The Transmission of Financial Shocks and Leverage of Banks: An Endogenous Regime Switching Framework

Abstract

We investigate the transmission of financial shocks through the macroeconomy. To that end we develop an endogenous regime-switching structural vector autoregressive model with time-varying transition probabilities. First, we allow for the transition probabilities to be dependent on the state of the economy, and thereby to be time-varying. Second, we facilitate rather general, non-recursive structural identification restrictions. Third, we allow the identification restrictions to differ across regimes. We employ a model with conventional and unconventional monetary policy, where the latter is modelled via the Fed balance sheet. Using bank-level data, we shed light on the role of leverage of banks for the transmission of financial shocks.