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... the economy As financial intermediaries, banks channel funds from depositors and short term capital markets to those that have investment opportunities. By borrowing and lending from large groups, they can benefit from a diversified portfolio and offer risk sharing to depositors. 1 We do not cover currency crises as this factor has not played an important role yet in the current crisis. Excellent surveys and analyses of currency crises are contained in Flood and Marion (1999), Krugman (2000) and Fourçans and Franck (2003). 4 Traditionally, intermediaries also act as delegated monitors, as in Diamond (1984), restructure loans to discipline borrowers, as in Gorton and Kahn (1994), or perform an important role in maturity transformation, as we will describe in the next section. Moreover, when the predominant source of external funding for firms is bank loans, banks become central to business activity as in Allen and Gale (2000a). Financial distress in the banking system appears to be a concern for the economy as a whole. For instance, Dell’Ariccia, Detragiache and Rajan (2008) provide evidence that bank distress contributes to a decline in credit and to low GDP growth by showing that sectors more ...

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...risis of 1997 and the policies of the IMF adopted then induced Asian governments to hoard funds. This created important global imbalances that expanded the credit available and helped to fuel the bubble. The bubble burst triggered problems with subprime mortgages, which in turn posed difficulties for the banking system and then spread to the real economy. When the prices of securitized subprime mortgages fell too low (see Bank of England (2008) for evidence prices were below fundamentals), a negative bubble was created. The sequence of events in the current crisis is, in fact, often observed. Kaminsky and Reinhart (1999) study a wide range of crises in 20 countries including 5 industrial and 15 emerging ones. A common precursor to most of the crises considered is financial liberalization and significant credit expansion. These are followed by an average rise in the price of stocks of about 40 percent per year above that occurring in normal times. The prices of real estate and other assets also increase significantly. At some point the bubble bursts and the stock and real estate markets collapse. In many cases banks and other intermediaries were overexposed to the equity and real estate markets and about a yea...

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...s fell significantly and this is when the financial crisis started to spill over into the real economy and had such a damaging effect. 5. Bubbles and crises Banking crises often follow collapses in asset prices after what appears to have been a ‘bubble’. This is in contrast to standard neoclassical theory and the efficient markets hypothesis which precludes the existence of bubbles. The global crisis that started in 2007 provides a stark example. Asset price bubbles can arise for many reasons, but one important factor is the amount of liquidity provided by the central bank as money or credit. Kindleberger (1978; p. 54) emphasizes the role of this factor in his history of bubbles: “Speculative manias gather speed through expansion of money and credit or perhaps, in some cases, get started because of an initial 24 expansion of money and credit.” With the current crisis, the monetary policies of central banks particularly the U.S. Federal Reserve appear to have been too loose and have focused too much on consumer price inflation, ignoring asset price inflation. Moreover, the Asian crisis of 1997 and the policies of the IMF adopted then induced Asian governments to hoard funds. This created important gl...

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...a crisis, it is difficult to use the theory for any policy analysis. A selection mechanism that applies to this type of coordination games is introduced in Carlsson and van Damme (1993). The authors analyze incomplete information games where the actual payoff structure is randomly drawn from a given class of games and where each player makes a noisy observation of the game to be played. Such games are called global games. In a global games setting, the lack of common knowledge about the underlying payoff structure selects the risk dominant equilibrium to be the unique equilibrium of the game. Morris and Shin (1998) successfully applied this approach to coordination games in the context of currency crises, when there is uncertainty about economic fundamentals. Rochet and Vives (2004) and Goldstein and Pauzner (2005) have used global games to study to banking crises. An important recent contribution by Chen, Goldstein, and Jiang (2007) establishes the empirical applicability of the global games approach. The authors develop a global games model of mutual fund 6 withdrawals, where strategic complementarities among investors generate fragility in financial markets. Using a detailed data set, they find that ...

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...sitors are getting out early may also withdraw. Chari and Jagannathan show crises occur not only when the outlook is poor but also when liquidity needs are high despite no one receiving information on future returns. Calomiris and Kahn (1991) show that the threat of bank liquidation disciplines the banker when he can fraudulently divert resources ex post. The first come-first served constraint provides an incentive for costly information acquisition by depositors. Calomiris and Kahn regard bank runs as always beneficial since they prevent fraud and allow the salvage of some of the bank value. Diamond and Rajan (2001) develop a model in which banks have special skills to ensure that loans are repaid. By issuing demand deposits with a first come-first served feature, banks can precommit to recoup their loans. This allows long-term projects to be funded and depositors to consume when they have liquidity needs. However, this arrangement leads to the possibility of a liquidity shortage in which banks curtail credit when there is a real shock. 8 Another strand of the business cycle literature integrates banks into models of the economy. Allen and Gale (2004) develop a general equilibrium framework for understan...

