A DSGE model of banks and financial intermediation with default risk

This paper takes the view that a major contributing factor to the financial crisis of 2008 was a failure to correctly assess and price the risk of default. In order to analyse default risk in the macroeconomy, a simple general equilibrium model with banks and financial intermediation is constructed in which default-risk can be priced. It is shown how the credit spread can be attributed largely to the risk of default and how excess loan creation may emerge due to different attitudes to risk by borrowers and lenders. The model can also be used to analyse systemic risk due to macroeconomic shocks which may be reduced by holding collateral.