Bank Deposits and Credit As Sources of Systemic Risk

The professional discussion divides itself into two broad categories. Macroeconomists typically are concerned with explaining business cycle fluctuations and determining when a recession will degenerate into a depression. 2 They are equally interested in the financial system's role as a propagator of this process because most depressions have been accompanied by serious disruptions in the financial system, including banking failures and panics. Eichengreen and Portes, for example , define a financial crisis as " a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries , which ramifies through the financial system, disrupting the market's capacity to allocate capital within the economy.. .. Our definition implies a distinction between generalized financial crisis on the one hand and bank failures, debt defaults and foreign-exchange market disturbances on the other " (1991, 10). Financial economists examine the micro behavior of market participants to explain disruptions in financial markets (see Diamond and Dybvig 1983; Chari and Jagannathan 1984). They have tended to focus on banking panics and runs and the reasons depositors withdraw funds rather than on the macro consequences for employment and output in the real economy per se. While differing in their emphases, the micro and macro approaches to analyzing financial stability share several themes. The first focuses on alternative explanations for why a crisis occurs. One prominent thesis argues that the financial system is inherently unstable and is therefore vulnerable to random shocks. Shocks simultaneously cause market participants to lose confidence in the system and exchange their bank deposits for currency. Others believe that such herd behavior cannot be explained solely by shocks that, like animal spirits, randomly induce depositors to run from bank deposits to currency. They offer more behaviorally oriented explanations and models, the most prevalent being models based on the existence of information asymmetries between borrowers and lenders. These models attempt to show that it is sometimes rational for depositors to attempt to withdraw their funds in such a way that it creates a run on the banking system. Most of the analysis in the random shock and information asymmetries models concentrates on aggregate behavior, assuming essentially that all market actors— both depositors and institutions—are identical. It does not admit differences among depositors and institutions or even the presence of more than one institution in the financial system. When the analysis recognizes more