The Impact of Banking Distress on Economic Activity: We Review a Comprehensive Analysis by Falk Bräuning and Viacheslav Sheremirov
When you hear about banking problems, remember that they can have a big impact on our economy. By understanding these effects, we can make better decisions to keep our economy strong and stable. Bräuning & Sheremirov from the Federal Reserve Bank of Boston (members can see the source link at the bottom of this post.)
A new study by Falk Bräuning and Viacheslav Sheremirov sheds light on the historical effects of banking distress on economic activity. The research finds that a systemic banking crisis has a significantly larger contractionary effect on output and employment compared to non-systemic financial distress.
Low-Level Banking Distress Economic Analysis
Falk Bräuning and Viacheslav Sheremirov. The Historical Effects of Banking Distress on Economic Activity. A systemic banking crisis has two to four times larger contractionary effects on output and employment compared with an episode of non systemic financial distress. High corporate leverage exacerbates banking turmoil whereas high bank capitalization and a relatively large share of market financing in corporate debt mitigate it.
The effects of financial distress are amplified by a highly leveraged business sector but dampened if corporate debt is financed by bonds rather than bank loans and if the banking system is well capitalized. The estimation sample covers 16 advanced economies during the 1960 2014 period with the output and unemployment effects analyzed through 2019. Of the 27 financial distress episodes occurring in this sample 10 correspond to a systemic banking crisis.
Non systemic financial distress in the banking system has sizable contractionary effects on real GDP per capita and the unemployment rate. These effects are estimated using lag augmented local projections. The estimated effect on inflation is not as clear and appears to be statistically insignificant.
Non systemic banking distress leads to a larger output decline when the 3non financial business sector is highly leveraged as measured by debt to income. An increase in non financial business debt of 10 percent of GDP amplifies output declines one year after the onset of the financial shock. A higher share of market based financing for example through issuance of corporate bonds relative to bank financing helps mitigate banking distress.
The factors amplifying or dampening the effects of financial distress are not only important for cross country differences but highly relevant for the ongoing domestic policy discussions. The U S economy on the one hand is characterized by historically high corporate leverage. On the other hand the U S banking system is likely better positioned to withstand an adverse financial shock than it was during the 2007 2008 financial crisis.
This study builds on vast academic research studying financial crises. The country coverage follows that in the Macrohistory Database except for Ireland and Switzerland for which the financial distress indicator is not available.
The year 2008 is associated with a systemic banking crisis in six countries in the sample. The 1950 1959 period is not in the estimation sample because it is used for lag controls. The estimated model includes lags of leverage and other variables discussed in this section as control variables.
Explained for a 5th Grader (this is really helpful)
Sometimes, banks can have big problems that affect the economy. When there is a big problem called a systemic banking crisis, it can make things worse for the economy. It can make output (which means how much stuff is made) and employment (which means how many people have jobs) go down a lot, about two to four times more than when there is a smaller problem called non-systemic financial distress.
When companies borrow a lot of money, it can make the banking problems worse. But if the banks have a lot of money and companies borrow from sources other than banks, like by selling bonds, it can help make the banking problems less bad.
This study looked at data from 16 rich countries from 1960 to 2014 to see what happens when there are banking problems. They looked at how it affected output and employment until 2019. Out of the 27 banking problems they studied, 10 of them were big systemic crises.
The study found that even the smaller banking problems can make the economy go down. They used a special way to estimate the effects, and they found that it made the amount of stuff made per person and the number of people without jobs go down. However, they didn't find clear evidence that it affected the prices of things (inflation).
When companies borrow a lot of money and have a hard time paying it back, it can make the economy go down even more. If the companies borrow money from places other than banks and if the banks have a lot of money, it can help make the banking problems less bad.
Knowing what makes the banking problems worse or better is not only important for different countries, but also for deciding what to do in our own country. In the United States, companies have borrowed a lot of money, but the banks are in a better position now to handle problems than they were during the 2007-2008 financial crisis.
This study looked at a lot of research about financial problems in the past. They studied many countries, except for Ireland and Switzerland, because they didn't have the right data for those countries.
They didn't use data from the 1950s because they used it for something else in their study. They also looked at other factors that could affect the economy to make sure their results were accurate.
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