Abstract:- 

How do shocks to bank funding costs propagate in economies with lending relationships? I develop a dynamic general equilibrium model with collateral-constrained entrepreneurs who borrow under credit relationships with banks. A rise in bank’s funding costs increases its deposit repayment burden, raises credit spread, disrupts bank intermediation and triggers a macroeconomic downturn. In the presence of lending relationships, the downturn is sharper but the recovery is faster; when such relationships are absent, the model predicts a more protracted decline in output, investment, and consumption. The results from the model are able to rationalize the recent finding in the literature that shows that deposit rates rise before an impending recession, thereby shedding light on discussions that focus on credit growth alone to predict financial crises. Strikingly, the effects of funding shocks are indistinguishable from those of asset-side shocks, despite originating from opposite sides of bank balance sheets. This suggests that observationally equivalent aggregate dynamics may mask distinct sources of financial stress, raising the possibility that observed macroeconomic responses may not uniquely reveal the source of financial stress, complicating both diagnosis and effective intervention.