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OVERLEVERAGING, FINANCIAL FRAGILITY, AND THE BANKING–MACRO LINK: THEORY AND EMPIRICAL EVIDENCE

Published online by Cambridge University Press:  20 November 2017

Stefan Mittnik  and
Willi Semmler
Stefan Mittnik
Affiliation:
Ludwig-Maximilian-Universität München
Willi Semmler*
Affiliation:
New School for Social Research, ZEW, and University of Bielefeld
*
Address correspondence to: Willi Semmler, New School for Social Research, 79 Fifth Avenue, New York, NY 10003, USA; e-mail: semmlerw@newschool.edu.
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Abstract

We analyze the consequences of overleveraging and the potential for destabilizing effects from financial- and real-sector interactions. In a theoretical model, we demonstrate that, in the presence of regime-dependent macro feedback relations, a highly leveraged banking system can result in instabilities and downward spirals. To investigate this question empirically, we analyze time series from eight advanced economies on industrial production and the components of the country-specific financial stress indices constructed by the IMF. Employing nonlinear, multiregime vector autoregressions, we examine how industrial production is affected by the individual risk drivers making up the indices. Our results strongly suggest that financial-sector stress has a substantial, nonlinear influence on economic activity and that individual risk drivers affect output rather differently across stress regimes and across groups of countries.

Keywords

Financial-Real LinkagesRegime Dependent Macro FeedbacksFinancial Stress MeasuresMultiregime VAR
Type
Articles
Information
Macroeconomic Dynamics , Volume 22 , Special Issue 1: Current Macroeconomic Challenges , January 2018 , pp. 4 - 32
Copyright
Copyright © Cambridge University Press 2017 

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Footnotes

A previous version, entitled “Estimating a Banking–Macro Model for Europe Using a Multi–regime VAR,” was presented at a conference on “The Future of the Euro and Europe,” Sapienza University, Rome, July 2013, organized by Giovanni Di Bartolomeo, at the 7th International Conference on Computational and Financial Econometrics, University of London, December 2013, and at the conference of the Society of Nonlinear Dynamics and Econometrics, New York, April 2014. We want to thank Lilia Cavallari and participants of the conferences for valuable comments. We are especially grateful for communications with Markus Brunnermeier, James Ramsey, and Timo Teräsvirta. Willi Semmler would also like to thank the Centre for European Economic Research (ZEW) for financial support. The research for this paper was partly conducted while Willi Semmler was a visiting researcher at the European Central Bank.

References

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