Financial Intermediation and Credit Policy in Business Cycle Analysis∗ pot

F in a n c ia l Inte r media tio n and C r e d it Po lic y in B usiness C y cle A n alysis ∗ Mark Gertler and Nobuhiro Kiyotaki N.Y.U. and Princeton October 2009 This version: Marc h 2010 Abstract We develop a canonical framework to think about credit mark et frictions and aggregate economic activity in the context of the current crisis. We use the framework to address two issues in particular: first, how disruptions in financial intermediation can induce a crisis that affects real activity; and second, how various credit mark et interven- tions by the central bank and the Treasury of the t ype we have seen recently, migh t work to mitigate the crisis. We make use of earlier literature to develop our framework and characterize how v ery recent literature is incorporating insights from the crisis. ∗ Prepared for the Handbook of Monetary Economics. Thanks to Mic hael Woodford, Larry Christiano, Simon Gilc hrist, Chris E rceg, and Ian Dew-Becker for helpful comments. Thanks also to Albert Queralto Olive for excellent research assistance. 1 1 Introduction To motivate interest in a paper on financial factors in business fluctuations it use to be necessary to appeal either to the Great Depression or to the experiences of man y em erging m ar ket economies. This is no longer necessary. Over the past few y ear s the Un ited States and muc h of the industrialized world have experienced the worst financial crisis of the post-war. The global recession that has follo wed also appears to have been the most sev ere of this era. Atthetimeofthiswritingthereisevidencethatthefinan cial sector has stabilized and the real economy has stopped con tractin g and output grow th has resumed. The path to full reco very, howev er, remains highly uncertain. The timing of recent ev en ts, though, poses a challenge for writing a Hand- book chapter on credit m arket f rictions and aggregate econ om ic activity. I t is true that o ver the l ast s everal decades there has been a robust literature in this area. Bernanke, Gertler and G ilc h rist (BGG, 1999) surveyed much of the earlier work a decade ago in the Handbook of Macroeconomics. Since the time of that sur vey, the literatur e has contin ue d to grow. W hile muc h of this work is relevan t to the current situation, this literature obviously did not anticipa te all the key empirical phenomena that have played out during the current crisis. A new literature that builds on the earlier wo rk is rapidly cropping up to address these issues. Most of these papers, though, are in preliminary working paper form. Our plan in this c hapter is to look both forward and backw ard. We loo k forward in th e sen se tha t we offer a canonical framework to t hink about c red it mar ket frictions and ag grega te econ om ic a ctivity in the context of the current crisis. The framework is not m eant as com pr ehensive description of recent ev ents but rather as a first pass at characterizing some of the k ey aspects and at laying out issues f or future research. We look backward by making use of earlier litera tu re to develop the particular fra m ework we o ffer. In d oing so, we address how this litera ture ma y be relevan t to the new issues that h av e arisen. We also, as best we can, chara cterize ho w v ery recen t literature is incorporating insights from the crisis. From our vantage, there are two broad aspects of the crisis that have not been fully captured in w ork on financial factors in business cycles. First, by all a cco unts, the cur rent crisis has featured a sign ifican t disruption of financial 2 intermediation. 1 Mu ch of the earlier macroeconomics literature w ith financial frictions emphasized credit m arket c on straints o n non-financial borro wers and treated intermediaries largely as a v eil (see, e.g. BG G ). Second, to com bat the crisis, both the m on etary and fiscal a uthorities in man y coun tries including the US. have emplo y ed various u nconventional policy m easures that in volv e some form of direct lending in credit markets. From the standpoin t of the Federal Reserve, these "credit" policies repre- sen t a significant bre ak from tradition. In the po st w ar era, t he Fed scrupu- lously avoid ed any exposure to private sector credit risk. How ever, in the current crisis the central bank has acted to offset t he disruption of i n ter- med iation by making imperfectly secured loan s to financial i nstitutions and by lendin g directly to high g ra de non-finan cial borro wers. In a dd ition , the fisca l auth ority acting in conjun ctio n w ith the c entral bank injected equity into the major banks