Capital Gaps, Risk Dynamics, and the Macroeconomy

IMF Working Papers, September 25, 2020

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Authors: Fabian Lipinsky, Mirela S. Miescu
Date: September 25, 2020
Research objective: Develop a macro-financial structural model to analyze links between the financial sector and the real economy.
Two novel model features:
- Inclusion of idiosyncratic and aggregate risk in a tractable general equilibrium model to capture sectoral dynamics, probabilities of default of both firms and financial intermediaries, and the feedback between them.
- Introduction of sticky (observed) versus flexible (agents’ target) capital, defining capital gaps as the differences between realized and optimal values for firms and banks.

Capital gaps of firms and banks:
- Lead financial and business cycles.
- Cause gaps in credit spreads and asset prices.
Model applications:
- Can be used as a signaling device for macroprudential intervention.
- Can gauge whether macroprudential action was successful ex-post (for example, whether gaps were closed).
Empirical illustration:
- The analysis of gaps is applied to the U.S. economy using Bayesian estimation techniques.

Macroprudential signaling:
- The model provides indicators (capital gaps, credit spread gaps, asset price gaps) that can inform the timing and design of macroprudential interventions.
Ex-post evaluation:
- The framework allows assessment of whether policy interventions closed observed capital gaps.

Subject: Credit, Financial crises, Financial statements, Mutual funds, Nonbank financial institutions
Keywords: adjustment cost, capital gap, capital level, cash flow, FIs capital, risk shock, WP