Financial Intermediation and Credit Policy in Business Cycle - - PowerPoint PPT Presentation

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Financial Intermediation and Credit Policy in Business Cycle - - PowerPoint PPT Presentation

Oct 06, 2022 140 likes •682 views

Financial Intermediation and Credit Policy in Business Cycle Analysis Gertler and Kiotaki 2009 Professor PengFei Wang Fatemeh KazempourLong 1 Motivation Bernanke, Gilchrist and Gertler (1999) studied great depression and the crisis in the

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Financial Intermediation and Credit Policy in Business Cycle Analysis

Gertler and Kiotaki 2009

Professor PengFei Wang Fatemeh KazempourLong

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Motivation

Bernanke, Gilchrist and Gertler (1999) studied great depression and the crisis in the past quarter

  • f centuries

The recent crisis has featured a significant disruption of intermediation Providing a framework to study dynamic through which disruption of financial intermediate which propagate to real activities The role of Central bank and Treasury intervention to mitigate the crisis, a significant break from tradition which was effective for recovery Crisis could be mitigated through liquidity and equity injection

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New Features in Study

Disruption of intermediaries can create a crisis Credit policy introduced by banks can mitigate it Agency problem between borrowers and lenders induce wedge between cost of internal and external finance which increase borrowing cost This premium will depend on borrower’s balance sheet and their share in project In equilibrium a financial accelerator strengthens balance sheet and controls the problems of external finance A mutual feedback between real and financial part of economy

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Set Up

  • At the beginning of the period each bank raises deposits from households in the retail financial

market at the deposit rate R t

  • Two investment and non-investment island
  • A fraction of non-financial firms have access to project and a fraction of them have no access
  • Then investment opportunities for non-financial firms arrive randomly only in investment Island
  • Financial friction only happens when banks collects deposit from households or get loan from
  • ther banks
  • No friction between bank and non-financial firms
  • Bank only can make loan in to financial market in the same Island
  • Instead of the loans, firms offer equity (a perfectly state-contingent debt)

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Other Assumptions

  • Financial intermediaries ( banks) are skillful and efficient in credit allocation
  • Household deposit their money before banks
  • Agency problem limits the ability of banks to raise money from households and other banks
  • when incentive constraint can bind, deterioration of balance sheet induces a wedge between the loan rate and

deposit rate

  • This wedge widens during crisis causing non-financial borrowers face with limited external funding and higher cost
  • f credit
  • This limitation affect real activities too

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Crisis

  • Sharp deterioration of borrower’s balanced sheet
  • Borrower bank can lend less and may have do fire sale
  • Possibly associated with a sharp deterioration in asset price captured by an exogenous variable called

quality of capital

  • External finance premium jumps
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Physical Setup

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Law of motion of capital

Crisis is an exogenous source of variation in quality

  • f capital

Capital depreciation

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Physical Set up

is physical adjustment cost

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Household

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Household

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The Problem of Households

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Financial Intermediary

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Intermediaries

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Intermediaries

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Households and Banks

Retail financial market at the beginning of period

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Household Deposit Bank Rt+1 & dt

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No friction between a bank and nonfinancial firm in the same island Firms are able to offer perfectly state-contingent debt After the bank knows about its lending opportunities decides the volume of loans accordingly decides about interbank loans

is the market price of the loan or the price of bank’s claim for one unite of capital in non-financial firms and depends on the opportunities a bank faces

Financial frictions affect real activity in our Framework via the impact on funds available to the banks

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Assumptions

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Source of Friction and Borrowing constraint

  • Bank can divert a fraction of divertible assets which consist Nt net a fraction
  • If a bank diverts then it defaults on its debts and creditors take
  • Friction also exist for interbank loan
  • With

banks recover their assets from other banks frictionlessly, so no constraint for interbank loan

  • With banks are like retail market in recovering their debt
  • Banks make its decision whether to default or not at the end of each period after the realization of the

idiosyncratic risk which determines its type

  • Incentive constraint for deviation: value of the bank for entrepreneur should exceeds the gain from cheating:

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Bank value at the end of period t-1 Bellman equation CONJUNCTURE:

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First Order Condition:

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Agency problem creates endogenous balance sheet constraint Marginal value of Assets is higher than interbank loan

