Ebook A Unified Approach to Credit Crunches, Financial Instability, and Banking Crises
The essence of central banking lies in the pursuit of macroeconomic and financial stability. There are complete models of macroeconomic stability, and a reasonably broad consensus on how to achieve it. Not so for financial stability. There is no widely accepted model, much less a consensus on how to achieve it even the definition is a matter of debate. This is disturbing, given the frequency with which financial instability has befallen the world in the last 25 years, often with devastating productive and redistributive consequences.
This paper extends the reach of macroeconomics to financial instability in a very simple and explicit way. We depart from Kiyotaki and Moore’s (1997) model of credit cycles. They consider leveraged firms, and how their exposure to asset prices generates macroeconomic dynamics. We believe that taking the route of leverage and asset prices is even more promising for understanding financial stability, the other dimension of central banking.
To push the theory in this direction, we focus on a new element: losses to the financial system. To do so, we integrate a banking system. Our main innovation is to allow for wide-spread default among bank borrowers following a decline in asset prices. We then ask how loan losses affect the banking system, and how the state of the banking system in turn affects the economy. We find that the interaction of credit, asset prices, and loan losses provides a unified approach for explaining capital crunches, financial instability, and banking crises.
In spite of their empirical relevance, loan losses have not previously been endogenized. They measure the transfer of losses from defaulting borrowers to the banking system. Being themselves indebted, banks cannot absorb them indefinitely. Loan losses of a certain size constrain bank lending [capital crunch]; larger losses cause an unstable contraction of credit [financial instability], which propels the system toward insolvency [banking crisis]. At that point, the credit and payment mechanisms cease to function.
Contents
1 Introduction
2 The Basic Model
- 2.1 Set-up
- (1) Firms
(2) Households
(3) The Banking System
2.2 Perfect Foresight Equilibrium
3 Fundamental Equilibrium with Default
- 3.1 Reactions to the Productivity Shock
- (1) New Firms and Asset Prices
(2) Old Firms and Debt Deflation
(3) The Banking System and Loan Losses
3.2 Fundamental Equilibrium
4 Financial Extremes
- 4.1 Capital-Constrained Equilibrium
4.2 Capital Crunches and Banking Crises
4.3 Financial Instability
4.4 Vulnerability
5 Applications
- 5.1 Case Study I: Japan’s Lost Decade
5.2 Case Study II: The US Great Depression
5.3 Policy Debate I: Monetary Policy and Asset Prices
5.4 Policy Debate II: Procyclical Effect of Capital Adequacy Requirements
5.5 Conclusion
References
Appendix
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