Financial Intermediaries, Credit Shocks and Business Cycles

I document the cyclical properties of aggregate balance sheet variables of the U.S. commercial banking sector: (i) Bank credit and deposits are less volatile than output, while net worth and leverage ratio are several times more volatile, (ii) bank credit and net worth are procyclical, while deposits, leverage ratio and loan spread are countercyclical. I then present an equilibrium real business cycle model with a financial sector to investigate how the dynamics of macroeconomic aggregates and balance sheet variables of U.S. banks are influenced by empirically-disciplined shocks to bank net worth. I find that these financial shocks are important not only for explaining the dynamics of financial flows but also for the dynamics of standard macroeconomic variables observed in the U.S. data. The simulation of the model shows that the recent deterioration in aggregate net worth of U.S. banking sector contributed significantly to the 2007-09 recession. The model-construct tightness measure of credit conditions tracks quite well the FED Board’s index of credit tightening in the last three recessions of the U.S economy implying that the Lagrange multipliers attached to the financial constraints in dynamic stochastic general equilibrium models with credit frictions might contain valuable real-time information about the financial conditions of an economy