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Banks' Precautionary Capital and Credit Crunches

Fabián Valencia

International Monetary Fund (IMF) ; Princeton University

April 1, 2012

Macroeconomic Dynamics, Forthcoming

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 non-linear 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.

Number of Pages in PDF File: 36

Keywords: Financial Frictions, Credit Crunch, Precautionary Motive

JEL Classification: C61, E32, E44

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Date posted: December 13, 2008 ; Last revised: March 22, 2013

Suggested Citation

Valencia, Fabián, Banks' Precautionary Capital and Credit Crunches (April 1, 2012). Macroeconomic Dynamics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1311897 or http://dx.doi.org/10.2139/ssrn.1311897

Contact Information

Fabian V. Valencia (Contact Author)
International Monetary Fund (IMF) ( email )
700 19th Street, N.W.
Washington, DC 20431
United States
Princeton University ( email )
22 Chambers Street
Princeton, NJ 08544
United States

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