Liquidity and Twin Crises

21 Pages Posted: 6 Dec 2005

See all articles by Hyun Song Shin

Hyun Song Shin

Bank for International Settlements (BIS)

Abstract

This paper proposes a simple analytical framework for understanding 'twin crises' - i.e. crises where a currency crisis and banking crisis occur simultaneously and reinforce each other. The distinguishing feature of such crises is the spill-over effects across financial institutions through collateral constraints, declines in market values of assets, currency mismatches on the balance sheet and the endogenous amplification of financial distress through asset sales. We explore the role of liquidity and the role of monetary policy in such crises. In particular, a central question is whether raising interest rates in the face of a twin crisis is the appropriate policy response. Raising interest rates has two countervailing effects. Holding the domestic currency becomes more attractive (other things being equal), but the value of the domestic banking system falls due to the fall in asset prices. When assets are marked to market, there is a potential for endogenously generated financial distress that leads to a collapse of asset prices, as well as the exchange rate. It is thus possible that raising interest rates can have the perverse effect of exacerbating both the currency crisis and the banking crisis.

JEL Classification: F31, G21, G33

Suggested Citation

Shin, Hyun Song, Liquidity and Twin Crises. Economic Notes, Vol. 34, No. 3, pp. 257-277, November 2005. Available at SSRN: https://ssrn.com/abstract=856681 or http://dx.doi.org/10.1111/j.0391-5026.2005.00151.x

Hyun Song Shin (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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