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Banks' Precautionary Capital and Credit Crunches

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  • Fabian Valencia

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.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/248.

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Length: 69
Date of creation: 01 Oct 2008
Date of revision:
Handle: RePEc:imf:imfwpa:08/248

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

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Cited by:
  1. Pierre-Richard Agénor & Koray Alper & Luiz Pereira da Silva, 2009. "Capital Requirements and Business Cycles with Credit Market Imperfections," Centre for Growth and Business Cycle Research Discussion Paper Series 124, Economics, The Univeristy of Manchester.
  2. Fabian Valencia, 2011. "Monetary Policy, Bank Leverage, and Financial Stability," IMF Working Papers 11/244, International Monetary Fund.
  3. Fabian Valencia, 2010. "Bank Capital and Uncertainty," IMF Working Papers 10/208, International Monetary Fund.
  4. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises: A New Database," IMF Working Papers 08/224, International Monetary Fund.

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