Real Effects of Bank Shocks

What are the effects of a bank shock – or a decline in bank loan repayments – in an economy featuring bank-firm lending relationships and what is the propagation mechanism? I answer these questions in this paper and build a dynamic general equilibrium model in which collateral-constrained entrepreneurs have endogenously-persistent credit relationships with banks. Credit relationships play a dual role of shock amplifier and stabilizer in this environment. In presence of credit relationships, a bank shock in this model drives up credit spread at impact, causing bank credit to fall and paving the way for a downturn in macroeconomic activity. Economic activity recovers later on as spread falls, resulting in a rebound in bank loans and investment. When credit relationships are turned off, the model shows prolonged fall in bank loans and a persistent slowdown in investment, consumption and output as spread remains continually elevated, making bank credit expensive. A more persistent bank shock leads to a sustained decline in output even in the presence of lending relationships while a more volatile shock causes protracted slump in output in absence of credit relationships but not when they are present.