MACROECONOMIC IMPLICATIONS OF FINANCIAL CONSTRAINTS 1. Credit crunch.

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

2. 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.

3. 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.

4. MODEL BORROWERS Risk neutral parties • borrowers (firms) • monitors (banks) • investors ("firms") Have 1 project / idea each Investment cost I Verifiable 0 (failure) return R (success) Moral hazard: Versions of the project bad (low private benefit) Bad (high private benefit) good Private benefit: Prob( R) (only good project is viable)

5. Have assets Total assets of intermediaries = Km. 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.

6. EXOGENOUS INTEREST RATE Equilibrium Intermediation

7. Certification

8. Intermediation Certification Bank loan (on balance sheet). Venture capitalist Lead investment bank Bankers acceptances (commercial paper) Partial securitization of a loan.

9. where DIRECT FINANCE Need

10. INDIRECT FINANCE

11. Because firm wants to use as little informed capital as possible: Firm gets financed if it has assets where is increasing in . EQUILIBRIUM M:

12. If interest rate  is endogenous Supply imperfectly elastic. Demand for uninformed capital:

13. COMPARATIVESTATICS 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.

14. CREDIT CRUNCH Fact: small firms are prime victims of credit crunch. [Empirical evidence.]

15. VARIABLE INVESTMENT SCALE decreases  A decrease in Km (credit crunch) increases  decreases solvency ratio of banks (intermediation) increases equity ratio of firms

16. decreases  decreases  increases rm decreases rb A decrease in Kb (balance sheet channel)

17. Description of equilibrium (1) inverse function of (2) (3)

18. 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!

19. OTHER RESEARCH PROJECTS Dynamics: • Simultaneous growth of financial and real sectors. • Increasing share of financial sector. Move toward less intensive monitoring. Certification vs intermediation. Division of labor between intermediaries and firms, among intermediaries: shallow vs deep information.