Banks' balance sheet, uncertainty and macroeconomy

Motivated by data on weak credit growth despite highly accommodative monetary policy in many advanced economies and by ample evidence on important effects of uncertainty in the course of the fi nancial crisis of 2007-2009, this paper studies relationships between economic uncertainty and the volume of bank lending. We obtain empirical evidence showing that an increase in uncertainty leads to reallocation of portfolio of assets by commercial banks: banks reduce issuance of loans, in particular, of commercial and industrial loans, while increasing the stock of safe assets - cash and Treasury and agency securities. The objective of the paper is to account for this evidence in a general equilibrium theoretical setup and to evaluate the importance of bank portfolio allocation effects on macroeconomy following a spike of uncertainty. DSGE model with portfolio-optimizing banking sector. We propose a DSGE model that incorporates a portfolio-optimizing banking sector facing non-diversifiable credit risk, where banks' attitude to risk and expected profitability help to explain the endogenous movements of the risk premium. Precautionary mechanism is in play: lending rate charged by risk-averse banks provides self-insurance from expected profitability reduction, brought about by heightened uncertainty about entrepreneurial productivity, in addition to remunerating for risk of defaults. Banks reduce their exposure to credit risk by cutting down the share of risky lending in their asset portfolios and increasing the share of risk-free assets. Variations in risk premium make the effect on economy via changing entrepreneurial demand for capital, such that financial accelerator mechanism is active.