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... (1980, 1996) shows that, despite the absence of collapses in US national macroeconomic time series, in the first two of the four crises identified by Friedman and Schwartz in the early 1930's there were large regional shocks and attributes the crises to these shocks. Calomiris and Mason (2003) undertake a detailed econometric study of the four crises using a broad range of data and conclude that the first three crises were fundamental-based while the fourth was panic-based. We have only touched on some highlights of the literature on banking crises here. More complete surveys are provided by Bhattacharya and Thakor (1993), Gorton and Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), and Degryse, Ongena and Kim (2009). 10 3. Liquidity and interbank markets Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity in the financial system from the banks that have cash in excess to the ones that have a shortage. In this process, they become the medium for implementing central banks’ monetary policy. Their smooth functioning is essential for maintaining financial stability. Bhattacharya and Gale (1987) is the pioneering theoretic...

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...d and so on in a downward spiral. Disruptions in liquidity provision can be the shock that initially lowers asset prices and starts the problem. While Kiyotaki and Moore (1997) take the ratio of the amount that can be borrowed against collateral as given, Geanakoplos (1997, 2003, 2009) and Fostel and Geanakoplos (2008) show how the interest rate and amount of collateral are simultaneously determined. In practice in crises, the amounts that can be borrowed against different kinds of collateral vary significantly and this is an important part of why shocks are amplified by the financial sector. Caballero and Krishnamurthy (2001) distinguish between collateral that can be used when borrowing domestically and collateral that can be used when borrowing internationally. In emerging economies the latter is particularly important. They show that the two types of collateral can interact in important ways. If domestic collateral is liquidated at fire sale prices, this can lead to wasted international collateral. When both international and domestic collateral are limited, buffers to deal with adverse shocks will be limited and the effects of such shocks will be severe. 27 Another seminal contribution is Holmstrom and Tirole ...

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...an Damme (1993). The authors analyze incomplete information games where the actual payoff structure is randomly drawn from a given class of games and where each player makes a noisy observation of the game to be played. Such games are called global games. In a global games setting, the lack of common knowledge about the underlying payoff structure selects the risk dominant equilibrium to be the unique equilibrium of the game. Morris and Shin (1998) successfully applied this approach to coordination games in the context of currency crises, when there is uncertainty about economic fundamentals. Rochet and Vives (2004) and Goldstein and Pauzner (2005) have used global games to study to banking crises. An important recent contribution by Chen, Goldstein, and Jiang (2007) establishes the empirical applicability of the global games approach. The authors develop a global games model of mutual fund 6 withdrawals, where strategic complementarities among investors generate fragility in financial markets. Using a detailed data set, they find that consistent with their model funds with illiquid assets exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. He and Xiong (2009) ...

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... analyze incomplete information games where the actual payoff structure is randomly drawn from a given class of games and where each player makes a noisy observation of the game to be played. Such games are called global games. In a global games setting, the lack of common knowledge about the underlying payoff structure selects the risk dominant equilibrium to be the unique equilibrium of the game. Morris and Shin (1998) successfully applied this approach to coordination games in the context of currency crises, when there is uncertainty about economic fundamentals. Rochet and Vives (2004) and Goldstein and Pauzner (2005) have used global games to study to banking crises. An important recent contribution by Chen, Goldstein, and Jiang (2007) establishes the empirical applicability of the global games approach. The authors develop a global games model of mutual fund 6 withdrawals, where strategic complementarities among investors generate fragility in financial markets. Using a detailed data set, they find that consistent with their model funds with illiquid assets exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. He and Xiong (2009) depart from the static framework ...

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...rices fall 55% over 3 years. Output falls by 9% over two years, while unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. While Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that “this time is different,” they warn that the global nature of this crisis will make it far more difficult for many countries to grow their way out. 2 A thorough overview of the events preceding and during the current financial crisis is provided in Adrian and Shin (2009), Brunnermeier (2009), Greenlaw et al. (2008), and Taylor (2008). Its seeds can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. and several other countries such as the U.K., Ireland and Spain. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere started to fall. Mayer, Pence and Sherlund (2009) and Nadauld and Sh...

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... over two years, while unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. While Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that “this time is different,” they warn that the global nature of this crisis will make it far more difficult for many countries to grow their way out. 2 A thorough overview of the events preceding and during the current financial crisis is provided in Adrian and Shin (2009), Brunnermeier (2009), Greenlaw et al. (2008), and Taylor (2008). Its seeds can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. and several other countries such as the U.K., Ireland and Spain. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere started to fall. Mayer, Pence and Sherlund (2009) and Nadauld and Sherlund (2008) provide excellent accounts ov...

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...e surveys are provided by Bhattacharya and Thakor (1993), Gorton and Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), and Degryse, Ongena and Kim (2009). 10 3. Liquidity and interbank markets Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity in the financial system from the banks that have cash in excess to the ones that have a shortage. In this process, they become the medium for implementing central banks’ monetary policy. Their smooth functioning is essential for maintaining financial stability. Bhattacharya and Gale (1987) is the pioneering theoretical study in this area. They analyze a setting in which individual banks face privately observed liquidity shocks due to a random proportion of depositors wishing to make early withdrawals. In addition, each bank has private information about the liquid fraction of its portfolio. Since the liquidity shocks are imperfectly correlated across intermediaries, banks coinsure each other through an interbank market. Bhattacharya and Gale show that, even in the absence of an aggregate liquidity shock for the intermediary sector as a whole, banks are induced to under-invest i...

