ESSAYS ON BANK CAPITALIZATION AND MACROECONOMIC FLUCTUATION

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2019

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Abstract

This thesis provides two studies in the relationship between bank capitalization and macroeconomic fluctuations. In the first chapter, I study the effect of bank capital shortfalls on macroeconomic fluctuations through changes in lending standards. Existing literature has primarily focused on the rise of credit spreads when banks suffer capital losses. In addition to this standard interest rate channel, this paper innovates by introducing a new credit rejection channel - denying more loan applications (tightening lending standards) - into a macro model with financial frictions. The model features an endogenous time-varying risk threshold for credit rejection, which in turn is linked to banks’ balance sheet conditions. I incorporate the rejection mechanism into a quantitative general equilibrium model and conduct a banking crisis experiment. During the crisis, loan rejection rates rise significantly, and lending rate spreads increase mildly, which are consistent with observations on the bank loan market during the Great Recession. The simulation results further show that the model with this new channel generates larger amplification of macroeconomic variables, compared to an otherwise identical benchmark model. This result is driven by a combination of two forces: a decline in loan volume and a shift in the composition of banks’ lending pool, as banks reallocate funds away from risky firms. Given that riskier firms tend to have better growth prospects, such reallocation can have long-lasting scarring effects on the economic recovery.

In the second chapter, we take a normative angle of bank capital analysis. We develop a quantitative dynamic stochastic general equilibrium model to identify bank capital gaps (deviations of the observed level from the optimum) and to shed light on regulatory policies regarding capital requirement. We propose a tractable model that includes firms’ and banks’ choice on joint capital structure, and their endogenous default caused by idiosyncratic and aggregate risk. The model is estimated using Bayesian methods with quarterly data on US macroeconomic and financial variables spanning from 1991Q1 to 2016Q4. Our counterfactual analysis shows that the impulse responses in the optimal economy exhibit smaller magnitude compared to that in the calibrated economy. We further decompose the historical fluctuations in bank capital gaps into contributions from a series of financial shocks, in addition to the standard macroeconomic shocks. We find that the aggregate risk shock plays an important role in explaining the spike in capital gaps during the 2007-09 financial crisis. Capital gaps lead to (i) excessive increases in banks’ default risk and cost of funding, (ii) gaps in lending, investment, employment and output.

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