Abstract:-
What are the effects of bank shocks in an economy featuring bank-firm lending relationships and what is the propagation mechanism? This paper builds a dynamic general equilibrium model in which collateral-constrained entrepreneurs have endogenously-persistent credit relationships with banks. A bank shock in this model takes the form of a negative shock to loan repayments and drives up credit spread. Bank credit falls and a downturn in macroeconomic activity ensues. These effects are initially amplified by presence of lending relationships but macroeconomic activity later recovers faster boosted by recovery in bank loans. When credit relationships are turned off, the model predicts prolonged slowdown in investment, consumption and output. These results indicate how borrower-lender relationships can act both as financial accelerators and as an economic stabilizer.