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...tralized solution approximates the first best. Besides the theoretical investigations, there has been a substantial interest in looking for evidence of contagious failures of financial institutions resulting from the mutual claims they have on one another. Most of these papers use balance sheet information to estimate bilateral credit relationships for different banking systems. Subsequently, the stability of the interbank market is tested by simulating the breakdown of a single bank. Upper and Worms (2004) analyze the German banking system, Cocco, Gomes, and Martins (2005) consider Portugal, Furfine (2003) the US, Boss, Elsinger, Thurner, and Summer (2004) Austria, and Degryse and Nguyen (2007) Belgium. These papers find that the banking systems demonstrate high resilience, even to large shocks. For instance, simulations of the worst case scenarios for German system show the failure of a single bank could lead to the breakdown of up to 15% of the banking sector based on assets. Since these results depend heavily on how the linkages between banks are estimated and they abstract from any type of behavioral feedback (Upper 2006), it is likely that they provide downward bias estimator of contagious...

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... in US national macroeconomic time series, in the first two of the four crises identified by Friedman and Schwartz in the early 1930's there were large regional shocks and attributes the crises to these shocks. Calomiris and Mason (2003) undertake a detailed econometric study of the four crises using a broad range of data and conclude that the first three crises were fundamental-based while the fourth was panic-based. We have only touched on some highlights of the literature on banking crises here. More complete surveys are provided by Bhattacharya and Thakor (1993), Gorton and Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), and Degryse, Ongena and Kim (2009). 10 3. Liquidity and interbank markets Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity in the financial system from the banks that have cash in excess to the ones that have a shortage. In this process, they become the medium for implementing central banks’ monetary policy. Their smooth functioning is essential for maintaining financial stability. Bhattacharya and Gale (1987) is the pioneering theoretical study in this area. They analyze a setting in...

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...nsufficient to prevent a significant contraction in the supply of credit at the arrival of a recession. There is a large empirical literature on banking crises. Friedman and Schwartz (1963) have written a comprehensive monetary history of the U.S. from 1867-1960. Friedman and Schwartz argued that the crises were panic-based, as evidenced by the absence of downturns in the relevant macroeconomic time series prior to the crises. This contrasts with Gorton’s (1988) evidence that banking crises in the National Banking Era were predictable, which suggests banking crises are business cycle related. Calomiris and Gorton (1991) provide a wider range of evidence that crises are fundamental-based. Wicker (1980, 1996) shows that, despite the absence of collapses in US national macroeconomic time series, in the first two of the four crises identified by Friedman and Schwartz in the early 1930's there were large regional shocks and attributes the crises to these shocks. Calomiris and Mason (2003) undertake a detailed econometric study of the four crises using a broad range of data and conclude that the first three crises were fundamental-based while the fourth was panic-based. We have only touched on some highlights of t...

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...usses the literature on bubbles and crises. Finally, Section 6 provides suggestions for future directions for research.1 2. Banking crises and the economy As financial intermediaries, banks channel funds from depositors and short term capital markets to those that have investment opportunities. By borrowing and lending from large groups, they can benefit from a diversified portfolio and offer risk sharing to depositors. 1 We do not cover currency crises as this factor has not played an important role yet in the current crisis. Excellent surveys and analyses of currency crises are contained in Flood and Marion (1999), Krugman (2000) and Fourçans and Franck (2003). 4 Traditionally, intermediaries also act as delegated monitors, as in Diamond (1984), restructure loans to discipline borrowers, as in Gorton and Kahn (1994), or perform an important role in maturity transformation, as we will describe in the next section. Moreover, when the predominant source of external funding for firms is bank loans, banks become central to business activity as in Allen and Gale (2000a). Financial distress in the banking system appears to be a concern for the economy as a whole. For instance, Dell’Ariccia, Detragiache and Ra...

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...ss, Elsinger, Thurner, and Summer (2004) Austria, and Degryse and Nguyen (2007) Belgium. These papers find that the banking systems demonstrate high resilience, even to large shocks. For instance, simulations of the worst case scenarios for German system show the failure of a single bank could lead to the breakdown of up to 15% of the banking sector based on assets. Since these results depend heavily on how the linkages between banks are estimated and they abstract from any type of behavioral feedback (Upper 2006), it is likely that they provide downward bias estimator of contagious outcomes. Mistrulli (2007) confirms this when analyzing contagion propagates within the Italian interbank market using actual bilateral exposures. Iyer and Peydró-Alcalde (2006) find second order behavioral feedback in a study of interbank linkages at the time of the failure of a large Indian bank: banks with higher interbank exposure to the failed bank experience higher deposit withdrawals. The second approach to modeling contagion focuses on indirect balance-sheet linkages. Lagunoff and Schreft (2001) construct a model where agents are linked in the sense that the return on an agent's portfolio depends on the portfol...

