The Asymmetric Bank Distress Amplifier of Recessions

This dissertation makes empirical, theoretical and quantitative contributions to the growing literature on financial amplification. Empirically, it documents that financial crises are characterized by asymmetric bank distress---the concentration of losses on a subset of banks---and that this is a feature evident in U.S. and international data. Theoretically, it proposes a model in which banks are heterogeneous, exposed to non-diversifiable borrower default risk, and constrained in raising external funds. Adverse shocks to borrowers raise default risk and thereby reduce the value of banks’ loan portfolios, especially for those heavily exposed to those borrowers. This asymmetry in bank distress amplifies economic downturns through two channels. First, the concentration of losses on some banks causes costly bank failures, reducing the aggregate net worth of banks. Second, it impairs banks' leverage capacity by raising uncertainty about the repayment capacity of banks due to asymmetric information between banks and depositors. Quantitatively, the model predicts that financial amplification via the asymmetric bank distress mechanism contributed significantly to the fluctuations in macro and financial variables observed in the Great Recession. In comparison to a standard Bernanke-Gertler setup, the addition of asymmetric bank distress doubles the decline in investment and produces 2.5 times the rise in spreads.