The Role of Bank Capital in the Propagation of Shocks ∗

Recent events in financial markets have underlined the importance of analyzing the link between the financial health of banks and real economic activity. We develop a dynamic stochastic general equilibrium model with a banking sector in which bank capital emerges endogenously to solve an asymmetric information problem between banks and their creditors. The capital position of a bank thus affects its ability to at-tract loanable funds and, as a result, bank capital influences the business cycle through a bank capital channel of transmission. The model is used to conduct quantitative experiments on the economy’s responses to technology and monetary policy shocks, as well as to financial shocks originating within the banking sector. We find that the bank capital channel amplifies and propagates the effects of shocks on output, investment and inflation. Further, we show that financial shocks causing exogenous declines in bank capital create sizeable declines in output and investment. These results suggest that accounting for the role of bank capital is important when building models for business cycle and monetary policy analysis