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...ues. This is often accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crisis or raising interest rates to defend the currency. Finally, a significant fall in output occurs and the recession lasts for an average of about a year and a half. There are a number of theories that can explain how bubbles can arise (see, e.g., Tirole (1982, 1985), Allen and Gorton (1993), Allen, Morris and Postlewaite (1993), Abreu and 25 Brunnermeier (2003), Scheinkman and Xiong (2003), Brunnermeier and Nagel (2004), Hong, Scheinkman and Xiong (2008), and Brunnermeier (2001) for an overview). Here we focus on theories that are explicitly related to crises. Allen and Gale (2000c) develop a model of boom and bust that relies on the existence of an agency problem. Many investors in real estate and stock markets obtain their investment funds from external sources. If the ultimate providers of funds are unable to observe the characteristics of the investment, there is a classic assetsubstitution problem. Asset substitution increases the return to investment in risky assets and causes investors to bid up prices above their fundamental values. A crucial determinant of a...

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...be willing to bail out other agents to prevent the collapse of the whole network. Leitner examines the design of optimal financial networks that minimize the trade-off between risk sharing and the potential for collapse. In a related paper, Kahn and Santos (2008) investigate whether banks choose the optimal degree of mutual insurance against liquidity shocks. They show that when there is a shortage of exogenously supplied liquidity, which can be supplemented by bank liquidity creation, the banks generally fail to find the correct degree of interdependence. In aggregate, they become too risky. Dasgupta (2004) also explores how linkages between banks, represented by crossholding of deposits, can be a source of contagious breakdowns. The study examines how depositors who receive a private signal about banks' fundamentals may wish to withdraw their deposits if they believe that enough other depositors will do the same. To eliminate the multiplicity of equilibria the author uses the concept of global games. Dasgupta isolated a unique equilibrium, depending on the value of the fundamentals. In the same spirit, Brusco and Castiglionesi (2007) show that there is a positive probability of bankruptcy and p...

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...e the absence of collapses in US national macroeconomic time series, in the first two of the four crises identified by Friedman and Schwartz in the early 1930's there were large regional shocks and attributes the crises to these shocks. Calomiris and Mason (2003) undertake a detailed econometric study of the four crises using a broad range of data and conclude that the first three crises were fundamental-based while the fourth was panic-based. We have only touched on some highlights of the literature on banking crises here. More complete surveys are provided by Bhattacharya and Thakor (1993), Gorton and Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), and Degryse, Ongena and Kim (2009). 10 3. Liquidity and interbank markets Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity in the financial system from the banks that have cash in excess to the ones that have a shortage. In this process, they become the medium for implementing central banks’ monetary policy. Their smooth functioning is essential for maintaining financial stability. Bhattacharya and Gale (1987) is the pioneering theoretical study in this area. The...

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...atic liquidity shocks, there is scope to invest in the long risk-free asset that can be traded in the market. Transferring credit risk is now detrimental as it induces a higher need of liquidity in the market and a greater variability in the asset prices. This in turn affects banks' ability to face their liquidity shocks as it implies a severe reduction in the price of the long asset that banks use to hedge their liquidity risk. The effect of introducing credit risk transfer depends crucially also on the accounting system in use, be it historical cost or mark-to-market accounting, as shown by Allen and Carletti (2008). When banks need to liquidate a long-term asset on an illiquid market, it may not be desirable to value such assets according to market values as it reflects the price volatility needed to induce liquidity provision. The current crisis made it clear we need a broader view on financial systems to capture externalities between institutions. The usual justification for intervention by central banks and 23 governments to prevent the bankruptcy of systemic financial institutions is that this will prevent contagion. This was the argument used by the Federal Reserve for intervening to ensure Bear St...

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...at 11 secured repo and unsecured interbank lending markets since both allow banks to cope with liquidity shocks, and they consider under what conditions segmented or integrated international interbank markets exist. They show that a segmented interbank market is always an equilibrium, while the emergence of an integrated international market depends on the quality of cross-border information. Only if cross-border information is sufficiently precise, is integration of markets possible. Turbulence in the interbank market in the current financial crisis has spurred a series of new papers. Allen, Carletti and Gale (2009) show that the interbank market is characterized by excessive price volatility when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic liquidity shocks. By using open market operations to fix the short-term interest rate, a central bank can prevent price volatility and implement the constrained efficient solution. Thus, the central bank effectively completes the market, a result in line with the argument of Goodfriend and King (1988) that open market operations are sufficient to address pure liquidity risk on the interbank markets. One implication of the model is t...

