Seminar 10 March, 2014

Banks, Lending and the Transmission of Monetary Shocks

Abstract
This paper examines the way financial intermediaries can amplify the effects of monetary and other shocks, in an attempt to understand the behavior of macroeconomic variables during the recent financial crisis. I built a theoretical model where loan officers' perceived uncertainty on the projects seeking finance is procyclical. Loan officers evaluate their lending decisions each period which makes them perceive that their ability to find good loan opportunities is weakened during recessions and strengthened during expansions. Due to the non-convex nature of bank cash flows from a loan, changes in the ability of loan officers' to value loans coming from variations in uncertainty, result in sharp loan contractions during recessions. During a recession, uncertainty increases and banks find it difficult to identify worthy lending opportunities, contracting the flow of funds to entrepreneurs, exacerbating the downfall. The pessimistic view of the banks for the economy arises because lending gives a weak feedback to the lenders as their sample of information is truncated. Successful loans are not monitored and thus banks get a stronger feedback only from the troubled loans as they are the ones usually monitored.

Contacts: Battista Severgnini and Cédric Schneider