Banks' Precautionary Capital and Credit Crunches

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Author/Editor: Fabian Valencia
Release Date: © October, 2008
ISBN : 978-1-45187-106-7
Stock #: WPIEA2008248
Stock Status: On back-order

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Periods of banking distress are often followed by sizable and long-lasting contractions in bank credit. They may be explained by a declined demand by financially impaired borrowers (the conventional financial accelerator) or by lower supply by capital-constrained banks, a "credit crunch". This paper develops a bank model to study credit crunches and their real effects. In this model, banks maintain a precautionary level of capital that serves as a smoothing mechanism to avert disruptions in the supply of credit when hit by small shocks. However, for larger shocks, highly persistent credit crunches may arise even when the impulse is a one time, non-serially correlated event. From a policy perspective, the model justifies the use of public funds to recapitalize banks following a significant deterioration in their capital position.

More publications in this series: Working Papers

More publications by: Fabian Valencia