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...syncratic liquidity shocks. By using open market operations to fix the short-term interest rate, a central bank can prevent price volatility and implement the constrained efficient solution. Thus, the central bank effectively completes the market, a result in line with the argument of Goodfriend and King (1988) that open market operations are sufficient to address pure liquidity risk on the interbank markets. One implication of the model is that situations where banks stop trading with each other can be a feature of the constrained efficient solution. Acharya, Gromb and Yorulmazer (2008), and Freixas and Jorge (2008) also study inefficiencies in the interbank market. Acharya et al. (2008) consider that interbank markets are characterized by moral hazard, asymmetric information, and monopoly power in times of crisis. They show that a bank with surplus liquidity has bargaining power vis-à-vis deficit banks which need liquidity to keep funding projects. Surplus banks may strategically provide insufficient lending in the interbank market in order to induce inefficient sales of bank-specific assets by the needy banks, which results in an inefficient allocation of resources. The role of the central bank 12 is t...

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... Households’ aggregate debt capacity drives the aggregate demand for homes. Home supply at a given date stems from foreclosures in case of default, sales motivated by the acquisition of a larger home, and sales that follow exogenous moving decisions. Market-clearing home prices in turn drive aggregate debt capacity. The model generates interesting insights into the impact of lower refinancing costs and housing bubbles on equilibrium outcomes. There has been a substantial literature attempting to understand how sales of assets can lead prices to fall too low so that there is a negative bubble. Bernanke and Gertler (1989) and 26 Bernanke, Gertler and Gilchrist (1996) develop the notion of the financial accelerator. They show that credit market conditions can amplify and propagate shocks. Asymmetric information leads to an agency problem between borrowers and lenders. They show that a negative shock to the borrowers’ wealth is amplified because of the nature of the principal-agent relationship between lenders and borrowers. Another very influential paper is Kiyotaki and Moore (1997) who show that small shocks can lead to large effects because of the role of collateral. A shock that lowers asset prices lowers th...

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... systemic risk. Adrian and Brunnermeier (2009) actually propose a new measure for systemic risk that is conditional on an institution (or the whole financial sector) being under distress. Their concern is confirmed by Boyson, Stahel and Stulz (2008) who find that the average probability that a hedge fund style index has extreme poor performance increases with the number of other hedge funds with extreme poor performance. Similarly, Jorion and Zhang (2009) find evidence of credit contagion via counterparty effects. Recent contributions have linked the risk of contagion to financial innovation. Parlour and Winton (2008) analyze the choice a bank has to lay off credit risk between credit default swaps (CDS) and loan sales. With a CDS, the originating bank retains the loan's control rights but no longer has an incentive to monitor; with loan sales, control rights pass to the buyer of the loan, who can then monitor, though in a less-informed manner. The authors show that when 22 capital costs are low, loan sales are dominant, while when capital costs are high, CDS and loan sales may co-exist. Shin (2009) studies the impact of securitization on financial stability. Since securitization allows credit expansion th...

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... receivable and payable among industrial firms, and interbank payment systems. Gai and Kapadia (2007) develop a model of contagion in financial networks and use similar techniques as the epidemiological literature on spread of disease in networks to assess the fragility of the financial system. As with Allen and Gale, they find that greater connectivity reduces the likelihood of widespread default. However, shocks may have a significantly larger impact on the financial system when they occur. The tools of the network literature have been applied also to analyze the issue of network formation. Babus (2007) proposes a model where banks form links with each other as an insurance mechanism to reduce the risk of contagion. At the base of the link formation process lies the same intuition developed in Allen and Gale (2000b): better connected networks are more resilient to contagion. The model predicts a connectivity threshold above which contagion does not occur, and banks form links to reach this threshold. However, an implicit cost associated with being involved in a link prevents banks from forming more connections than required by the connectivity threshold. Banks manage to form networks where c...

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...cipal-agent relationship between lenders and borrowers. Another very influential paper is Kiyotaki and Moore (1997) who show that small shocks can lead to large effects because of the role of collateral. A shock that lowers asset prices lowers the value of collateral. This means that less borrowing is possible, asset prices are further lowered and so on in a downward spiral. Disruptions in liquidity provision can be the shock that initially lowers asset prices and starts the problem. While Kiyotaki and Moore (1997) take the ratio of the amount that can be borrowed against collateral as given, Geanakoplos (1997, 2003, 2009) and Fostel and Geanakoplos (2008) show how the interest rate and amount of collateral are simultaneously determined. In practice in crises, the amounts that can be borrowed against different kinds of collateral vary significantly and this is an important part of why shocks are amplified by the financial sector. Caballero and Krishnamurthy (2001) distinguish between collateral that can be used when borrowing domestically and collateral that can be used when borrowing internationally. In emerging economies the latter is particularly important. They show that the two types of collat...

