A Credit Cycle Model of Bank Loans and Corporate Bonds: A Bank Capital View

This paper investigates macroeconomic effects of bank regulation in a continuoustime macro-finance framework with both bond-financing and bank-financing. Risky firms appreciate bank credit because banks are efficient at liquidating assets for troubled firms. However, risky firms must pay the risk premium for banks’ exposure to aggregate risks. Our framework captures the feature that the cost of bank-financing endogenously fluctuates and the fact that bond-financing is less volatile and cyclical than bank-financing. We show that if bank regulation is to raise the marginal funding cost for banks, these financial intermediaries transfer most of the incremental cost to their borrowers. Hence, risky firms switch to bond-financing due to the raised loan rate. Although financial stability improves, the average productivity declines. The impact of bank regulation on economic growth is unclear because more bond-financing leads to more inefficient liquidation. Overall, bank regulation benefits the real sector and hurts financial intermediaries.