Business Cycles and the Balance Sheets of the Financial and Non-Financial Sectors

55 Pages Posted: 5 Nov 2020

See all articles by Alonso Villacorta

Alonso Villacorta

University of California, Santa Cruz - Department of Economics

Date Written: February, 2018

Abstract

I propose and estimate a dynamic model of financial intermediation to study the different roles of the condition of banks’ and firms’ balance sheets in real activity. The net worth of firms determines their borrowing capacity both from households and banks. Banks provide risky loans to multiple firms and use their diversified portfolio as collateral to borrow from households. This intermediation process allows additional funds to flow from households to firms. Banks require net worth for intermediation as they are exposed to aggregate risk. The net worth of banks and firms are both state variables. In normal recessions, firm and bank net worth play the same role, so their sum determines the allocation of capital. During financial crises, shocks to bank net worth have an additional effect beyond that in standard financial frictions’ models. This mechanism works through intermediation and affects activity, even if shocks redistribute net worth from banks to firms. I estimate my model and find that the new mechanism accounts for 40% of the fall in output and 80% of the fall in bank net worth during the Great Recession. Finally, the model is consistent with the different dynamics of the share of bank loans in total firm debt and credit spreads during the recessions of 1990, 2001, and 2008.

Keywords: balance sheet channel, financial crises, financial frictions, financial markets and the macroeconomy

JEL Classification: E44, E32, G01

Suggested Citation

Villacorta, Luis Alonso, Business Cycles and the Balance Sheets of the Financial and Non-Financial Sectors (February, 2018). ESRB: Working Paper Series No. 2018/68, Available at SSRN: https://ssrn.com/abstract=3723415 or http://dx.doi.org/10.2139/ssrn.3723415

Luis Alonso Villacorta (Contact Author)

University of California, Santa Cruz - Department of Economics ( email )

Santa Cruz, CA 95064
United States

HOME PAGE: http://https://sites.google.com/site/alonsovillacorta/

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