Debt Market Imperfections and Macroeconomic Implications

The project is funded by Deutsche Forschungsgemeinschaft (DFG)

The basic idea is to pursue and then combine two different strands of research, one in the field of general equilibrium modelling and the other in the field of financial intermediation and pricing in bank bond markets, to gain a better understanding of how macroeconomic outcomes are influenced by the complexities of financial systems. We believe that the particular imperfections studied in this project are essential for understanding why individual financial institutions faltered during this crisis. These imperfections are therefore an important ingredient in a new generation of macro models that explicitly address the fragility of a financial system. The project with an estimated total duration of six years (two phase of 3 years) is joint work by macroeconomists and finance researchers.

The research agenda of this ongoing project is articulated around three main pillars, each subdivided in different work packages. The first pillar is primarily macro-oriented and entails the development of suitable macro models for incorporating financial intermediation and default risk. In the first phase, we have applied a macro model with bank runs to analyze various policy questions and to test empirically the risk taking channel. In the second phase, we plan to analyze the consequences of excessive leverage on the macro-economic dynamic and on the formation of bubbles. Here we develop a macro model with both bank and household debt: in this model, we will consider behavioral elements that affect the formation of excessive leverage and we will focus in particular on loss averse agents (banks’ managers and households).

In the second pillar, which is mainly finance-oriented, we focus on the risk taking decisions by financial institutions. One of the work packages focuses on the response of bank risk taking to government intervention in markets. We have analyzed two such interventions in phase I: implicit bailout guarantee and sovereign default risk. Phase II will add management compensation as a third intervening factor. Another work package focuses on the response of bank risk taking to the (re-)emergence of asset securitization in loan markets. This work is concentrated in Phase II.

The third pillar is a capstone project, integrating the finance work stream, focusing on bank default propagation, with the analysis of monetary policy. During the first phase of the project, we have developed a simple numerical network model of banks that endogenizes network formation and asset correlation. This work-horse model will be extended in the second phase to include a range of policy rules and a set of different regulatory instruments. The aim is to analyze the interplay of monetary policy (targeting price stability) and financial regulation (targeting systemic stability) for different regulatory regimes and banking structures. We expect to derive policy conclusions from all work packages.