Self-fulfilling Credit Market Freezes

This article develops a model of a self-fulfilling credit market freeze and uses it to study alternative governmental responses to such a crisis. We study an economy in which operating firms are interdependent, where their success depends on the ability of other operating firms to obtain financing. In such an economy, an inefficient credit market freeze may arise in which banks abstain from lending to operating firms with good projects because of their self-fulfilling expectations that other banks will not be making such loans. Our model enables us to study the effectiveness of using alternative measures as a means of getting an economy out of an inefficient credit market freeze. In particular, we study the effectiveness of interest rate cuts, an infusion of capital into banks, direct lending by the government to operating firms, and the provision of government capital or guarantees to encourage privately managed lending. Our analysis provides a framework for analyzing and evaluating the standard and nonstandard instruments used by authorities during the 2008--2009 financial crisis. Our analysis also provides testable implications for how firms, banks, and economies can be expected to be affected by shocks to the banking system. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.