Essays on Macroeconomic Dynamics, Credit Intermediation and Financial Stability
This dissertation consists of three chapters. In the first chapter, we study the role of financial frictions on the demand side of the economy. In particular, we study the interaction between firm and household credit constraints over the business cycle. We construct a real business cycle model with explicit modeling of price and quantity side of housing. This allows us to include both firm and household financing frictions. The model is estimated for the U.S economy using quarterly data on key macroeconomic variables over the period 1970 - 2006. Household and firm financial accelerators operate primarily through movement in house and capital prices respectively. We find clear evidence of the operation of a financial accelerator mechanism, whereby shocks to the economy are amplified most in the presence of both types of frictions, as opposed to just firm or household frictions. Over the business cycle, total factor productivity shocks in the non-housing sector explain about half of the volatility of GDP and consumption. However, cyclical variations in housing investment and housing prices are predominantly explained by housing preference and housing technology shocks. Finally, spillovers from household financing frictions are mostly concentrated in consumption. However, they also affect business investment via its impact on the demand for capital and consequently its price.
The second chapter focuses on financial frictions on the supply side. We study the role of bank capital in the transmission of shocks to the economy. Given the evolutionary change in the financial services industry and the growth of shadow banking in the decades prior to the global recession, we characterize credit intermediation with a heterogeneous banking sector comprised of traditional retail and shadow banking. We approach the shadow banking system from a regulation perspective wherein commercial banks have incentives to transfer loans from on- to off-balance sheet to gain regulatory relief. Since bank capital is costly, banks cover part of their funding needs by loan sale in the secondary market. Furthermore, these transferred loans are bundled together and converted into liquid asset backed securities. Commercial banks’ effective return is subject to their monitoring effort, which is unobservable and hence introduces a moral hazard problem in loan sale. This limits the amount of loan sold in the secondary market. We find that loan sale and securitization enhances credit intermediation in normal times and improves the resilience of the system to productivity shocks. However, it also exposes the economy to shocks emerging in the financial system. In response to financial market shocks, the government via its backstop program, can ameliorate its impact on the economy. Finally, we compare the model economy with Basel I and Basel II capital requirement and find that business cycle fluctuations are amplified under Basel II regime. Furthermore, in response to a negative productivity shock there is a transfer of loans from on to off balance sheet under Basel II rules with procyclical capital constraints. This points towards a need for countercyclical capital requirement as being implemented under Basel III accord.
In the third chapter, we focus on the question of trade off between price and financial stability goals for the conduct of monetary policy. The recent crisis has generated renewed interest in Hayekian theory and Minsky’s instability hypothesis, which claims that accommodative monetary policy can be harmful for an economy by promoting excessive risk taking – the so called risk taking channel of monetary policy transmission. Risk Taking Channel has been documented for the U.S and Euro area and we investigate the presence of this in Asia. Using annual and quarterly data on publicly listed banks in Asia, we find that when interest rates are too low - lower than a benchmark - bank risk increases. Furthermore, there is also a case for greater supervision and capital stringency to alleviate risk taking.