Firm default risk threatens banks, macroprudential tools offer stability
A Banca d'Italia working paper finds that increased firm default risk raises bank default probability, decreasing output and prices. The study shows that high minimum capital requirements and countercyclical capital buffers effectively dampen these adverse consequences.
Corporate defaults ripple through the economy
Based on US data, increases in firm default risk raise the probability of bank default while decreasing output and prices.
To rationalize this, a New Keynesian model is used where entrepreneurs and banks are subject to default risk.
Corporate defaults lead to losses on banks' balance sheets, and a highly leveraged banking sector exacerbates these contractionary effects.
The model successfully replicates observed dynamics, including the transmission of risk shocks to the financial sector, increased bank default risk, and decreased output and inflation.
Firm risk shocks are found to dominate other disturbances in accounting for business cycle fluctuations in output.
This highlights the critical role of the banking sector in transmitting these shocks to the real economy, leading to demand-driven recessions with falling output and prices.
Capital buffers for financial resilience
The study demonstrates that high minimum capital requirements, jointly implemented with a countercyclical capital buffer (CCyB), are effective in dampening the adverse consequences of firm risk shocks.
Such policies reduce bank and firm leverage, thereby decreasing the impact of risk shocks on borrower defaults and stabilizing bank default rates.
The release of a CCyB can mitigate the decline in credit caused by reduced bank equity, supporting investment and output.
The paper's key insight is the strong complementarity between high steady-state capital requirements and CCyBs for macroeconomic stabilization, particularly in the presence of firm risk shocks.
This joint implementation can effectively dampen the negative effects on output.
A timely call for robust buffers
This paper provides crucial empirical and theoretical backing for strengthening macroprudential frameworks against corporate vulnerabilities.
Its finding on the complementarity of capital requirements and countercyclical buffers offers actionable guidance for regulators.
While focused on the US, the implications for European financial stability, especially amidst current economic uncertainties, are undeniably significant.