Bank intermediation over the business cycle

A model is developed in which banks engage in valued asset transformation by converting illiquid assets (working capital loans) into highly liquid demand deposit accounts that households use for transactions purposes. Consumption-smoothing behavior induces countercyclicality in the degree to which firms rely on bank borrowings to finance their working capital expenses, which is consistent with U.S. data. The importance of financial markets that provide alternative sources of short-term funds to firms is also illustrated. Absent these markets, nominal interest rates become nearly perfectly positively correlated with output, which is counterfactual, and monetary shocks induce (perhaps, artificially) large aggregate employment responses.