The Funding Gap in the Credit Cycle

I build a dynamic stochastic general equilibrium model with endogenous financial intermediary leverage and costly state verification to study credit cycle dynamics. Intermediary leverage is driven by a trade-off between costly bank capital and a benefit of capital as a buffer against adverse shocks. Capital is costly because it is wiped out when borrowers default, whereas deposits are insured. On the other hand, higher capital reduces the bank's `funding gap' in times of distress. Changes in this funding gap drive the intermediary credit supply. The model displays three active credit channels: the business conditions channel, the bank net worth channel, and the funding cost channel. I show that the business conditions channel is active, and that credit supply is influential in times of credit contractions. The model delivers empirically observed procyclical credit conditions. 

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