Asset Prices and Banking Distress: A Macroeconomic ApproachAbstract: This paper links banking with asset prices in a monetary macroeconomic model. The main innovation is to consider how falling asset prices affect the banking system through wide-spread borrower default, while deriving explicit solutions and balance sheet effects even far from the steady state. We find that the effect of falling asset prices is indirect, non-linear, and involves feedback from the banking system in the form of credit contraction. When borrowers repay, the effect ‘passes through’ the bank balance sheet; once borrowers default, asset prices drive bank capital, and constrained credit in turn drives asset prices. This interaction can explain capital crunches, financial instability, and banking crises, either as fundamental or as self-fulfilling outcomes. This model, unlike others, distinguishes between financial and macroeconomic stability, and makes precise the notion of balance sheet vulnerability. It also sheds some light on the role of asset prices in monetary policy and carries regulatory implications. The case studies apply the model to Japan’s Lost Decade, the Nordic Banking Crises, and the US Great Depression. Keywords: Banking; Asset Prices; Inside Money; Default; Non-Performing Loans; Capital Requirements; Credit Crunch; Financial Instability; Banking Crisis; Vulnerability. (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0411034 Access Statistics for this paper More papers in Finance from EconWPA |
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