Uncertainty and Investment: The Financial Intermediary Balance Sheet Channel

IMF Working Papers, March 20, 2015

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Rollover risk imposes market discipline on banks’ risk-taking behavior but it can be socially costly.
When the bank is capital constrained, uncertainty in asset quality and rollover risk create a negative externality that spills over to the real economy by ex ante credit contraction.
Macroprudential and monetary policies can be used to reduce the social cost of market discipline and improve efficiency.

Two-sided model setup:
- A bank simultaneously lends to a firm and borrows from the short-term funding market.
- Bank faces uncertainty in asset quality and rollover risk.
Economic channel:
- Capital constraints amplify the effect of uncertainty and rollover risk.
- The interaction generates a negative externality that reduces credit supply before uncertainty is resolved (ex ante credit contraction).
Frictions and constraints emphasized in the model:
- Asset portfolio composition and asset quality uncertainty.
- Short-term debt and rollover risk in the funding market.
- Incentive compatibility constraint tied to bank financing and bank-creditor contracts.
- Liquidity needs and liquidity requirements.

Use macroprudential policies to mitigate the social cost of market discipline arising from rollover risk and balance-sheet constraints.
Use monetary policy as a complementary tool to improve efficiency when rollover risk and capital constraints lead to underinvestment.
Policy interventions target:
- Reducing the negative externality from uncertainty and rollover risk on credit supply.
- Alleviating capital constraints or smoothing funding conditions to prevent ex ante credit contraction.