Credit spread variability in the U.S. business cycle: The Great Moderation versus the Great Recession

Abstract

This paper establishes the prevailing flnancial factors that in∞uence credit spread variability, and its impact on the U.S. business cycle over the Great Moderation and Great Recession periods. To do so, we develop a dynamic general equilibrium framework with a central role of flnancial intermediation and equity assets. Over the Great Moderation and Great Recession periods, we flnd an important role for bank market power (sticky rate adjustments and loan rate markups) on credit spread variability in the U.S. business cycle. Equity prices exacerbate movements in credit spreads through the flnancial accelerator channel, but cannot be regarded as a main driving force of credit spread variability. Both the flnancial accelerator and bank capital channels play a signiflcant role in propagating the movements of credit spreads. We observe a remarkable decline in the in∞uence of technology and monetary policy shocks over three recession periods. From the demand-side of the credit market, the in∞uence of LTV shocks has declined since the 1990i91 recession, while the bank capital requirement shock exacerbates and prolongs credit spread variability over the 2007i09 recession period. Across the three recession periods, there is an increasing trend in the contribution of loan markup shocks to the variability of retail credit spreads.