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I am grateful to Christopher Carroll, Lawrence Ball, Allen Berger, Jon Faust, Andrew Levin, and Egon Zakrajsek for constructive suggestions. Remaining errors are my own.
In a world of perfect capital markets, the Modigliani and Miller (1958) theorem implies that the capital structure of firms is uninformative for real economic decisions. However, this conclusion may be invalid when information about the default risk of borrowers cannot be costlessly acquired by lenders (Blinder and Stiglitz (1983)).
For an open economy extension of this literature see Aghion, Bacchetta, and Banerjee (2004), Caballero and Krishnamurthy (2001), Paasche (2001), Burnside, Eichenbaum, and Rebelo (2000), Mendoza (2004) and Gertler, Gilchrist, and Natalucci (2001).
Standard means that the amount of repayment is fixed in the absence of bankruptcy. Maximum equity participation refers to the use of all resources available to the entrepreneur in the investment project.
This assumption rules out the need to keep track of the entire credit history of borrowers. Alternatively we could assume that there is enough anonymity among borrowers that only their endowment at the moment of applying for a loan matters for credit decisions.
The assumption of lognormally distributed productivity guarantees a non-rationing outcome. See Bernanke, Gertler, and Gilchrist (1999).
This is a standard result in principal-agent problems of this type. See Mas-Colell and Green (1995).
Similar to Bernanke, Gertler, and Gilchrist (1999), we assume
We abstract from modeling any conflicts of interest between managers and stockholders by assuming that the bank is managed by its owners, or simply that stockholders’ and managers’ interests are aligned.
Berger and Bonaccorsi (2002) find evidence consistent with the hypothesis that increases in leverage of U.S. banking firms raises agency costs.
The endogenous gridpoints method involves using end-of-period values of the state variables, the marginal value functions, and first order conditions to construct middle-of-period levels of the state variables.
If bank capital is large enough so that the constraint on dividends is not binding, the Envelope theorem implies that ∂Vt+1(nt+1,lt)/∂n = 1. If in addition to that, we know that as q → ∞ we have that f → 0, then the marginal value of bank capital is simply given by the deposit interest rate. However, keep in mind that q is an endogenous variable, and therefore its limit was taken only for expositional clarity purposes.
In this model, credit cycles are induced by exogenous shocks; Gorton and He (2004) provide empirical evidence consistent with the hypothesis that competition among banking firms could enhance these cycles. An interest extension of this model could be to analyze both mechanisms together.
For instance, the new shareholders-possibly the state-would require board participation, veto power on certain decisions, dividend restrictions, etc.
The shock corresponds to 4 standard deviations.
This cumulative difference is exactly zero when the size of recapitalization reaches 63 percent of target capital.
This is an absorbing state because the bank cannot generate profits without lending, and thus cannot restore solvency.
The thresholds can be found by solving: ∂Vt(q1,0,lt-1)/∂l=0, and ∂Vt(qh,l*,lt-1)/∂l=0 using the converged marginal value function, and with l* denoting the target level of lending.
(33) follows from the assumption of f = v(cT-1/lT-2)a, with the values of v and a given in the calibration section.
The expectations are approximated using a Gaussian quadrature-See Judd (1998)-with 3 points. There was no material difference when more points were used.
The marginal value functions ∂Vt+1(nt+1,lt)/∂n and Vt+1(nt+1,lt)/∂l are updated after each iteration according to: ∂Vt+1(nt+1,lt)/∂n = ∂Vt+2(ndt+2(n,l), lt+2(n,l),l)/∂q and ∂Vt+1(nt+1,lt)/∂l=∂Vt+2(n-dt+2(n,l), lt+2(n,l),l)/∂l.