Financial frictions and the business cycle

Hollander, Hylton (2014-11-05)

Thesis (PhD) -- Stellenbosch University, 2014.


ENGLISH ABSTRACT: This dissertation emphasizes the financial instability inherent in modern financial markets and the real economy and introduces a different aspect to dynamic stochastic general equilibrium (DSGE) models with financial frictions. Specifically, I introduce a role for the equity market in financial intermediation, firm production and household consumption—termed the equity price channel. This innovative model forms the foundation of three research papers which successively studies: the systemic and pro-cyclical effect of equity, the sources of credit spread variability, and the role of contingent convertible capital (CoCos) in Basel III macroprudential regulation. In chapter two, I show that the equity price channel significantly exacerbates business cycle fluctuations through both financial accelerator and bank capital channels. I find that a New- Keynesian DSGE model with an equity price channel well mimics the U.S. business cycle and reproduces the strong procyclicality of equity. The results also reflect the increasing emphasis on common equity capital in Basel regulations. This is beneficial in terms of financial stability, but amplifies and propagates shocks to the real economy. In chapter three, I establish the prevailing financial factors that influence credit spread variability, and its impact on the U.S. business cycle over the Great Moderation and Great Recession periods. Over both periods, I find an important role for bank market power (sticky rate adjustments and loan rate markups) on credit spread variability in the U.S. business cycle. Equity prices exacerbate movements in credit spreads through the financial accelerator channel, but cannot be regarded as a main driving force of credit spread variability. Both the financial accelerator and bank capital channels play a significant role in propagating the movements of credit spreads. Across the last three U.S. recession periods (1990¡91, 2001, and 2007¡09) I observe a remarkable decline in the influence of technology and monetary policy shocks. Whereas, there is an increasing trend in the contribution of loan rate markup shocks to the variability of retail credit spreads. The influence of loan-to-value shocks has declined since the 1990¡91 recession, while the bank capital requirement shock exacerbates and prolongs credit spread variability over the 2007¡09 recession period. In chapter four, I show that countercyclical capital requirements (as in Basel III) and contingent convertible capital provide an effective dual approach to macroprudential policy. On the one hand, a countercyclical capital adequacy rule dominates CoCos in the stabilization of real shocks. That is, by raising a capital buffer the Basel III regime mitigates the build-up of excess credit supply and, as a result, constrains the expansion of overleveraged banks. On the other hand, CoCos have a strong advantage over the Basel III regime against negative financial shocks. Here, CoCos effectively re-capitalize banks, reduce financial distress in a timely manner, and mitigate knockon effects to the real economy. Countercyclical capital requirements and contingent convertible capital instruments therefore limit financial instability, and its influence on the real economy.

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