Interconnectedness, Firm Resilience and Monetary Policy

We develop a novel approach to understand how central bank policy rates affect individual firms and banks and how aspects of interconnectedness accentuate these effects in nontrivial ways. Changes in policy rate impact – either direct or indirectly – these agents, depending on their balance-sheet composition and network relationships. Interest rate shocks change bank capital on spot, which in turn reflects on how banks issue credit to firms. Firms experience increasing financial costs that revert to banks in the form of credit defaults, exacerbating the aftereffects of the monetary policy change. We apply the model to a unique data set from Brazil and find nonlinear and asymmetric effects on firms and banks that depend on the magnitude and direction of policy rate changes. The effects of interest rate changes are distinct in environments of expansion and recession. Finally, we find that monetary policy can have linear and nonlinear implications for financial stability, depending on the magnitude of the interest rate shock and network relationship patterns. Particularly, we show that big swings in the interest rate can cause undesirable nonlinear consequences to the financial stability.