Creator: Bocola, Luigi Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 722 Abstract:
This paper examines the macroeconomic implications of sovereign credit risk in a business cycle model where banks are exposed to domestic government debt. The news of a future sovereign default hampers financial intermediation. First, it tightens the funding constraints of banks, reducing their available resources to finance firms (liquidity channel). Second, it generates a precautionary motive for banks to deleverage (risk channel). I estimate the model using Italian data, finding that i) sovereign credit risk was recessionary and that ii) the risk channel was sizable. I then use the model to evaluate the effects of subsidized long term loans to banks, calibrated to the ECB’s longer-term refinancing operations. The presence of strong precautionary motives at the time of policy enactment implies that bank lending to firms is not very sensitive to these credit market interventions.
Keyword: Credit policies, Financial constraints, and Sovereign debt crises Subject (JEL): E44 - Financial Markets and the Macroeconomy, G21 - Banks; Depository Institutions; Micro Finance Institutions; Mortgages, E32 - Business Fluctuations; Cycles, and G01 - Financial Crises
Creator: Gavazza, Alessandro, Mongey, Simon J., and Violante, Giovanni L. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 553 Abstract:
We develop an equilibrium model of firm dynamics with random search in the labor market where hiring firms exert recruiting effort by spending resources to fill vacancies faster. Consistent with microevidence, fast-growing firms invest more in recruiting activities and achieve higher job-filling rates. These hiring decisions of firms aggregate into an index of economy-wide recruiting intensity. We study how aggregate shocks transmit to recruiting intensity, and whether this channel can account for the dynamics of aggregate matching efficiency during the Great Recession. Productivity and financial shocks lead to sizable pro-cyclical fluctuations in matching efficiency through recruiting effort. Quantitatively, the main mechanism is that firms attain their employment targets by adjusting their recruiting effort in response to movements in labor market slackness.
Keyword: Firm dynamics, Unemployment, Macroeconomic shocks, Recruiting intensity, Aggregate matching efficiency, and Vacancies Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, D25 - Intertemporal Firm Choice: Investment, Capacity, and Financing, G01 - Financial Crises, J23 - Labor Demand, J64 - Unemployment: Models, Duration, Incidence, and Job Search, and J63 - Labor Turnover; Vacancies; Layoffs
Creator: Conesa, Juan Carlos and Kehoe, Timothy Jerome, 1953- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 497 Abstract:
In January 1995, U.S. President Bill Clinton organized a bailout for Mexico that imposed penalty interest rates and induced the Mexican government to reduce its debt, ending the debt crisis. Can the Troika (European Commission, European Central Bank, and International Monetary Fund) organize similar bailouts for the troubled countries in the Eurozone? Our analysis suggests that debt levels are so high that bailouts with penalty interest rates could induce the Eurozone governments to default rather than reduce their debt. A resumption of economic growth is one of the few ways that the Eurozone crises can end.
Keyword: Sovereign debt, Bailout, Collateral, and Penalty interest rate Subject (JEL): F34 - International Lending and Debt Problems, G01 - Financial Crises, and F53 - International Agreements and Observance; International Organizations
Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 495 Abstract:
This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.
Keyword: Renegotiation policy, Contagion, and Sovereign default Subject (JEL): F30 - International Finance: General and G01 - Financial Crises
Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 491 Abstract:
We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders. Countries default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. Defaulting is also attractive in response to foreign defaults because the cost of rolling over the debt is higher when other countries default. Such forces are quantitatively important for generating a positive correlation of spreads and joint incidence of default. The model can rationalize some of the recent economic events in Europe as well as the historical patterns of defaults, renegotiations, and recoveries across countries.
Keyword: Renegotiation, European debt crisis, Contagion, Self-fulfilling crisis, and Sovereign default Subject (JEL): F30 - International Finance: General and G01 - Financial Crises
Creator: Koijen, Ralph S. J. and Yogo, Motohiro Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 500 Abstract:
During the financial crisis, life insurers sold long-term policies at deep discounts relative to actuarial value. The average markup was as low as −19 percent for annuities and −57 percent for life insurance. This extraordinary pricing behavior was due to financial and product market frictions, interacting with statutory reserve regulation that allowed life insurers to record far less than a dollar of reserve per dollar of future insurance liability. We identify the shadow cost of capital through exogenous variation in required reserves across different types of policies. The shadow cost was $0.96 per dollar of statutory capital for the average company in November 2008.
Keyword: Life insurance, Financial crisis, Leverage, Annuities, and Capital regulation Subject (JEL): G28 - Financial Institutions and Services: Government Policy and Regulation, G22 - Insurance; Insurance Companies; Actuarial Studies, and G01 - Financial Crises
Creator: Perri, Fabrizio and Quadrini, Vincenzo Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 463 Abstract:
The 2007–2009 crisis was characterized by an unprecedented degree of international synchronization as all major industrialized countries experienced large macroeconomic contractions around the date of Lehman bankruptcy. At the same time countries also experienced large and synchronized tightening of credit conditions. We present a two-country model with financial market frictions where a credit tightening can emerge as a self-fulfilling equilibrium caused by pessimistic but fully rational expectations. As a result of the credit tightening, countries experience large and endogenously synchronized declines in asset prices and economic activity (international recessions). The model suggests that these recessions are more severe if they happen after a prolonged period of credit expansion.
Keyword: International co-movement, Global liquidity, and Credit shocks Subject (JEL): F41 - Open Economy Macroeconomics, F44 - International Business Cycles, and G01 - Financial Crises
Creator: Ordonez, Guillermo Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 431 Abstract:
Concerns about constructing and maintaining good reputations are known to reduce borrowers’ excessive risk-taking. However, I find that the self-discipline induced by these concerns is fragile, and can break down without obvious changes in economic fundamentals. Furthermore, in the aggregate, breakdowns are clustered among borrowers with intermediate and good reputations, which can exacerbate an economy’s weakness and contribute to a broad economic crisis. These results come from an aggregate dynamic global game analysis of reputation formation in credit markets. The selection of a unique equilibrium is accomplished by assuming that borrowers have incomplete information about economic fundamentals.
Keyword: Fragility, Reputation, Risk-taking, and Global games Subject (JEL): E44 - Financial Markets and the Macroeconomy, D82 - Asymmetric and Private Information; Mechanism Design, G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill, and G01 - Financial Crises
Creator: Perri, Fabrizio and Stefanidis, Georgios Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 554 Abstract:
We use balance sheet data and stock market data for the major U.S. banking institutions during and after the 2007-8 financial crisis to estimate the magnitude of the losses experienced by these institutions because of the crisis. We then use these estimates to assess the impact of the crisis under alternative, and higher, capital requirements. We find that substantially higher capital requirements (in the 20% to 30% range) would have substantially reduced the vulnerability of these financial institutions, and consequently they would have significantly reduced the need of a public bailout.
Keyword: Financial crises and Too big to fail Subject (JEL): G21 - Banks; Depository Institutions; Micro Finance Institutions; Mortgages and G01 - Financial Crises
Creator: Arellano, Cristina, Bai, Yan, and Lizarazo, Sandra Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 559 Abstract:
We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).
Keyword: Bond spreads, Sovereign default, Renegotiation, and European debt crisis Subject (JEL): G01 - Financial Crises and F30 - International Finance: General