Department of Economics Brown Bag with Dr Giacomo Cattelan The Interaction of Capital Constraints and Financial Volatility

Abstract: This paper presents new evidence on how the countercyclicality of excess returns is driven by the interaction between the financial sector's balance sheet conditions and uncertainty shocks. Using a nonlinear specification of the local projection method to estimate impulse response functions, I find that the effects of shocks to various volatility indices — both on excess returns and real economic variables — are amplified when the financial sector was under-capitalized prior to the shock. These empirical findings are replicated by a macro-finance general equilibrium model that incorporates an occasionally constrained financial sector as in Gertler and Karadi (2011). The model introduces a novel source of uncertainty, modeled as a stochastic component affecting the total external funding available to financial intermediaries. When this “financial uncertainty” increases, it raises the likelihood that intermediaries' financial constraints will bind, triggering precautionary deleveraging. This, in turn, leads to a surge in excess returns and a decline in economic activity, effects that grow in magnitude as intermediaries' capitalization weakens.