Banks' Precautionary Capital and Credit Crunches

37 Pages Posted: 18 Dec 2008

See all articles by Fabián Valencia

Fabián Valencia

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2008

Abstract

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.

Keywords: Banking crisis, Bank credit, External shocks, Liquidity management, Financial risk, Economic models

Suggested Citation

Valencia, Fabian V., Banks' Precautionary Capital and Credit Crunches (October 2008). IMF Working Papers, Vol. , pp. 1-35, 2008. Available at SSRN: https://ssrn.com/abstract=1316716

Fabian V. Valencia (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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