolve the discrepancy since both shocks have the ability to move this wedge. Estimating the augmented model using Bayesian techniques reveals that default cost shocks account for most of the variance of COD, while risk shocks account for most of the credit spread. Both shocks also matter for standard U.S. business cycle variables, with the anticipated components of each being most important.

Keywords: charge-offs and defaults, default cost shocks, news shocks, risk shocks, financial accelerator models, business cycles

JEL Classification: E3, E44

Suggested Citation

Gunn, Christopher and Johri, Alok and Letendre, Marc-Andre, Charge-offs, Defaults and the Financial Accelerator (October 14, 2020). McMaster University Department of Economics Working Paper No. 2020-17 , Available at SSRN: https://ssrn.com/abstract=3711768 or http://dx.doi.org/10.2139/ssrn.3711768

Christopher Gunn

Carleton University - Department of Economics ( email )

1125 Colonel By Drive
Ottawa, Ontario K1S 5B6
Canada

Alok Johri (Contact Author)

McMaster University - Department of Economics ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

Marc-Andre Letendre

McMaster University - Department of Economics ( email )

1280 Main Street W
Hamilton, Ontario L8S 4M4
Canada

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