Working Paper: CEPR ID: DP10830
Authors: David Martinez-Miera; Rafael Repullo
Abstract: We present a model of the connection between real interest rates, credit spreads, and the structure and the risk of the banking system. Banks intermediate between entrepreneurs and investors, and choose the monitoring intensity on entrepreneurs' projects. We characterize the equilibrium for a fixed aggregate supply of savings, showing that safer entrepreneurs will be funded by nonmonitoring (shadow) banks and riskier entrepreneurs by monitoring (traditional) banks. We also show that a savings glut reduces interest rates and spreads, increases the relative size of the shadow banking system and the probability of failure of the traditional banks. The model provides a framework for understanding the emergence of endogenous boom and bust cycles, as well as the procyclical nature of the shadow banking system, the existence of countercyclical risk premia, and the low levels of interest rates and spreads leading to the buildup of risks during booms.
Keywords: Bank Monitoring; Banking Crises; Boom and Bust Cycles; Credit Spreads; Financial Stability; Real Interest Rates; Savings Glut; Shadow Banks
JEL Codes: E44; G21; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| global savings glut (E21) | long-term real interest rates (E43) |
| global savings glut (E21) | credit spreads (G12) |
| long-term real interest rates (E43) | risk-taking in the banking system (G21) |
| long-term real interest rates (E43) | risky lending practices (G21) |
| risk-taking in the banking system (G21) | financial instability (F65) |
| shadow banking system (G21) | monitoring intensity of banks (G21) |
| monitoring intensity of banks (G21) | probability of failure for traditional banks (G21) |
| accumulation of savings (E21) | interest rates (E43) |
| accumulation of savings (E21) | investment (G31) |
| investment (G31) | financial bust (G33) |
| initial increase in savings (D14) | financial bust (G33) |