with the objective of improving credit flows. Though the issue is not without considerable con trov ersy, many observ ers argue that these interv entions helped stab ilized financial markets and, as consequence, helped limit the dec line of real activit y. Since these policies are relatively new, m uc h of the existing literature is silen t about them. With th is backgroun d in m ind, we begin in the next section b y d eveloping a baseline model that incorporates financial intermediation into an otherwise frictionless business cycle f ram e work. O u r goal is twofold: first t o illustrate how disruptions in financial interm ediation can induce a crisis that affects real ac tiv ity; and seco nd , to illustrate how various credit market interv entions b y th e central bank and th e Tr easury o f the type w e hav e seen recently, might work to mitigate the crisis. As in Bernanke and Gertler (1989), Kiyotaki and Moore (1997) and oth- ers, we endogenize financial mark et frictions by in troducing an agency prob- lem between borrowers and lenders. 2 The agency problem works to introduce a wedge between the cost of external finance and the opportunity cost of in- 1 For a description of the disruption of financial intermediation during the current re- cession, see Brunnermeier (2008), Gorton (2008) and Bernanke (2009). For a more general description of financial crisis over the last several hundred years, see Reinhart and Rogoff (2009). 2 A p artial of other m acro models with financial frictions in this vein includes, Williamson (1987), Kehoe and Livene (1994), Holmstrom and Tirole (1997), Carlstrom and Fuerst (1997), Caballero and Kristhnamurthy (2001), Kristhnamurthy (2003), Chris- tiano, Motto and Rostagno (2005), Lorenzoni (2008), Fostel and Geanakoplos (2009), and Brunnermeir and Sannikov (2009). 3 ternal finance, whic h adds to the overall cost of credit that a borrowe r faces. Thesizeoftheexternalfinance premium, further, d epends on the c ondition of borrower balance sheets. Roughly speaking, as a borrower’s percenta ge stake in the outcom e of an investment project increases, his or her incen- tiv e to deviate from the interests of lenders’ declines. The external finance premium then d eclines as a result. In general eq u ilib riu m, a "financial accelerator" em erges. As balance sheets strengthen with impro ved econ om ics conditions, the external finance problem declines, whic h works to enhance borrow er s pending, th us en ha ncing the boom. Along the w a y, there is m utual feedback between the financial and real sectors. In this framework, a crisis is a situation where balance sheets of borrowers deteriorate sharply, possibly associated with a sharp deterioration in a sset prices, causing the external finance premium to jum p. The im pact of the financial distress on the cost of credit t hen depresses real activity. 3 Bernanke and Gertler (1989), Kiyotaki and Moore (1997) and others focus on credit constraints faced by non-financial borrow ers. 4 As we noted earlier, ho wever, the evidence suggests that disruption of financial intermediation is a key feature of both recen t and histo rical crises. Thus w e focus our atten tion here on financial interm ediation. We begin by supposing that financial in termediaries hav e skills in evaluat- ing and monitoring borrow ers, whic h makes it efficient for credit to flow from lenders to non-financial borro wers through the in term ed iaries. In particular, we a ssum e that households deposit fu n ds in financial intermediaries that in turn lend funds to non-financial firm s. We then in troduce an agency problem that poten tially constrains the ability of intermediaries to obtain funds from depositors. When the constraint is binding (or there is s ome chance it may bind), the intermediary’s balance sheet lim its i ts ability to ob ta in deposits. In this instance, the con straint effectively in troduces a w edg e between the loan and deposit rates. During a c risis, th is spread widens substan tially, whichinturnsharplyraisesthecostofcreditthatnon-financial borro wers face. As recent ev ents suggest, ho wever, in a cr isis, fina ncial institu tion s face 3 Most of the models focus on the impact of borrower constraints on producer durable spending. See Monacelli (2009) and Iacoviello (2005) for extensions to consumer durables and housing. Jermann and Quadrini (2009), amongst others, focus on borrowing con- straints on employment. 4 An exception is Holmstrom and Tirole (1997). More recent work includes see He and Kristhnamurthy (2009), and Angeloni and Faia (2009). 