Real effects of bank shocks

This paper studies how bank-firm lending relationships shape the macroeconomic effects of banking sector shocks. I develop a dynamic general equilibrium model in which collateral-constrained entrepreneurs borrow from banks through endogenously persistent credit relationships, modeled using a deep habits in banking framework. A negative repayment shock to bank loans triggers a sharp rise in credit spread and a contraction in bank lending and investment. However, the persistence embedded in credit relationships accelerates recovery – as spread normalizes, credit and output rebound. In contrast, when lending relationships are absent, the same shock generates a milder initial downturn but a more prolonged slowdown, as high spread persists and credit remains depressed. These findings highlight a fundamental trade-off in financial crises – relationship lending amplifies short-run effects but stabilizes recovery. The results underscore the importance of preserving bank-firm ties during financial shocks – through potential mechanisms such as credit guarantees, liquidity provision, or regulatory flexibility – as a means to support faster post-crisis normalization.