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...d the correct degree of interdependence. In aggregate, they become too risky. Dasgupta (2004) also explores how linkages between banks, represented by crossholding of deposits, can be a source of contagious breakdowns. The study examines how depositors who receive a private signal about banks' fundamentals may wish to withdraw their deposits if they believe that enough other depositors will do the same. To eliminate the multiplicity of equilibria the author uses the concept of global games. Dasgupta isolated a unique equilibrium, depending on the value of the fundamentals. In the same spirit, Brusco and Castiglionesi (2007) show that there is a positive probability of bankruptcy and propagation of a crises across regions when banks keep interbank deposits and may engage in excessive risk taking if they are not enough capitalized. Parallel to this literature, other researchers applied network techniques developed in mathematics and theoretical physics to study contagion. For instance, Eisenberg and Noe (2001) investigate default by firms that are part of a single clearing mechanism. First, the authors show the existence of a clearing payment vector that defines the level of connections between firms. 19 Next, the...

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...orm of monitoring. Chari and Jagannathan (1988) focus on a signal extraction problem where some depositors withdraw money for consumption purposes while others withdraw money because they know that the bank is about to fail. In this environment, depositors who cannot distinguish whether there are long lines to withdraw at banks because of consumption needs or because informed depositors are getting out early may also withdraw. Chari and Jagannathan show crises occur not only when the outlook is poor but also when liquidity needs are high despite no one receiving information on future returns. Calomiris and Kahn (1991) show that the threat of bank liquidation disciplines the banker when he can fraudulently divert resources ex post. The first come-first served constraint provides an incentive for costly information acquisition by depositors. Calomiris and Kahn regard bank runs as always beneficial since they prevent fraud and allow the salvage of some of the bank value. Diamond and Rajan (2001) develop a model in which banks have special skills to ensure that loans are repaid. By issuing demand deposits with a first come-first served feature, banks can precommit to recoup their loans. This allows long-term p...

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...generate trading but have no impact on prices. In contrast, when market presence is costly, the need for liquidity arises endogenously and idiosyncratic shocks can affect prices via two channels: first trading becomes infrequent which makes traders more risk averse, and second the gains from trading for potential sellers are always larger than the gains from trading for potential buyers. The asymmetry in their appetite to trade leads to order imbalances in the form of excess supply, and the price has to decrease in response. Two studies isolate illiquidity risk from other confounding effects. Morris and Shin (2009) define “illiquidity risk" the probability of a default due to a run when the institution would otherwise have been solvent. They show that is difference between “asset insolvency risk", as the conditional probability of default due to deterioration of asset quality if there is no run by short term creditors, and “total credit risk,“ as the unconditional probability of default, either because of a (short term) creditor run or (long run) asset insolvency. Brunnermeier and Pedersen (2008) distinguish between market liquidity and funding liquidity. Market liquidity reflects how difficult is to ra...

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...ermeier (2009), Greenlaw et al. (2008), and Taylor (2008). Its seeds can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. and several other countries such as the U.K., Ireland and Spain. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere started to fall. Mayer, Pence and Sherlund (2009) and Nadauld and Sherlund (2008) provide excellent accounts over the developments of the housing market preceding the crisis. The fall in house prices led to a fall in the prices of securitized subprime mortgages, affecting financial markets worldwide. In August 2007 the interbank markets, particularly for terms longer than a few days, experienced considerable pressures and central banks were forced to inject massive liquidity. Conditions in collateralized markets have also changed significantly. Haircuts increased and low quality collateral became more difficult to borrow against. The Federal Reserve and other central banks...

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...more liquidity than (incomplete) markets, during financial disruption, banks themselves face considerable uncertainty regarding their own idiosyncratic liquidity needs. An interbank market can achieve the optimal allocation, which implies efficient risk sharing to consumers and insuring banks against idiosyncratic liquidity shocks. In the optimum, however, the interest rate on this market must be state-contingent and low in states of financial disruption. This suggests a role for a central bank which can implement the efficient allocation by setting the interest rates in the interbank market. Diamond and Rajan (2008) consider a model where banks fund long term illiquid projects by borrowing short term from households. But when household needs for funds are high, banks will have to call in loans to long gestation projects in order to generate the resources to pay them. Interest rates will rise sharply to equate the household demand for consumption goods and the supply of these goods from terminated projects. Debtors will have to shut down illiquid projects, and the net worth of the bank decreases, leading in the limit to runs. The optimal policy response may require authorities to commit to raising rates w...

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...librium framework for understanding the normative aspects of crises. This framework is used to investigate the welfare properties of financial systems and to provide conditions for regulation to improve the allocation of resources. Allen and Gale explicitly model the interaction of banks and markets. Financial intermediaries and markets play important but distinct roles in the model. Intermediaries provide consumers with insurance against idiosyncratic liquidity shocks. Markets allow financial intermediaries and their depositors to share risks from aggregate liquidity and asset return shocks. He and Krishnamurthy (2008) are interested in the role of financial intermediaries in determining asset prices. They develop a dynamic general equilibrium framework where the need for intermediation arises endogenously based on optimal contracting considerations. The model has the feature that low intermediary capital reduces the risk-bearing capacity of the marginal investor, and replicates the observed rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets held by the intermediary sector, and fall in riskless interest rates. Since banks play a crucial role in the economy ...

