Banking Risk and Macroeconomic Fluctuations

Abstract

This paper develops a model of banking frictions and banking risk. As a sort of systemic risk, changes in banking risk lead to fluctuations in aggregate economic activity. We decompose the macroeconomic effect of a banking risk shock into a pure default effect and a risk-aversion effect when risk sharing among investors is imperfect. When the shock generates a bank risk spread similar to the peak value during the Global Financial Crisis, the overall effect is a decline in employment by 4.66%. The default effect leads to a 3.40% employment decline by a “within-model” measure, and a 3.51 decline by a “between-model” measure. The remaining is attributed to the risk-aversion effect. A practical implication of our analysis is that by developing financial safety net and improving risk sharing among investors, the society can mitigate the adverse macroeconomic effects of banking risk shocks to some extent, but cannot eliminate all of them.