How Much and When Did Financial Vulnerabilities Influence the Evolution of the Great Recession?

Abstract

In many parts of the world, banks entered the Great Recession with high leverage and reliance on short-term wholesale funding, rendering them vulnerable to economic setbacks. Did these vulnerabilities influence the evolution of the Great Recession? To answer that question, this thesis examines whether the vulnerabilities were systematically correlated with forecast errors of the real GDP growth in a cross-section of countries over the period 2008- 2012 after controlling for macroeconomic factors such as trade linkages, the output gap and fiscal consolidation. I find that the correlates of growth forecast errors evolved as the crisis progressed. High reliance on short-term funding amplified the downturn at the beginning of the crisis, especially in the Eurozone and emerging economies. High leverage, coupled with austerity measures, undermined growth recovery during the later years of the Great Recession. These results provide added empirical support for enhanced regulatory capital requirements and current initiatives to regulate funding structures under the framework of Basel III.