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Financial Frictions, Bank Credit and Business Cycle

Author: AiYao
Tutor: YeDeLei
School: East China Normal University
Course: World economy
Keywords: Agency Problem DSGE Model Deposit Procyclicality Cointegration Test Deposit Insurance
CLC: F830
Type: PhD thesis
Year: 2012
Downloads: 805
Quote: 1
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Abstract


In traditional theory, debitor’ net worth has no effect on real economy and banking sector is only a frictionless veil in business cycle. However, banks failed and agency problems exposed since the Crisis from2007. Financial frictions exist when bank has agency problems in credit and deposit. Financial friction in banking sector violate the MM Theorem hypothesis and balance sheet condition (mainly net worth) of borrowers will be taken into account. Thus the equilibrium is lower than the theoretical first-best economy. As in China, bank credit accounts for more than half of all-system financing aggregate and plays key role in credit transmission mechanism. This essay focus on the dual financial frictions the banking sector bears. One is on the credit side because of banks’agency problem. The other is on the debit side owing to firms’agency problem. Incorporating banking sector with dual financial frictions, the macro economic models can explain the crisis better and promote DSGE models in monetary policy.In theoretical parts, establish two-period models with households, firms and banks. When banks draw deposit from HHs, the higher transfer rate is, the greater financial frictions are, the more utility lose is. Bank’s net worth offsets negative effects of frictions. However, asset price crashed in crisis, bank’s net worth fell and became binding to limite the maximum of deposits. Bank’s net worth doesn’t limit in normal times, but constrains deposit in crisis, which makes deposit procyclicality. As for frictions in credit side, the higher monitor costs are, the greater frictions are, the more loss it brings. Systematic risk harms but single firm’s risk could be tolerable.Introducing banking sector frictions caused by banks’agency problem in DSGE model, enhances the amplification and persistence of macroeconomic fluctuations. Investment and output return to steady state more slowly. Fortunately, expansionary credit policy as directly lending to firms mitigates the crisis, which is regarded as catalyst effect. In empirical study, construct VAR models of deposits, bank net worth and interest rate spread to study frictions between banks and HHs. In normal times (1999-2006) and crisis times (2007-2011), Cointegration Test shows significant long-run equilibrium relationship among variables. When net worth increased, deposits increased in normal times but fell in crisis. The risks of bank failures induced greater agency problems in banking sector, which makes deposits not too large in crisis. Bank deposits did not iron the fluctuations but amplified the ups and downs in business cycles. In the short term, the VEC model shows failures of back to equilibrium after short-term deviations. The IRF shows accelerating recovery in crisis times as government promoted the economy. The Variance Decomposition shows interest rate spread took a larger information share in crisis.Meanwhile, panel data model constructed by loans, investment cashflow, economic growth and money supply shows the empirical study of frictions between banks and firms. Comparing to manufacturing firms in SME Board, those in Main Board have higher net worth, better balance sheet condition, lower agency costs, and thus lower frictions. In the long run, the Panel Cointegration Test shows long-term equilibrium relationship. Dynamic Panel Model shows that firm investment has positive effect on bank loans. Controlling other factors, M2increase by1%, bank loans of Main Board manufacture increased by0.2301%, while SME Board0.1616%. With frictions, banks prefer firms with high net worth in Main Board.Finally, to mitigate financial frictions, this paper gives suggestions, including preventing financial factors propogating risks, establishing deposit insurance, improving firms’ information exposure, implementing countercyclical macro-prudential framework, coordinating credit policy and interest rate policy in crisis and advocating proxy spirit.

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