Credit, Endogenous Collateral and Risky Assets: A DSGE Model

We propose a new Dynamic Stochastic General Equilibrium (DSGE) model with credit frictions and a banking sector. LTV ratios are assumed to be influenced by systemic and idiosyncratic risk. The model also features endogenous balance sheet choices and a novel formulation of the capital ratio, in which assets are risk-weighted by risk-sensitivity measures. We find that the presence of endogenous LTV ratios exacerbates the procyclicality of lending. Moreover, the model captures the role played by prudential regulatory frameworks in affecting business cycle fluctuations and restoring macroeconomic and financial stability. Our findings highlight the scope for coordination between monetary and macro-prudential policies