Banks, Capital Flows and Financial Crises
45 Pages Posted: 29 Nov 2014
Date Written: October 29, 2014
This paper proposes a macroeconomic model with financial intermediaries (banks), in which banks face occasionally binding leverage constraints and may endogenously affect the strength of their balance sheets by issuing new equity. The model can account for occasional financial crises as a result of the nonlinearity induced by the constraint. Banks' precautionary equity issuance makes financial crises infrequent events occurring along with "regular" business cycle fluctuations. We show that an episode of capital in flows and rapid credit expansion, triggered by low country interest rates, leads banks to endogenously decrease the rate of equity issuance, contributing to a higher likelihood of future crises. Macroprudential policies directed at strengthening banks' balance sheets, such as capital requirements, are shown to lower the probability of financial crises and to enhance welfare.
Keywords: Financial Intermediation; Sudden Stops; Leverage Constraints; Occasionally Binding Constraints.
JEL Classification: E32; F41; F44; G15
Suggested Citation: Suggested Citation