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Further Explanation

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Bank cannot divert asset in interbank market and interbank market is frictionless Marginal value of asset equalize marginal cost of borrowing on interbank market Perfect arbitrage equalize the shadow value of assets and asset price in each market

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Given that banks are constrained in retail market:

  • SINCE INTERBANK MARKET IS FRICTIONLESS, THE CONSTRAINT APPLIES T O ASSETS INTERMEDIATED

MINUS INTERBANK BORROWING

  • HOW TIGHTLY THE CONSTRAINT BINDS, DEPENDS ON THE DEVIATION FACT OR
  • ALSO THE HIGHER EXCESS RETURN MEANS THE GREATER FRANCHISE VALUE OF THE BANK AND THE

LESS LIKELY IT DEVIATES, THEREFORE THE HIGHER WOULD BE THE AGGREGATE INTERBANK ASSETS

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Bellman Equation

CONJUNCTION:

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Rtk tk+1 is is th the e gr gross rate of

  • f retu

turn on

  • n assets

ts

Marginal Value of net worth is a weighted average of marginal Value for exiting and for continuing bank

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Marginal Value of net worth is a weighted average of marginal value for exiting and for continuing bank If a continuing bank has an additional net worth it can save the cost of deposits and can increase assets by leverage ratio Bank’s balance sheet constraint

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Interbank loan and deposits become perfect substitute If the constraints on interbank borrowing binds, bank in non-investing island only finance their

  • wn old project

Hence banks in non-investing Island are likely to get zero return This friction lowers asset price in investing island

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  • Type of Island matters
  • The banks in non-investment Island give less loan

than they afford through their net worth

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Equilibrium: Market Clearing for security market

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The market price of capital in each island depend

  • n the situation of bank in the same Island.
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Equilibrium: Market Clearing for labor market

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Crisis and Impact on balance sheet effect

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  • Fed directly acquire high quality private securities
  • Fed is not balance sheet constrained and guarantee

repayment so can borrow from public

  • Fed can reach all markets
  • Less efficient in monitoring and incurs a cost of T
  • In recent crisis fed issued government debt from treasury

and then used interest bearing reserves

  • Total amount of assets intermediated in the market

increase , but no subsidized rate

  • Equilibrium rate of lending falls
  • Asset price goes up

Credit policy: Direct lending

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Credit policy: Direct lending

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Total Intermediated Asset Increases

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Discount window lending ( case of symmetric friction w=0)

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  • The Fed dir

irectly le lends to banks to enable th their le lending to fir firms

  • Offering at penalty rate driven by distressed borrower’s unusual high

excess return

  • CB offers dis

iscount win indow cr credit in in non-contingent in interest rate Rmt+ t+1 to banks who borrow on in interbank market. Here governmental debt is is a perfect substitute for household deposit

  • CB better enforces repayment th

than th the household

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Discount window lending ( case of symmetric friction w=0)

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Total Assets Intermediated Increases The condition that both bank borrowing and discount window borrowing become used

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Equity Injection

Equity Injection:

Fiscal authority coordinate with monetary authority to acquire

  • wnership in bank
  • Efficiency costs with government acquiring equity
  • Equity injection is slower than direct lending
  • Bank inject equity at the beginning of period before investment
  • pportunities arrive
  • Perfect interbank lending
  • Government receive the equity value after liquidation of bank or

upon passing crisis sell off its holding at this value before the bank exits

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Equity Injection

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  • Equity Sharing expands private bank net worth which in turn

expand asset demand by multiple equal to leverage

  • Risk absorption for high risks involved in the crisis

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The doted line is the model without financial friction. The negative shock has a much modest effect compared to the friction case

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Critics

Critics:

  • A great technical paper which clearly demonstrates its intended mechanism
  • A new contribution which could be a base for future works
  • Unjustified unilateral insistence on emboldening the role of banks :
  • All problems and solution are attributed to banks’ disruption
  • Not much empirical evidence to back this claim
  • Not enough development for showing the negative side of government intervention
  • Extreme assumptions such as no bank no production
  • Incentive constraint shows unwillingness not inability
  • No discussion on the impact of credit policies on nonfinancial firms
  • Not enough discussion of the welfare impact which readers await for

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Future Research re Research Area

  • Heterogeneous asset models
  • Models which exposes downside of the policies
  • More empirical research which shows the claims for effectiveness
  • f policies
  • Idiosyncratic asset risk , and so on…

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