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The current financial crisis highlights the need to develop DSGE models with real-financial linkages and an active banking sector. This paper proposes a fully micro-founded framework that incorporates optimizing banks, the interbank market, and the credit market into a DSGE model, and evaluates the role of banks and financial shocks in the U.S. business cycles. We assume two types of heterogenous banks that offer different banking services and interact in an interbank market. Loans are produced using interbank borrowing and bank capital subject to the bank capital requirement condition. Banks have monopoly power, set nominal deposit and prime lending rates, choose their portfolio compositions and their leverage ratio, and may endogenously default on fractions of their interbank borrowing and bank capital returns. The model also includes financial and unconventional monetary policy shocks. The main findings are that: (1) The model captures the key features of the U.S. economy; (2) bank behavior substantially affects credit supply conditions and the transmission of different shocks; (3) the banks ’ leverage ratio is procyclical; and (4) financial

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We argue that a firm’s aggregate risk is a key determinant of whether it manages its future liquidity needs through cash reserves or bank lines of credit. Banks create liquidity for firms by pooling their idiosyncratic risks. As a result, firms with high aggregate risk find it costly to get credit lines from banks, and opt for cash reserves in spite of higher opportunity costs and liquidity premium. We verify this hypothesis empirically by showing that firms with high asset beta have a higher ratio of cash reserves to lines of credit, controlling for other determinants of liquidity policy. The effect of aggregate risk on liquidity management is economically significant, and is robust to variation in the proxies for firms ’ exposure to aggregate risk, and availability of credit lines. This effectistrueatthe firm level as well as the industry level, and it is significantly stronger in times when aggregate risk is higher. The positive relation between a preference for cash and asset risk is particularly strong for firms that are more likely to be financially constrained (small, non-rated, low payout firms).

We analyze optimal risk management strategies of a bank financed with deposits and equity in a one period model. The bank’s motivation for risk management comes from deposits which can lead to bank runs. In the event of such a run, liquidation costs arise. The hedging strategy that maximizes the value of equity is derived. We identify conditions under which well known results such as complete hedging, maximal speculation or irrelevance of the hedging decision are obtained. The initial debt ratio, the size of the liquidation costs, regulatory restrictions, the volatility of the risky asset and the spread between the riskless interest rate and the deposit rate are shown to be the important parameters that drive the bank’s hedging decision. We further extend this basic model to include counterparty risk constraints on the forward contract used for hedging.

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We report evidence from the equity market that unused loan commitments expose banks to systematic liquidity risk, especially during crises such as the one observed in the fall of 1998. We also find, however, that banks with higher levels of transactions deposits had lower risk during the 1998 crisis than other banks. These banks experienced large inflows of funds just as they were needed-- when liquidity demanded by firms taking down funds from commercial paper backup lines of credit peaked. Our evidence suggests that combining loan commitments with deposits mitigates liquidity risk, and that this deposit-lending synergy is especially powerful during periods of crisis, when nervous investors move funds into their banks.

norm during the late 1980s and early 1990s. While these "twin crises" have inspired a number of recent theoretical and empirical contributions to the literature on financial crises in developing economies, much less consideration has been given to analytic case studies of actual country experiences with these twin crises and their aftermath. This paper attempts to fill this gap by studying the specific case of Thailand, which was the first domino to fall, triggering the East Asian financial crisis of 1997-98. Emphasis is laid on the issue of post-crisis foreign bank entry into Thailand.

This paper investigates U.S. bank common stock returns and their sensitivity to market risk, interest rate risk, and illiquidity risk. Due to known problems with conducting inference using Generalized Method of Moments, I use the Empirical Likelihood Block Bootstrap established in Allen, Gregory, and Shimotsu (2004). Preliminary results suggest that once the test-statistics are bootstrapped, aggregate illiquidity is not a significant factor in explaining U.S. bank stock returns. However, bank stock returns are sensitive to illiquidity in the commercial paper market. There is also evidence of a negative relationship between market capitalization and sensitivity to illiquidity in the commercial paper market.