The magnifying role of the banking sector during depressions

Abstract

Is there a magnifying role of the banking sector during depressions? How can a financial perturbation, possibly small-sized, create large impacts on output and enduring recessions? What is the role played by the massive stock of due claims brought about by a financial crisis? We address these questions by putting forth a general equilibrium model endowed with a banking system in which due claims – henceforth named due loans – and occasionally binding credit restrictions coexist and their effects reinforce each other. Under “bad” financially-driven perturbations due loans hike and the concomitant opportunity, holding, regulatory, and impairment costs trigger sizable increases in external finance premia and promote credit restrictiveness. Firms’ net worth collapses as they are called in to finance banks’ problems, and their ability to invest and accumulate capital becomes compromised. The amplification effect can be very large: the full-fledged banking model may only require a perturbation of one-tenth the size of a plain vanilla version to deliver the same output drop at the trough. Effects are non-linear, since credit restrictions remain slack on the boundary of the steady state, and asymmetric, since these restrictions play no role whatsoever under “good shocks.”