Interactions between bank-specific risk and macroeconomic performance

The global financial crisis has demonstrated that financial markets and the real economy are closely related. We have learned that risk at the level of individual financial institutions can harm the stability of the financial system as a whole. This, in turn, affects macroeconomic performance and potentially slows down economic recovery. In this project, we will investigate how risk at the level of large banks and macroeconomic performance, as measured by GDP growth or volatility, are related. To that goal, we will build on the theory of granularity. This theory reveals that volatility at the level of individual firms can translate into macroeconomic fluctuations if market concentration is high. Moreover, we will explore how regulatory policy affects the link between bank-level and systemic risk. In order to analyze how bank-specific shocks, financial regulation and macroeconomic performance are interrelated, we will address the following research questions:

1. How do credit supply shocks at the bank-level contribute to systemic risk at the regional,
country and international level (Module 1)?
2. How does a regulatory change that affects the competitive environment of banks impact
bank risk and macroeconomic performance (Module 2)?
3. What role does bank size play for risk at the bank-level and how is this link affected by
financial regulation (Module 3)?

Our project results will provide evidence to inform the current debate on micro- and macroprudential regulation. According to the concept of granularity, macroeconomic volatility can be reduced via two channels. On the one hand, microprudential regulation, i.e. regulation at the level of individual (large) banks, can reduce macroeconomic instability: If large banks get less risky, macroeconomic volatility is ceteris paribus mitigated. Our research aims at identifying specific policy tools that help to mitigate the volatility (or risk) at the bank-level. On the other hand, macroprudential policies that monitor the development of bank market structures like concentration are important; the higher concentration, the stronger gets the transmission of bank-level shocks to the aggregate economy. Moreover, concentration and competitive pressures in the banking system impact banks risk-taking behavior and hence bank-specific volatility. Consequently, micro- and macro-prudential regulation should be coordinated in order to address possible trade-offs between stability at the micro- and macroeconomic level. In this project, we aim at addressing these inter-linkages between bank-specific risk, the competitive environment and macroeconomic performance.