Long-term bank lending and the transfer of aggregate risk

Michael Reiter, Leopold Zessner-Spitzenberg

Research output: Contribution to journalArticlepeer-review

Abstract

Long-term loan contracts transfer aggregate risk from borrowing firms to lending banks. When aggregate shocks increase the future default probability of firms, banks are not compensated for the rising default risk of existing contracts. The flip side is that firms benefit from not facing higher interest rates in recessions. If banks are highly leveraged, this can lead to financial instability with severe repercussions in the real economy. If banks are well capitalized, the risk transfer stabilizes the economy. To study this mechanism quantitatively, we build a macroeconomic model of financial intermediation with long-term defaultable loan contracts and calibrate it to match aggregate firm and bank exposure to business cycle risks in the US. We find that moving from Basel II to Basel III capital regulation eliminates banking crises, increases output in the long run and improves welfare.

Original languageEnglish (US)
Article number104651
JournalJournal of Economic Dynamics and Control
Volume151
DOIs
StatePublished - Jun 2023

Keywords

  • Banking
  • Financial frictions
  • Maturity transformation

ASJC Scopus subject areas

  • Economics and Econometrics
  • Control and Optimization
  • Applied Mathematics

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