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Distress in the Financial Sector and Economic Activity

  • Carlson Mark A

    ()

    (Board of Governors of the Federal Reserve)

  • King Thomas

    ()

    (Board of Governors of the Federal Reserve)

  • Lewis Kurt

    ()

    (Board of Governors of the Federal Reserve)

We construct daily market-based measures of distance to default for large U.S. financial institutions since 1973. These measures have significant predictive power for institution bankruptcy more than one year in advance. We aggregate the distances to default across institutions to provide an index of the overall health of the financial-services industry. We show that deteriorations in this Financial Institution Health Index are associated with tighter lending standards and higher interest rates on bank loans and precede declines in employment and industrial production. We argue that this points to the condition of financial institutions as an independent source of macroeconomic variability, distinct from traditional accelerator mechanisms.

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Article provided by De Gruyter in its journal The B.E. Journal of Economic Analysis & Policy.

Volume (Year): 11 (2011)
Issue (Month): 1 (June)
Pages: 1-31

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Handle: RePEc:bpj:bejeap:v:11:y:2011:i:1:n:35
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