Financial crises in emerging markets: a canonical model

We present a simple model that can account for the main features of recent financial crises in emerging markets. The international illiquidity of the domestic financial system is at the center of the problem. Illiquid banks are a necessary and a sufficient condition for financial crises to occur. Domestic financial liberalization and capital flows from abroad (especially if short-term) can aggravate the illiquidity of banks and increase their vulnerability to exogenous shocks and shifts in expectations. A bank collapse multiplies the harmful effects of an initial shock, as a credit squeeze and costly liquidation of investment projects cause real output drops and collapses in asset prices. Under fixed exchange rates, a run on banks becomes a run on the currency if the central bank attempts to act as a lender of last resort.Banks and banking, Central ; International finance ; Liquidity (Economics) ; Monetary policy ; Money supply

A Twin Crisis Model Inspired by the Asian Crisis

In this paper, we propose a twin crises synthetic model. We show that there may be multiple equilibria on the exchange market as well as on the international financial one and emphasize the possible connections between currency and financial crises. On the exchange market, the currency devaluation is the outcome of a trade-off by the government in presence of implicit safety nets of the banking sector. The crisis occurs whenever the anticipated devaluation rate by the market is equal to the "optimal" devaluation rate of the government. As far as the international financial market is concerned, the passage from one equilibrium to another is triggered by the evolution of the ratio Currency Reserves/Short Term Debt as a fundamental factor. Combining bank run dynamics and fundamental factors, we aim at reconciling the two major interpretations of currency and banking crises, namely the fragility of emerging financial systems and the ex-post worsening of domestic fundamentals originating in debtors or domestic government moral hazard.twin crises models, multiple equilibria, bank runs, capital flows

The Diamond-Rajan Bank Runs in a Production Economy

To analyze the macroeconomic consequences of a systemic bank run, we integrate the banking model `a la Diamond and Rajan (2001a) into a simplified version of an infinite-horizon neoclassical growth model. The banking sector intermediates the collateral-secured loans from households to entrepreneurs. The entrepreneurs also deposit their working capital in the banks. The systemic bank run, which is a sunspot phenomenon in this model, results in a deep recession through causing a sudden shortage of the working capital. We show that an increase in the probability of occurrence of the systemic run can persistently lower output, consumption, labor, capital and the asset price, even if the systemic run does not actually occur. This result implies that the slowdown of economic growth after the financial crises may be caused by the increased fragility of the banking system or the raised fears of recurrence of the systemic runs.

Financial imbalances and financial fragility

This paper develops a general equilibrium model to analyze the link between financial imbalances and financial crises. The model features an interbank market subject to frictions and where two equilibria may (co-)exist. The normal times equilibrium is characterized by a deep market with highly leveraged banks. The crisis times equilibrium is characterized by bank deleveraging, a market run, and a liquidity trap. Crises occur when there is too much liquidity (savings) in the economy with respect to the number of (safe) investment opportunities. In effect, the economy is shown to have a limited liquidity absorption capacity, which depends —inter alia— on the productivity of the real sector, the ultimate borrower. I extend the model in order to analyze the effects of financial integration of an emerging and a developed country. I find results in line with the recent literature on global imbalances. Financial integration permits a more efficient allocation of savings worldwide in normal times. It also implies a current account deficit for the developed country. The current account deficit makes financial crises more likely when it exceeds the liquidity absorption capacity of the developed country. Thus, under some conditions —which this paper spells out— financial integration of emerging countries may increase the fragility of the international financial system. Implications of financial integration and global imbalances in terms of output, wealth distribution, welfare, and policy interventions are also discussed. JEL Classification: E21, F36, G01, G21Asymmetric information, financial crisis, financial integration, global imbalances, Moral Hazard

Bank panics in transition economies

This paper discusses recent bank runs in seven transition economies (Russia, Bulgaria, Estonia, Hungary, Latvia, Lithuania and Romania), comparing them against the older US experience and theoretical research. Bank runs seem to usually be information based. For example, improvements in bank transparency such as new accounting rules can reveal a bank’s insolvency and trigger a run. However, bank runs, as seen a few years ago in East Asia, Bulgaria and Russia, may also be accompanied by runs on national currencies. We include a bank run model that shows a bank may issue liquid demand deposits and avoid runs without deposit insurance as long as it also issues less liquid time deposits. Self-fulfilling runs are prevented through elimination of the maturity mismatch. The well-known Diamond & Dybvig (1983) model is modified to account for depositors’ risk affinities, whereby high-risk depositors hold their savings as demand deposits and low-risk depositors prefer time deposits. These deposit choices transfer liquidity optimally from low-risk to high-risk depositors who value liquidity. By exploiting these choices, a bank can improve its intertemporal risk-sharing by issuing deposits of varying degrees of liquidity. This maturity transformation does not necessarily raise the economy’s total liquidity.ansition economies; bank panics; bank regulation; financial crises

