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BANKS' PRECAUTIONARY CAPITAL AND CREDIT CRUNCHES

Published online by Cambridge University Press:  12 June 2013

Fabián Valencia
Fabián Valencia*
Affiliation:
International Monetary Fund
*
Address correspondence to: Fabían Valencia, International Monetary Fund, 700 19th Street N.W., Washington, DC 20431, USA; e-mail: fvalencia@imf.org.
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Abstract

This paper develops a bank model to study supply-driven contractions in credit or credit crunches. In the model, the bank is affected by financial frictions in raising external funds. These frictions imply that the bank repairs its balance sheet only gradually following a negative shock that weakens the bank's capital position. Consequently, there is persistency in the response of bank lending even when the original shock (productivity or interest rate) is i.i.d. The nonlinear nature of these financial frictions also generates (i) a precautionary motive even with risk-neutral shareholders: the bank increases its desired level of capital if risk increases; (ii) an asymmetric response of lending: negative disturbances can have a bigger impact than positive ones; and (iii) volatility clustering in risk spreads and the bank's share price.

Keywords

Financial FrictionsCredit CrunchPrecautionary Motive
Type
Articles
Information
Macroeconomic Dynamics , Volume 18 , Issue 8 , December 2014 , pp. 1726 - 1750
Copyright
Copyright © Cambridge University Press 2013 

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