Kirstin Hubrich, Federal Reserve Board
Project Description/Abstract
We investigate the transmission of financial shocks through the macroeconomy and the role of leverage of financial institutions in that context. To investigate that question 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, including sign restrictions and narrative sign restrictions. Third, we allow for different identification restrictions across different regimes.
Our empirical analysis is motivated by recent developments of structural models emphasizing the role of bank balance sheets for the build-up of financial instabilities and the amplification of financial shocks. We build a market-based measure of leverage of financial institutions employing bank-level data. Using this measure and our new regime-switching vector autoregressive model we shed light on the role of leverage of banks for the transmission of financial shocks. Our results indicate that real effects are amplified by the leverage of financial institutions in a high financial constraint regime. Furthermore, we also find that the real effects differ between a financial constraint regime and normal times based on a multivariate regime-switching model. Finally, we investigate the role of the heterogeneity of financial institutions for the transmission of financial shocks.
Co-author
Daniel Waggoner, Federal Reserve Bank of Atlanta