Capital Flows in the Financial System and Supply of Credit

73 Pages Posted: 18 May 2021 Last revised: 23 Jun 2021

Date Written: May 17, 2021

Abstract

This paper develops a model to study how capital flows in the financial system affect banks’ coordination problem in the credit supply process. The economy is susceptible to self-fulfilling credit freezes: banks abstain from lending when they fear that other banks will withhold lending, and the resultant credit contraction impedes economic growth. Capital flows across banks can alleviate the problem by enabling optimistic banks to borrow from pessimistic banks and extend more credit to the real economy. However, the equilibrium interest rate reveals public information about economic fundamentals and banks’ aggregate willingness to lend, increasing the fragility of the credit market. As a result, the economy can get stuck in an equilibrium where both interbank capital flows and the real credit supply freeze and they reinforce each other through a vicious feedback loop. Regulations addressing counterparty risks can help to maintain active capital flows in the financial system and stabilize the real credit market.

Keywords: Credit Supply, Coordination, Capital Flows

JEL Classification: G01, G21, G28

Suggested Citation

Shen, Lin, Capital Flows in the Financial System and Supply of Credit (May 17, 2021). Available at SSRN: https://ssrn.com/abstract=3847983 or http://dx.doi.org/10.2139/ssrn.3847983

Lin Shen (Contact Author)

INSEAD ( email )

Boulevard de Constance
77305 Fontainebleau Cedex
France

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