TCF- trans - set 9

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MACROECONOMIC IMPLICATIONS OF FINANCIAL
CONSTRAINTS 1. Credit crunch. 9th set of
transparencies for ToCF
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INTRODUCTION
GREAT DEPRESSION

• Irving Fisher (EMA 1933) aggrevated by "poor
  performance" of financial markets

DEBT DEFLATION

• Friedman-Schwartz (1963) role of money supply.

• Bernanke (1983) breakdown in banking.

BALANCE SHEET CHANNEL vs LENDING CHANNEL
Typical pattern
Recession, high interest rates
weak balance sheets of firms
loan losses low asset prices reduce equity in
financial sector.
Two sectors (real financial) are constrained.
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US 1990-91 recession (rather typical)

• banks reduction in capital ratio
  decline in bank lending

• flight to quality

• credit crunch hits poor firms first
• large/healthy firms can go to CP or bond markets.

Same pattern in the wake of a tight money episode
(Romer-Romer BPEA 1990).
Modeling Apply logic of credit rationing to the
two tiers.
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MODEL
BORROWERS

• Risk neutral parties
• borrowers (firms)
• monitors (banks)
• investors

("firms")
Have 1 project / idea each
Investment cost I
return R (success)
Verifiable 0 (failure)
Moral hazard
Versions of the project
bad (low private benefit)
Bad (high private benefit)
good
Private benefit
Prob( R)
(only good project is viable)
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Have assets
Cumulative distribution G(A).
MONITORS
("financial intermediaries", "banks")
can rule out high private benefit bad project of
borrower at cost c (moral hazard).
INVESTORS
uninformed / free riding (actually implication
of the model),
demand expected return
Exogenous interest rate access to
"storage facility" yielding interest rate i.
Endogenous interest rate savings.
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EXOGENOUS INTEREST RATE
Equilibrium
Intermediation
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Certification
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Certification
Intermediation
Venture capitalist Lead investment bank Bankers
acceptances (commercial paper) Partial
securitization of a loan.
Bank loan (on balance sheet).
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DIRECT FINANCE
Need

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INDIRECT FINANCE
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Because firm wants to use as little
informed capital as possible
Firm gets financed if it has assets where
is increasing in ?.
EQUILIBRIUM
M
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If interest rate ? is endogenous
Demand for uninformed capital
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COMPARATIVE STATICS
3 types of recessions
Lending channel
Classical recession
Balance sheet channel
Credit crunch
Industrial recession
Shortage of savings
Intermediaries
Firms
Investors
parameter of first order stochastic dominance
or
Correlation. Leads and lags
In the three types of capital squeeze, aggregate
investment goes down and goes up.
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VARIABLE INVESTMENT SCALE
decreases ?
A decrease in Km (credit crunch)
increases ?
decreases
solvency ratio of banks (intermediation)
increases
equity ratio of firms
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A decrease in Kb (balance sheet channel)


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Description of equilibrium
(1)
inverse function of
(2)
(3)
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r increases with c
High monitoring intensity high solvency
requirements.

• Banks have become low-intensity monitors over the
  years.

• Finance companies, firms themselves are higher-
  intensity monitors better capitalized.

Intermediation (banks) vs certification (venture
capital)
Certifiers have r 1!
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OTHER RESEARCH PROJECTS
Division of labor between intermediaries and
firms, among intermediaries
shallow vs deep information.