We embed that basic model of banks into a macroeconomic model of a small open economy Such extension enables us to discuss, in a unified way, the issues raised by the recent sequence of crises in emerging markets. In particular, we argue that other:
1. Capital flows from abroad, caused by an opening of the capital account and/or an increase in the country’s access to international credit, can magnify the illiquidity problem. In particular, the vulnerability of domestic banks can be sharply increased when these foreign loans are of short maturity: a creditors’ panic, that is, a creditors’ refusal to roll over the short term loans, may render a self-fulfilling bank run possible.
2. The illiquidity problem may also be aggravated by a round of financial liberalization, which accentuates the maturity mismatch between assets and liabilities that is typical of commercial banks. In particular, we show how two kinds of financial liberalization, lowering of reserve requirements and increasing competition in the banking sector, can increase banks’ vulnerability to runs.
3. The financial system may greatly magnify the effects of small changes in exogenous circumstances (i.e., terms of trade, competitiveness, world interest rates). Small shocks may result in financial distress, implying costly asset liquidation, an unnecessarily large credit crunch, and large drops in asset prices and economic activity
4. Prices of assets that are in inelastic supply (such as land and real estate) will typically rise as financial flows from abroad are intermediated by the financial system, and crash in the event of a bank collapse. But the initial increase is not, in and of itself, evidence of an “asset bubble;” similarly, the crash need not be an indication that prices are returning to their “fundamental level.” In our model the meaning of “fundamental” is conditional on the absence or occurrence of a bank collapse. If a financial run occurs and asset prices crash, the resulting price drop is unnecessary, since it results from inefficient asset liquidation; a higher price (and associated higher welfare) would have prevailed if the run had not taken place.
5. The main danger of unsound policies of the kind described by Krugman (1998) and allegedly pursued in East Asia (government deposit guarantees and investment subsidies, leading to overinvestment and overborrowing) is that they can increase the fragility of banks. If banks collapse as a result, the associated costs far outweigh the conventional efficiency losses caused by such policies.