Working Paper

Banks, Capital Flows and Financial Crises

Abstract: This paper proposes a macroeconomic model with financial intermediaries (banks), in which banks face occasionally binding leverage constraints and may endogenously affect the strength of their balance sheets by issuing new equity. The model can account for occasional financial crises as a result of the nonlinearity induced by the constraint. Banks' precautionary equity issuance makes financial crises infrequent events occurring along with \"regular\" business cycle fluctuations. We show that an episode of capital infl ows and rapid credit expansion, triggered by low country interest rates, leads banks to endogenously decrease the rate of equity issuance, contributing to an increase in the likelihood of a crisis. Macroprudential policies directed at strengthening banks' balance sheets, such as capital requirements, are shown to lower the probability of financial crises and to enhance welfare.

Keywords: Financial intermediation; sudden stops; leverage constraints; occasionally binding constraints;

JEL Classification: E32; F41; F44; G15;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2014-11-07

Number: 1121

Pages: 40 pages