From Missing Matches to Macroeconomic Costs
The incomplete European Banking Union becomes a macroeconomic problem only when a missing bank-firm relationship changes what a firm can afford to produce. This chapter reconstructs the paper’s model of that transmission: households supply deposits, banks intermediate funds, banking groups choose where to operate, and firms choose among lenders. The aim is to see why a broader set of available relationships can lower a firm’s effective cost of capital even when the interest-rate difference on an observed foreign loan is modest.
The actors are linked by financing decisions
The model is a spatial general-equilibrium model of the euro area. Its “spatial” feature is not a map for its own sake. Countries matter because households, firms, banks, and banking groups are located in different national environments, and because a group deciding to operate abroad faces a different cost from a bank serving its home market. The economy-wide result emerges from these local choices interacting through wages, deposits, loans, and wholesale funding.
Households begin with liquid wealth and decide where to place deposits. Banks offer deposit rates and bank-specific amenities or non-pecuniary services. A household chooses the bank that offers the most attractive combination, while also choosing consumption and labor supply. The resulting deposit shares determine how much funding each bank receives from households. This matters for cross-border banking because a bank’s ability to intermediate credit depends not only on the demand for loans but also on how it funds its balance sheet.
Firms combine capital and labor to produce output. In the model, output is represented by a production function with firm-specific productivity and diminishing returns. Firms finance their capital spending with loans, potentially from several banks, and decide how much labor and capital to use given wages, the cost of capital goods, and the borrowing conditions offered by banks. Because capital and labor work together, a change in financing conditions can affect both inputs rather than only the amount of credit on a balance sheet.
Default risk is part of the borrowing decision. After production, a firm may default when the savings from repaying less than the full loan exceed its idiosyncratic cost of default. Banks therefore care about expected recovery, while firms care about the risk-adjusted cost of borrowing. A loan rate that includes a credit-risk premium is not the same thing as a risk-free price. The model accounts for expected losses so that the firm’s relevant financing object is the user cost of capital: the cost of obtaining and carrying capital after interest, default risk, and depreciation are taken into account.
Banks intermediate the funds supplied by households and can also use wholesale funding. Their balance sheets connect deposits and loans: if loan demand exceeds deposits, the bank borrows from the wholesale market; if deposits exceed loans, it can invest the excess. Banks set deposit rates and loan rates while taking the wholesale funding rate as given. The loan rate is a bank-level base rate adjusted for bank-firm-specific costs and the borrower’s probability of default.