Bank Runs in Open Economies and The International Transmission of Panics

In this paper, we extend the bank run literature to an open economy model. We show that a foreign banking system, by raising deposit rates in the presence of a domestic banking panic, may generate sufficient liquid resources to acquire assets sold by the domestic banking system at bargain prices. In this case, foreign depositors will benefit from the domestic panic. We also show that our simple model is able to generate the spreading of panics. Perhaps not surprisingly, the crucial element in determining the propagation of financial crises is the effect of interest rates on savings decisions.

The relationship between financial crises and South African bank lending activities

Financial assets, and particularly fiat money, play a critical role in the prosperity of an economy. Its health therefore becomes the cornerstone of an economy, as asserted by modern financial intermediation theory. Fundamentally, as established by literature, crises affect bank balance sheets and subsequently banks’ ability to provide credit, thereby restricting investment, capital and asset growth, aggregate output, and eventually national income. This study conclusively establishes the relationship between financial crises and the South African bank lending activities. It describes this relationship, concluding that crises and bank lending have a negative short run relationship and positive long run relationship. The study gives a brief background of recent crises that were experienced by different economies in the world. The study uses South African quarterly data for the period 1996 to 2015, where it employs a VECM model that gives empirics to the effect that lending is indeed negatively affected by financial crises, but only in the short run. This is due to the South African Reserve Bank, through its monetary policy, cushioning the banking sector against the detrimental effects of economic distress. The study recommends that given the indebtedness of South Africa relative to GDP growth, to avoid credit downgrades and disinvestment in the long run, government should focus on improving GDP growth rather than debt; and should establish a policy framework that centralises operational transactions in order to reduce the effect of crises on real output

Monetary Policy and Endogenous Financial Crises

We study whether a central bank should deviate from its objective of price stability to promote financial stability. We tackle this question within a textbook New Keynesian model augmented with capital accumulation and microfounded endogenous financial crises. We compare several interest rate rules, under which the central bank responds more or less forcefully to inflation and aggregate output. Our main findings are threefold. First, monetary policy affects the probability of a crisis both in the short run (through aggregate demand) and in the medium run (through savings and capital accumulation). Second, a central bank can both reduce the probability of a crisis and increase welfare by departing from strict inflation targeting and responding systematically to fluctuations in output. Third, financial crises may occur after a long period of unexpectedly loose monetary policy as the central bank abruptly reverses course

