A Unified Approach to Credit Crunches, Financial Instability, and Banking Crises

We link banking and asset prices in a simple monetary macroeconomic model. Our main innovation is to consider how wide-spread default affects the banking system. We find that the interaction of credit, asset prices, and loan losses explains a complete spectrum of outcomes, including financial extremes for which separate theories were thought to apply. When fundamentals deteriorate, an asset price decline causes default among leveraged firms, and banks suffer loan losses. Their size determines whether a capital crunch, financial instability, or a banking crisis occurs. But self-fulfilling capital crunches and banking crises are also possible when loan losses force a credit contraction that feeds back onto asset prices. This model, unlike others, distinguishes between financial and macroeconomic stability, and derives explicit solutions and balance sheet effects even far from the steady state. It is applied to Japan’s Lost Decade and to the US Great Depression. It also sheds light on the role of asset prices in monetary policy, and on the procyclical effect of capital adequacy requirements.