Abstract:-

What are the effects of bank shocks in an economy featuring bank-firm lending relation-
ships and what is the propagation mechanism? This paper builds a dynamic general equi-
librium model in which collateral-constrained entrepreneurs have endogenously-persistent

credit relationships with banks. A bank shock in this model takes the form of a negative
shock to loan repayments and drives up credit spread. Bank credit falls and a downturn in
macroeconomic activity ensues. These effects are initially amplified by presence of lending
relationships but macroeconomic activity later recovers faster boosted by recovery in bank
loans. When credit relationships are turned off, the model predicts prolonged slowdown in

investment, consumption and output. These results indicate how borrower-lender relation-
ships can act both as financial accelerator and as an economic stabilizer.