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Asset Prices and Banking Distress: A Macroeconomic Approach

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Author Info
Goetz von Peter (Columbia University & Bank for International Settlements)

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Abstract

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.

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Paper provided by EconWPA in its series Finance with number 0411034.

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Length: 46 pages
Date of creation: 12 Nov 2004
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Handle: RePEc:wpa:wuwpfi:0411034

Note: Type of Document - pdf; pages: 46
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Web page: http://129.3.20.41

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Related research
Keywords: Banking; Asset Prices; Inside Money; Default; Non-Performing Loans; Capital Requirements; Credit Crunch; Financial Instability; Banking Crisis; Vulnerability.;

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Find related papers by JEL classification:
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Eric Wong & Cho-Hoi Hui, 2009. "A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks," Working Papers 0906, Hong Kong Monetary Authority. [Downloadable!]
  2. Mejra Festić, 2006. "Procyclicality Of Financial And Real Sector In Transition Economies," Prague Economic Papers, University of Economics, Prague, vol. 2006(4), pages 315-349. [Downloadable!] (restricted)
  3. Livio Stracca, 2007. "Should we take inside money seriously?," Working Paper Series 841, European Central Bank. [Downloadable!]
  4. Jan Willem van den End, 2008. "Liquidity Stress-Tester: A macro model for stress-testing banks' liquidity risk," DNB Working Papers 175, Netherlands Central Bank, Research Department. [Downloadable!]
  5. Pesola , Jarmo, 2005. "Banking fragility and distress: An econometric study of macroeconomic determinants," Research Discussion Papers 13/2005, Bank of Finland. [Downloadable!]
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