Risky firms and fragile banks: implications for macroprudential policy

Abstract

Increases in firm default risk raise the default probability of banks while decreasing output and prices in US data. To rationalize the empirical evidence, we analyze firm risk shocks in a New Keynesian model where entrepreneurs and banks engage in a loan contract and both are subject to default risk. Corporate defaults lead to losses on banks’ balance sheets. A highly leveraged banking sector exacerbates the contractionary effects of firm defaults. We estimate the parameters of the model by matching VAR impulse responses of firm and bank risk, output, prices and the policy rate to a range of shocks – firm risk, demand, technology and monetary policy. Our model performs well at replicating the observed dynamics, making it suitable for policy analysis. We show that high minimum capital requirements jointly implemented with a countercyclical capital buffer are effective in dampening the adverse consequences of firm risk shocks.