Financial News, Banks and Business Cycles

Can variations in the expected future return on a portfolio of sovereign bonds itself have real effects on a small open economy? We build a model where banks face a capital sufficiency requirement to demonstrate that news about a fall in the expected return on a portfolio of long bonds can lead to an immediate recession. Even if the news never materializes, the model can generate a severe recession followed by a slow recovery. The presence of long bonds in bank portfolios causes the news to have an immediate impact on bank capital via an immediate fall in bond prices. The portfolio adjustment induced by the capital sufficiency requirements leads to a rise in loan rates while aggregate output, investment and employment collapse. The model contributes to the news-shock literature by showing that imperfect signals about future financial returns can create business cycles without relying on the usual suspects: variation in domestic fundamentals such as technology shocks, preference shocks and fiscal policy. It also contributes to the emerging economy business cycle literature in that disturbances in world financial markets can lead to domestic business cycles without relying on shocks to the world interest rate or to country spreads.