Macroeconomic Dynamics

Articles

BANKS' PRECAUTIONARY CAPITAL AND CREDIT CRUNCHES

Fabián Valencia 

International Monetary Fund

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 Frictions;
  • Credit Crunch;
  • Precautionary Motive

Correspondence

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

Footnotes

  I am especially grateful to Christopher Carroll for his guidance and encouragement throughout graduate school. I would also like to thank Lawrence Ball, William Barnett (the editor), Allen Berger, Markus Brunnermeier, Jon Faust, an anonymous referee, and seminar participants at the Johns Hopkins University, the Bank of Canada, the International Monetary Fund, the Board of Governors of the Federal Reserve System, and the 2009 Financial Intermediation Research Society Conference for helpful comments. The views expressed in this paper are solely those of the author and do not represent the views of the IMF or IMF policy.

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