4 difficu lty not only in obtaining depositor funds in retail financial m arkets but a lso in obta ining f unds from one another in wholesale ("in ter-bank") mar kets. Indeed, the first signals of a crisis are often strains in the in terbank mar ket. We capture this phenom en on by subjecting financia l institutions to idiosyncra tic "liquidity" shock s, whic h have the effect of creating surplus and deficits of fun ds across financial institutions. If the in terbank market works perfectly, then funds flow sm oothly from in stitu tion s w ith surp lus f unds to those in need. In this case, loan rates are th us equalized across differen t fin an cial institutions. Aggregate behavio r in this instance resembles the case of homogeneous intermediaries. However,totheextentthattheagencyproblemthatlimitsanintermedi- ary’s ability to obtain f u nd s from depositors also lim its its ability to obtain funds from other financial institutions and to the exten t that nonfinancial firm s can obtain funds only from a limited set of financial interm ediaries, disruptions of in ter-bank mark ets are possible that can affect real activit y. In this instance, intermediaries w ith de ficit funds offer higher loan rates to nonfinancial firms than intermediaries with surplus funds. In a crisis this gap widens. Financial markets effectiv ely become segmen ted and sclerotic. A s we show, the inefficien t allocation of funds across in termediaries can further depress a ggregate activity. In section 3 we incorporate credit policies w it hin the fo rm al framework. In practice th e central bank emp loyed three b road types of policies. The first, which was int roduced early i n the crisis, was to permit disc ount window lend- ing to ban ks secured by private credit. The second, introduced in the wake of the Lehmann default was to lend directly in relativ ely high grade credit mar kets, including markets in commercia l paper, agency debt and mortga ge- backed securities. The third (and m ost co ntro versial) in volv ed direct a ssis- tance to large financial institutions, includin g the equity injections and debt guarantees under the Troubled Assets Relief Program (TAR P) as w ell as the emergency loans to JP Morgan Chase ( who t ook o ver Bear Stearns) and AIG. We stress that within our framework, the net benefits from these various credit market interven tions are increasing in the severity of t he crisis. This helps account for wh y it makes sense to employ them only in crisis situations. In section 4, we use the model to sim ulate numerically a crisis that has some key features of the curren t crisis. Ab sent credit market frictions, the disturban ce initiating the crisis induces only a mild recession. W ith credit frictions (especially those in interb ank mark et), ho wev er , an endogenous dis- ruption of financial intermediation w orks to magnify the downturn. We then 5 explore ho w various credit policies can help mitigate the situation. Our baseline model is quite parsimonious and meant mainly to exposit the key issues. In section 5, we discuss a number of qu estions and possible extensions. In s o m e cases, we discuss a relevan t literature, stressin g the implica tion s of this literature for going forw ard . 2 A Canonical Model of Financial I ntermedi- ation and B usiness Fluctuations Overall, the specific business cycle model is a h ybrid of Gertler and Karad i’s (2009) f ram ework that allo ws for financial in term ediation a nd Kiy otaki and Moore’s (2008) framework that allo w s for liquidity risk. We keep the core macro model simple in order to see clearly the role of inter m ed iation and liquidity. On the other hand, w e also allo w for some features prevalent in con ventional qu antitativ e macro models ( such as Christiano, Eichen ba um and Evans (2005), Smets and Wouters (2007)) in order to get rough sense of theimportanceofthefactorsweintroduce. 5 For simplicit y we restrict atten tion to a purely real model and only credit policies, as opposed to conven tion al moneta ry models. Extending the model to allo w for nom inal rigidities is s traightforw ard (see., e.g., G ertler and Karadi, 2 009), and permits study ing conv entional monetary policy along with uncon ventional po licies. Ho wev er, because much of the insight in to how credit market frictions ma y a ffect real activity and ho w various credit policies may work can be obtained from studying a purely real model, we abstract from nominal f rictions. 6 5 Some recent monetary DSGE models that incorporate financial factors include Chris- tiano, Motto, and Rostagno (2009) and Gilchrist, Ortiz and Zakresjek (2009). 