By Tamas Csabafi, Max Gillman and Ruthira Naraidoo
The world-wide financial crisis of 2007 to 2009 caused bankruptcy and bank failures in the US and many other parts such as Europe. Recent empirical evidence suggests that this simultaneous drop in output was strongest in countries with greater financial ties to the US economy with important cross border deposit and lending. This paper develops a two-country framework to allow for banking structures within an international real business cycle model. The banking structure across countries is modelled using the production approach to financial intermediation. We allow both countries. banks to be able to take deposits both locally and internationally. We analyze the transmission mechanism of both goods and banking sector productivity shocks. We show that goods total factor productivity (TFP) and bank TFP have different effects on the finance premium. Most countries have shown procyclic equity premium over their histories but with evidence that these are countercyclic during the Great Recession especially. The model has the ability to explain the countercyclical movements of credit spreads during major recession and financial crisis when goods TFP also affects banking productivity. This we model as a cross correlation of shocks to replicate the recent events during the crisis period. Importantly, the model can also explain business cycles facts and the countercyclical behaviour of the trade balance.
Opening up and economy brings obvious efficiency gains and allows for smoothing out domestic shocks. But it also opens up the domestic economy up to foreign shocks. The impact of foreign TFP shocks has long been discussed in the literature. This paper brings in the impact of of foreign finance shocks, something that was an obvious driver in the dissemination of the financial crisis from the US to some other countries. The story is likely not as simple as this paper makes it, but it is a nice contribution that attempts to take the banking sector seriously in the international business cycle literature.