Productivity Booms, Bank Fragility, and Financial Crises

While financial crises tend to be preceded by economic booms, most booms do not end with crises. Crises typically occur when booms are interrupted by persistent slowdowns in productivity growth. I develop a model in which risk of crisis emerges endogenously during boom because of increased fragility of the banking sector. Banks raise financing from households to invest in long-term projects, but their ability to do so is hindered by moral hazard, since bankers can misappropriate investors’ funds. Demandable deposits create discipline by exposing misbehaving banks to runs, and thus help them increase external financing. Normally, banks finance themselves with a mix of equity and deposits that maximizes discipline, but ensures that they always remain solvent. But when growth prospects become sufficiently strong, worsening agency problems induce banks to intensify deposit financing, which enables a boom in credit, asset prices, and investment. If the anticipated growth fails to materialise, however, the excessive deposit financing leads to a systemic banking crisis.