Bank Due Diligence in the Business Cycle

This paper studies the interaction between bank monitoring and liquidity and its impact on business cycle transmission. We develop a dynamic general equilibrium model with endogenous loan monitoring and constrained banks in retail and wholesale liquidity markets. Liquidity shortages and loan portfolio values govern banks' monitoring incentives and productivity. Calibrating the model to U.S. data reveals that banks monitoring acts as a countercyclical attenuator of aggregate liquidity shocks but as an amplifier of capital shocks that erode loan portfolio values. Credit policies can temporarily dilute stabilizing effects of bank monitoring. The model predictions are broadly consistent with granular evidence on 200 U.S. banks over 1995-2015.