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Credit Defaults, Bank Lending and the Real Economy

Sebastiaan Pool

DNB Working Papers from Netherlands Central Bank, Research Department

Abstract: This paper examines how the materialization of credit defaults affects the real economy. I estimate a DSGE model including banks, firms and financial frictions using euro area data. The estimation results show that a positive credit default shock, which is identified as an unanticipated increase in credit default losses, complicates monetary policy because output falls while inflation goes up. The monetary authority must choose between stabilizing output and inflation and is therefore less effective. Inflation increases slightly because firms experience besides a demand contraction also a cost-push effect when banks increase the lending rate. Countercyclical capital buffers can in this case complement conventional monetary policy but there is a trade-off: they effectively attenuate macroeconomic fluctuations, but increase the persistence of the slump as banks rebuild their capital more slowly. A bank recapitalization overcomes this trade-off and significantly reduces macroeconomic fluctuations.

Keywords: Banking; Credit risk; Credit defaults; Countercyclical Capital Buffer; Bayesian Estimation (search for similar items in EconPapers)
JEL-codes: E44 E51 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-mon
Date: 2016-08
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Persistent link: https://EconPapers.repec.org/RePEc:dnb:dnbwpp:518

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