Essays on financial crises and bank capital regulation

This thesis consists of three chapters, all of which contribute to the literature on financial crises and bank capital regulation. A common feature of the quantitative models in the three chapters is the endogenous bank run equilibrium a la Gertler and Kiyotaki (2015). Chapter 1 studies the cost and benefit of retail bank capital requirements in an economy with both retail and shadow banks, where financial crises take the form of shadow bank runs. Chapter 2 compares the effect of three macroprudential policies on financial stability in an economy with intertwined housing and banking crises. Chapter 3 analyzes the macroeconomic effects of the policy combination of bank capital requirement (an ex-ante intervention policy) and credit easing (an ex-post intervention policy). Chapter 1 is co-authored with Johannes Poeschl. Chapter 2 is a joint work with Johannes Poeschl and Marcus Molbak Ingholt. Chapter 3 is single-authored. Chapter 1, titled Endogenous Shadow Banking Crises and Bank Capital Regulation, sheds light on the optimal level and dynamic design of retail bank capital requirements in an economy with two banking sectors – retail and shadow banking. Systemic banking crises occur endogenously in the form of self-fulfilling runs on shadow banks. A negative externality exists, as banks do not internalize the effects of their leverage choices on the probability of bank runs, creating a role for government interventions, e.g., through bank capital requirements. We show that a dynamic capital requirement, which requires retail banks to build up capital buffers during normal times and allows the buffers to be depleted during a bank run, can reduce the frequency and severity of systemic banking crises. We highlight the importance of relaxing the capital requirement in a timely manner when a bank run happens. Otherwise, the capital requirement would restrict the retail banks’ ability to absorb liquidated assets of shadow banks, resulting in more frequent and more severe banking crises. Meanwhile, tightening the capital requirement leads to less financial intermediation and shifts banking activities from retail to shadow banks. Based on our calibration, we find retail bank capital requirements undesirable, as the welfare cost of less financial intermediation outweighs the benefit of fewer bank runs. Chapter 2 is titled Housing, Financial Crises and Macroprudential Regulation: The Case of Spain. Based on the observation of the intertwined housing and banking crisis in Spain between 2008 and 2016, our objective is to study the effectiveness of different macroprudential regulation policies in preventing crises of this kind. We develop a dynamic stochastic general equilibrium (DSGE) model in which we introduce a housing market and mortgage credit while keeping the mechanism of banking crises as in Chapter 1. However, instead of distinguishing retail and shadow banking, we simplify the model by including only one banking sector in the economy. The equilibrium mortgage credit allocation in the economy is determined either by a capital requirement on the banks or a loan-to-value (LTV) constraint on the borrowers. Large drops in the house price (housing crises) occur endogenously and can lead to runs on the banking sector (banking crises). We calibrate the model to match the Spanish economy in 2007-2017. We find that all three macroprudential policies can reduce the mortgage default rate and the frequency of bank runs, but the effect is stronger with the higher capital requirement and the tighter LTV constraint. Dynamic loan loss provisioning is effective at reducing the cyclicality of the capital structure of banks, while a tighter LTV constraint amplifies the cyclicality of bank and household leverage. Chapter 3 is titled Capital Requirements and Credit Easing: Ex-ante vs Ex-Post Intervention Policy. In the first two chapters, the policy focus is on ex-ante macroprudential policies, which are designed to improve financial stability and prevent potential financial crises in the future. In this chapter, I turn to ex-post intervention policies. In particular, I introduce a credit easing policy by the central bank to an economy with endogenous banking crises similar to Chapter 1 but has only one banking sector. I show that bank capital requirements and credit easing policies exhibit very different trade-offs. In particular, tightening bank capital requirements effectively reduces bank leverage but leads to less financial intermediation. For the credit easing policy, I highlight an unintended ex-ante effect: it decreases the banks’ risk premium in a financial crisis, resulting in more leverage taking of banks and a higher frequency of bank runs. Nonetheless, the credit easing policy facilitates financial intermediation in both normal and crisis periods and stabilizes asset prices during financial crises. A combination of the two policies can offset their respective negative effects, reducing the frequency and severity of financial crises while maintaining efficient financial intermediation in the economy. The thesis is structured as follows. The quantitative model and main findings of each chapter are presented in respective Chapters 1 to 3. Data sources, full statement of the model equilibrium, and numerical solution algorithms for Chapter 1 and 2 are gathered in Appendices A and B, respectively. All the references are in Bibliography

DETERMINANTS OF THE FUNDING VOLATILITY OF INDONESIAN BANKS: A DYNAMIC MODEL

Illiquidity is at the core of the various currency and banking/financial crises of the 1990s. In the wake of the Asian crisis of 1997/98 the term "systemic liquidity" has been coined to refer to adequate arrangements and practices which permit efficient liquidity management and which provide a buffer during financial distress. A constructed balance-sheet-based variable that captures the essence of the risk from systemic liquidity is funding volatility ratio, FVR. Using data covering January 1990 to July 2003 and employing cointegration techniques, this study attempts to quantify the purported link between FVR and the measurable determinants of a balanced liquidity infrastructure for Indonesia, the country that suffered the most from the Asian crisis. A good fit is obtained for the dynamic regression model and estimates of short-run and long-run impacts and elasticities are computed. FVR is shown to be increasing in the rupiah-US dollar exchange rate, the Jakarta stock market index, interest rate and the number of banks, and decreasing in capital:asset ratio and foreign liabilities: total asset ratio. The best option for lowering the FVR in the short run is increasing bank capital; over the long term enduring increases in foreign-currency accounts and reduction in the number of banks seem to hold the best prospect for lowering the FVR.autoregressive distributed lag model, cointegration, funding volatility ratio, systemic liquidity, Financial Economics, C22,