6 There, however, several i nsights that monetary models add, however. First, if the zero lo wer bound on the nominal interest is binding, the financial market disruptions will have a larger effect than otherwise. This is because the central bank is not free to further reduce the nominal rate to offset the crisis. Second, to the extent there are nominal price and/or wage rigidities that induce countercyclical markups, the effect of the credit market disruption and aggregate activity is amplified. See, e.g., Gertler and Karadi (2009) and Del Negro, Ferrero, Eggertsson and Kiyotaki (2010) for a n illustration of both of these points. 6 2.1 Physical S etup Befor e describing our economy with financial frictions, w e present the phy s- ical en vironm ent. There are a con tin uu m of firmsofmassunitylocatedonacontinuum of islands. Each firm produces output using an identical constant returns to scale Cobb-Douglas production function with capital and labor as inputs. Cap ital is not mob ile, but labor is perfectly mob ile across firms and islands. Because labor is perfectly mobile, we can express aggregate output Y t as a function of aggregate capital K t and aggregate labor hours L t as: Y t = A t K t α L 1−α t , 0 <α<1, (1) where A t is aggregate productivit y which follow s a Markov process. Eac h period in vestment opportunities arrive randomly to a fraction π i of islands. On a fraction π n =1− π i of islands, there are no investment op- portunities. Only firm s on islands with in vestment opportunities can acquire new capital. The arrival of investment opportunities is i.i.d. across time and across islands. The structure of this idiosyncratic risk pro vides a simple w ay to introduce liquidity ne eds by firms, follo wing Ki y otaki and Moore (2008). Let I t denote aggregate in vestmen t, δ the rate of physical deprecation and ψ t+1 a shock to the qualit y of capital. Then the law of m o tion for capital is given by : K t+1 = ψ t+1 [I t + π i (1 − δ)K t ]+ψ t+1 π n (1 − δ)K t = ψ t+1 [I t +(1− δ)K t ]. (2) The first term of the righ t reflects capital accumulated by firms on in vesting islands and the second is capital that remains on non-investing islands, after depreciation. Summ ing across i sland s yields a con ven tion al aggregate relation for the evolu tion of c ap ital, except for the presence of th e disturbance ψ t+1 , which w e refer to as a capital quality shock. Follo wing the finance literature (e.g., Merton (1973)), w e introduce the capital quality shock as a simple w ay to introduce an exogenous source of variation in the value of capital. As will become cl ear later, the mark et price o f capital wi ll be e ndogenous within our framew ork. In this regard, the capital qual it y shock will s erve as a n exogenous trigger of asset price dynamics. The random variable ψ t+1 is best thought of as cap turing some form o f economic o bsolescence, as opposed t o 7 ph ysical depreciation. 7 We assume the capital qualit y shock ψ t+1 also follo w s a Marko v process. 8 Firms on inv estin g islands acqu ire cap ital from capital good s pr oducers who operate in a national market. There are con vex adjustment costs in the gross rate of c hange in investmen t for capital goods producers. Aggregate output is divided between household consumption C t , in vestmen t expendi- tures, and go vernment consumption G t , Y t = C t +[1+f( I t I t−1 )]I t + G t (3) where f( I t I t−1 )I t reflects physical adjustment costs, with f(1) = f 0 (1) = 0 and f 00 (I t /I t−1 ) > 0. Thus the aggregate production function of capital goods producers is decreasing returns to scale in the short-run and is constan t returns to scale in the long-run. Next we turn to preferences: E t ∞ X i=0 β i ∙ ln(C t+i − γC t+i−1 ) − χ 1+ε L 1+ε t+i ¸ (4) where E t is th e expectation operator conditional on date t information and γ ∈ (0, 1). We abstract from many f rictions in the conventional DSGE frame- work (e.g. n om in al price a nd w a ge rigidities, variable capital u t ilization, etc.). Howev er, we allo w both habit formation of consumption and adjust- ment costs o f inv estment because, as th e DSGE literatu re has found, these features a r e h elp ful for reasonable quantita tive performance an d because they can be kept in the model at minimal cost of additional complexity. If there were no financial frictions, the competitiv e equilibrium w o uld correspond to a solution of the planner’s problem that involv es choosing ag- gregate quantities (Y t ,L t ,C t ,I t ,K t+1 ) as a function of the aggregate state 7 One w ay to motivate this disturbance is to assume that final output is a C.E.S. com- posite of a continuum of intermediate goods that are in turn produced by employing capital and labor in a Cobb-Douglas production technology. Suppose that, once capital is installed, capital is good-specific and that eac h period a random fraction of goods become obsolete and are replaced b y new goods. The capital used to produced the obsolete goods is now worthless and the capital for the n ew goods is not fully on line. The aggregate capital stock will then evolve according to equation. (2). 