Bubbles, banks and financial stability

Asset price bubbles are considered to be a major risk to financial stability. In this article, we show that an asset price bubble poses a bigger risk when banks are exposed to it. This is because when the bubble bursts, banks realise losses and this may trigger bank failures and a credit crunch. In contrast, when overvalued assets are held by ordinary savers, the consequences for financial stability are less severe. We show that low bank profitability and a generous financial safety net for banks are important determinants in their decisions to take risks. JEL Classification: G0