Distress in the Financial Sector and Economic Activity

Abstract

This paper explores the relationship between the health of the financial sector and the rest of the economy. We develop an index of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. Our index spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. We then use vector autoregressions to assess whether our index of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that our index has a considerable impact. Moreover, we find that this financial channel amplifies changes in investment resulting from shocks to non-financial firm profitability.