A Theory of Banking Crises (Part 1)

In order to protect the public's confidence in deposit money, governments usually guarantee bank deposits implicitly or through an explicit deposit insurance system. Thus bank insolvency does not induce immediate bank runs. In many episodes of banking crises, several years passed quietly after bank insolvency had occurred, with the insolvency continuing to develop under the surface, and the rash of bank failures broke out only when the bank insolvency exceeded a certain level. In this paper I present a simple model that describes the dynamics of bank insolvency in a form that eventually results in banking system failure or bank recapitalization by the government. The main results are as follows: (1) The government cannot indefinitely postpone recognizing the fiscal loss associated with bank insolvency. (2) The consumption level is too high (low) before (after) bank recapitalization compared with the optimal level. Thus the price conditions become deflationary (inflationary) before (after) bank recapitalization. (3) Social welfare decreases as bank recapitalization is delayed.