Banks’ Financial Structure and Business Cycles

A puzzling fact in macroeconomics is that small and transitory shocks seem to be followed by large and persistent fluctuations in macroeconomic variables. Theoretical models explaining this empirical fact focus on the borrower but most of them neglect to model the bank. This paper proposes a framework in which changes in the financial condition of banks can have persistent aggregate consequences. The bank is modeled as a firm in a dynamic framework, in a world of imperfect capital markets. An important feature of the model is the existence of an optimal financial structure defined as the level of net cash position relative to size of the loans portfolio. In the model, an i.i.d shock may generate a persistent effect on output because the shock may cause a significant weakening of the bank, while the latter restores its financial position only through retained earnings. A similar persistent effect arises in the event of a permanent increase in productivity, in such scenario, the bank adjusts lending gradually rather than instantly—as in a frictionless model—until the new target is reached. Finally, the bank’s response to shocks is not symmetric. A negative shock has much stronger effects on lending than a positive one. JEL classification: C61, E32, E44