8 Other recent papers that mak e use of this kind of disturbance include, Gertler and Karadi (2009), Brunnermeier and Sannikov (2009) and Gourio (2009). 8 (C t−1 ,I t−1 ,K t ,A t ,ψ t ) in order to maximize th e expected discou nted utility of the represen tative household subject to the resource c o nstraints. This frictionless econo my (a standard real busin ess cycle model) will serve as a benchmark to w hic h we may compare the im plications of the financial fric- tions. In what follow s w e will introduce banks that intermediate funds between households and non-financial firms i n a retail financial m arket. I n addition, we will allo w for a wholesale in ter-ba n k market, where banks with surplus funds on non-inv estment islands lend to banks in need o f funds on i n vesting islands. We will also in troduce financial frictions that ma y impede credit flowsinboththeretailandwholesalefinancial mark ets and then study the consequences for real activit y. 2.2 Households In our econom y with c redit frictions, households lend t o no n-financial firms via fin ancial in term e diaries. Following Gertler and Karad i (2009), w e formu - late the household sector in way that permits maintaining the tractability of the representative agen t approac h. In particular, t here is a representative household with a continuum of members of measure unit y. Within the household there are 1 − f "w ork- ers" and f "bankers". Work ers supply labor and return their wages to the household. Each banker manages a fin an cial in ter m ed iary (which we will call a "bank") and transfers nonnegativ e dividends bac k to household subject to its flow of fund constraint. Within the f am ily there i s perfect consumption insurance. Households do not hold capital directly. Rather, they deposit funds in banks. (It may be best t o think o f them as d epositing f unds in banks other than the ones they ow n ). In our model, bank deposits are riskless one period securities. Households may also hold riskless one period government debt which is a perfect substitute for bank deposits. Let W t denote the wage rate, T t lump sum taxes, R t the gross return on riskless debt from t − 1 to t, D ht the quantity of riskless debt held, a nd Π t net distributions from o w nership of both banks and non-financial firms. Then t he h ousehold chooses consumption, labor supply a nd ri skless debt (C t ,L t ,D ht+1 ) to maximize expected discoun ted utility (4) subject to t he flow of f unds constrain t, 9 C t = W t L t + Π t − T t + R t D ht − D ht+1 . (5) Let u Ct denote the marg ina l utilit y of consump tion and Λ t,t+1 the house- hold’s stoc h astic discoun t factor. Then the househo ld’s first order conditions for labor supply and consumption/sa ving are given by E t u Ct W t = χL ϕ t , (6) E t Λ t,t+1 R t+1 =1, (7) with u Ct ≡ (C t − γC t−1 ) −1 − βγ(C t+1 − γC t ) −1 and Λ t,t+1 ≡ β u Ct+1 u Ct . Because b a nks may be financially constrained, bankers will reta in earn- ings to accum ulate assets. Absent some motiv e for pa ying dividends, they may find it optimal to accumulate to the point where the financial constraint they face is no longer binding. In o rder to limit bankers’ abilit y to sa ve to overcome fina ncial constraints, w e allo w for turn over between bankers and w ork ers. In particular, w e assume that with i.i.d. probabilit y 1 − σ, a bank er exits next period, (which gives an av erage survival time = 1 1−σ ). Upon ex- iting, a banker transfers retained earnings to the household and becom es a w or ker. Note that the expected survival time ma y be quite long (in our baseline calibration it is ten y ear s.) It is critical, ho wever, that the expected horizon is finite, in order to motivate pa youts while the financial c onstrain ts are still binding. Each period, (1 − σ)f w o rkers randomly become bank ers, keeping the num ber in each occup atio n constan t. Finally, because in equ ilibrium bankers willnotbeabletooperatewithoutanyfinancial resources, each new bank er receiv es a "start up" transfer from the family as a small constant fraction of the total assets of entrepreneurs. Accordingly, Π t is net funds transferred to the household:i.e., funds transferred from exiting bankers min us the funds transferred to new bankers ( a side from small profits of capital producers). An alternativ e to our ap proach of having a consolidated f am ily of work- ers and bankers would be to hav e the two groups as di stinct sets of agents, without any consumption i nsurance bet ween the two groups. It is unlikely, however, that the key results of our paper would change qualitatively. By 10 [...]