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... the monetary policy transmission mechanism. In their model, firms face liquidity shocks and rely on bank credit to raise external finance. Firms’ shocks will result in a demand for credit and a liquidity shock for the banks that can be smoothed out through an interbank market. Asymmetry of information the interbank market disrupts the efficient allocation of liquidity to solvent illiquid banks. Consequently, by tightening monetary policy banks with less liquidity are forced to cut down on their lending. Motivated by the current financial crisis, several papers seek to explain market freezes. Diamond and Rajan (2009) relate the seizing up of term credit with the overhang of illiquid securities. When banks have a significant quantity of assets with a limited set of potential buyers, shocks in future liquidity demands may trigger sales at fire sale prices. The prospect of a future fire sale of the bank’s assets depresses their current value. In these conditions, banks prefer holding on to the illiquid assets and risking a fire sale and insolvency than selling the asset and ensuring its own stability in the future, since the states in which the depressed asset value recovers are precisely the states in which...

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...banks form links with each other as an insurance mechanism to reduce the risk of contagion. At the base of the link formation process lies the same intuition developed in Allen and Gale (2000b): better connected networks are more resilient to contagion. The model predicts a connectivity threshold above which contagion does not occur, and banks form links to reach this threshold. However, an implicit cost associated with being involved in a link prevents banks from forming more connections than required by the connectivity threshold. Banks manage to form networks where contagion rarely occurs. Castiglionesi and Navarro (2007) are also interested in decentralizing the network of banks that is optimal from a social planner perspective. In a setting where banks invest on behalf of depositors and there are positive network externalities on the investment returns, fragility arises 20 when banks that are not sufficiently capitalized gamble with depositors' money. When the probability of bankruptcy is low, the decentralized solution approximates the first best. Besides the theoretical investigations, there has been a substantial interest in looking for evidence of contagious failures of financial institutions resulting f...

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... The crisis has changed the financial landscape worldwide and its costs are yet to be evaluated. The purpose of this paper is to concisely survey the literature on financial crises. Despite its severity and its ample effects, the current crisis is similar to past crises in many dimensions. In a recent series of papers, Reinhart and Rogoff (2008a, 2008b, 2009) document the effects of banking crises using an extensive data set of high and middle-to-low income countries. They find that systemic banking crises are typically preceded by credit booms and asset price bubbles. This is consistent with Herring and Wachter (2003) who show that many financial crises are the result of bubbles in real estate markets. In addition, Reinhart and Rogoff find that crises result, on average, in a 35% real drop in housing prices spread over a period of 6 years. Equity prices fall 55% over 3 years. Output falls by 9% over two years, while unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. While Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that “this time is different,” they warn th...

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...cts how difficult is to raise money by selling the asset, instead of by borrowing against it. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders’ funding, i.e., their capital and margin requirements, depends on the 15 assets’ market liquidity. They show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. Most models of banking crises ignore the role of money. Ultimately, banks contract with depositors in nominal terms. Smith (2002) considers a model in which spatial separation and limited communication introduce a role for money into a standard banking model with early and late consumers. He shows that the lower the inflation rate and the nominal interest rate, the lower is the probability of a banking crisis. Reducing the inflation rate to zero, in line with the Friedman rule, eliminates banking crises. However, this solution is inefficient as it causes banks to hold excess cash reserves at the expense of investment in higher yielding assets. Diamond and Rajan (2006) introduce money and nominal deposit contracts into t...

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...the first two of the four crises identified by Friedman and Schwartz in the early 1930's there were large regional shocks and attributes the crises to these shocks. Calomiris and Mason (2003) undertake a detailed econometric study of the four crises using a broad range of data and conclude that the first three crises were fundamental-based while the fourth was panic-based. We have only touched on some highlights of the literature on banking crises here. More complete surveys are provided by Bhattacharya and Thakor (1993), Gorton and Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), and Degryse, Ongena and Kim (2009). 10 3. Liquidity and interbank markets Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity in the financial system from the banks that have cash in excess to the ones that have a shortage. In this process, they become the medium for implementing central banks’ monetary policy. Their smooth functioning is essential for maintaining financial stability. Bhattacharya and Gale (1987) is the pioneering theoretical study in this area. They analyze a setting in which individual banks face privately ...

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...liquid market, it may not be desirable to value such assets according to market values as it reflects the price volatility needed to induce liquidity provision. The current crisis made it clear we need a broader view on financial systems to capture externalities between institutions. The usual justification for intervention by central banks and 23 governments to prevent the bankruptcy of systemic financial institutions is that this will prevent contagion. This was the argument used by the Federal Reserve for intervening to ensure Bear Sterns did not go bankrupt in March 2008, for example (see Bernanke (2008a)). The bankruptcy of Lehman Brothers a few months later in September of 2008 illustrated how damaging contagion can be. The process did not work in quite the way envisaged in the academic literature and was not accounted for in the decision of the Federal Reserve and Treasure that Lehman should not be saved. The first spillover was to the money market mutual fund sector. Reserve Capital “broke the buck” as it held a significant amount of paper issued by Lehman. This led to many withdrawals from other money market mutual funds and four days after Lehman announced bankruptcy, the government wa...

