Banks' Precautionary Capital and Credit Crunches

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 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.

Keywords: Financial Frictions, Credit Crunch, Precautionary Motive

JEL Classification: C61, E32, E44