Financial Meltdown, Endogenous Defaults and the Business Cycle

Abstract Starting from some of the most recent literature developed after the world financial crisis, it has been developed a new-Keynesian DSGE model with heterogeneous agents and an active interbank market, characterized by an endogenous default probability. The key feature of the analysis is that the probability of default of banks evolves endogenously and is explicitely taken into account by banks in their investment decisions. In each period banks, that are heterogeneous, decide to invest only a part, or even none, of their surplus funds on loans to other financial institutions. If the probability of default is high enough, they shift their portfolio choices to risk-less assets. This decision affects the total supply of credit to firms and, through it, the total level of investments, output and employment. The model is then estimated using the bayes technique and several test are carried on to verify the robustness of the estimation. Additionally we decomposed the variance of key variables in order to assess the impact of each shock on them. Our findings show that indeed the default probability plays a crucial role in the decision of banks and directly affects the economy. On top of that we found that usual real and financial shocks changes the risks on the interbank market where they have long lasting and significant effects