... that the marginal cost of interbank borrowing is equal to the marginal cost of deposits ν bt = ν t (25) Here, even if banks on investing islands are financially constrained, banks on non-investing islands may or may not be Roughly speaking, if the constraint on inter-bank borrowing binds tightly, banks in non-investing islands will be more inclined to use their funds to re-finance existing investments... constrained in obtaining funds from depositors In contrast, with ω = 0, lending banks are no more efficient than depositors in recovering assets from borrowing banks In this case, the friction that constrains a banks ability to obtaining funds on the interbank market is the same as for the retail financial market In general, we can allow parameter ω to differ for borrowing versus lending banks However, maintaining... proceeding, we emphasize that, consistent with the Federal Reserve Act, we have in mind that these interventions be used only during crises and not during normal times Indeed, within the logic of the model, the net benefits from credit policy are increasing in the distortion of credit markets that the crisis induces, as measured by the excess return on capital 3.1 Lending Facilities (Direct Lending) What... way they do in investing regions, only the superscript i is replaced by n in (45) One other hand, if banks in non-investing regions are not constrained (i.e., μn = 0), then central bank t credit merely displaces private credit, leaving total asset demand in the sector n∗ unaffected Let St be total asset demand consistent with a zero excess return on assets on non-investing islands in equilibrium Then... might determine the allocation of credit policy intervention between direct lending, discount window lending and equity injections We argued earlier that in the context of our model, it might be natural to think of capacity constraints on discount window lending secured by private credit So long as the efficiency costs of direct central bank lending are not large, extensive use of the direct lending makes... surplus funds to banks in investing region For reasonable variations of our calibration, banks remain unconstraint in non-investing regions and remain constrained in investing regions Finally, we suppose that the capital quality shock obeys a first order autoregressive process 35 4.2 Crisis Experiment 4.2.1 No Policy Response We now turn to the crisis experiment Broadly speaking, what triggered the... prices will clear at lower values on investing islands where supplies per unit of bank net worth are greater In the previous case of a perfect interbank market, funds flow from non-investing to investing islands to equalize asset prices Here, frictions in the inter-bank market limit the degree of arbitrage, keeping Qi below Qn t t A lower asset price on the investing island, of course, means a higher expected... discount window lending can expand the total level of assets intermediated by banks on investing regions Because the excess value of bank assets on non-investing islands is less than that on investing islands, i.e., μn < μi , banks on non-investing islands t t will not borrow from the discount window Given that the discount rate is set to satisfy equation (50) discount window lending will be too expensive... those financed by deposits) Equation (15) states that the marginal value of assets in terms of goods ν st exceeds the marginal cost of interbank borrowing by banks on Qh t type h island to the extent that the incentive constraint is binding (λh > 0) t and there is a friction in interbank market (ω < 1) Finally, equation (16) is the incentive constraint It requires that the values of the bank’s net worth... policy t Assuming that banks investing regions are constrained under a symmetric frictions in wholesale and retail financial markets (ω = 0), lending facilities expand the total amount of assets intermediated in the market Combining equations (31), (43) and (44), yields Qi Sti = t 1 φi N i 1 − ϕi t t t 15 (45) Other potential costs include the potential for politicization of credit flows We abstract from . accumulated by firms on in vesting islands and the second is capital that remains on non-investing islands, after depreciation. Summ ing across i sland s yields a. marginal cost of interbank borrowing by banks on type h island to the extent that the incentive constraint i s binding (λ h t > 0) andthereisafrictionininterbankmarket(ω<1).