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...het and Vives (2004) and Goldstein and Pauzner (2005) have used global games to study to banking crises. An important recent contribution by Chen, Goldstein, and Jiang (2007) establishes the empirical applicability of the global games approach. The authors develop a global games model of mutual fund 6 withdrawals, where strategic complementarities among investors generate fragility in financial markets. Using a detailed data set, they find that consistent with their model funds with illiquid assets exhibit stronger sensitivity of outflows to bad past performance than funds with liquid assets. He and Xiong (2009) depart from the static framework and analyze a dynamic model of bank runs. A coordination problem arises between creditors whose debt contracts with a firm mature at different times. In deciding whether to roll over his debt, each creditor faces the firm’s future rollover risk with other creditors. There is a unique equilibrium in which preemptive debt runs occur through a rat race among the creditors who coordinate their rollover decisions based on the publicly observable time-varying firm fundamental. The second set of theories of banking crises is that they are a natural outgrowth of the b...

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... or not. 18 Concerned with the optimal financial network, Leitner (2005) constructs a model where the success of an agent's investment in a project depends on the investments of other agents she is linked to. Since endowments are randomly distributed across agents, an agent may not have enough cash to make the necessary investment. In this case, agents may be willing to bail out other agents to prevent the collapse of the whole network. Leitner examines the design of optimal financial networks that minimize the trade-off between risk sharing and the potential for collapse. In a related paper, Kahn and Santos (2008) investigate whether banks choose the optimal degree of mutual insurance against liquidity shocks. They show that when there is a shortage of exogenously supplied liquidity, which can be supplemented by bank liquidity creation, the banks generally fail to find the correct degree of interdependence. In aggregate, they become too risky. Dasgupta (2004) also explores how linkages between banks, represented by crossholding of deposits, can be a source of contagious breakdowns. The study examines how depositors who receive a private signal about banks' fundamentals may wish to withdraw their deposi...

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...Finally, Section 6 provides suggestions for future directions for research.1 2. Banking crises and the economy As financial intermediaries, banks channel funds from depositors and short term capital markets to those that have investment opportunities. By borrowing and lending from large groups, they can benefit from a diversified portfolio and offer risk sharing to depositors. 1 We do not cover currency crises as this factor has not played an important role yet in the current crisis. Excellent surveys and analyses of currency crises are contained in Flood and Marion (1999), Krugman (2000) and Fourçans and Franck (2003). 4 Traditionally, intermediaries also act as delegated monitors, as in Diamond (1984), restructure loans to discipline borrowers, as in Gorton and Kahn (1994), or perform an important role in maturity transformation, as we will describe in the next section. Moreover, when the predominant source of external funding for firms is bank loans, banks become central to business activity as in Allen and Gale (2000a). Financial distress in the banking system appears to be a concern for the economy as a whole. For instance, Dell’Ariccia, Detragiache and Rajan (2008) provide evidence that bank distress ...

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...liquid market, it may not be desirable to value such assets according to market values as it reflects the price volatility needed to induce liquidity provision. The current crisis made it clear we need a broader view on financial systems to capture externalities between institutions. The usual justification for intervention by central banks and 23 governments to prevent the bankruptcy of systemic financial institutions is that this will prevent contagion. This was the argument used by the Federal Reserve for intervening to ensure Bear Sterns did not go bankrupt in March 2008, for example (see Bernanke (2008a)). The bankruptcy of Lehman Brothers a few months later in September of 2008 illustrated how damaging contagion can be. The process did not work in quite the way envisaged in the academic literature and was not accounted for in the decision of the Federal Reserve and Treasure that Lehman should not be saved. The first spillover was to the money market mutual fund sector. Reserve Capital “broke the buck” as it held a significant amount of paper issued by Lehman. This led to many withdrawals from other money market mutual funds and four days after Lehman announced bankruptcy, the government wa...

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...assetsubstitution problem. Asset substitution increases the return to investment in risky assets and causes investors to bid up prices above their fundamental values. A crucial determinant of asset prices is thus the amount of credit provided by the financial system. Financial liberalization, by expanding the volume of credit and creating uncertainty about the future path of credit expansion, can interact with the agency problem and lead to a bubble in asset prices. When the bubble bursts, either because returns are low or because the central bank tightens credit, there is a financial crisis. Makarov and Plantin (2009) analyze changes in house prices in an economy where banks grant mortgages to liquidity-constrained households to finance a fixed supply of homes. Households’ aggregate debt capacity drives the aggregate demand for homes. Home supply at a given date stems from foreclosures in case of default, sales motivated by the acquisition of a larger home, and sales that follow exogenous moving decisions. Market-clearing home prices in turn drive aggregate debt capacity. The model generates interesting insights into the impact of lower refinancing costs and housing bubbles on equilibrium outcomes. There h...