Bank net worth, asset prices and economic activity

A dynamic general equilibrium model is proposed to study the interactions between the banking sector, asset prices and aggregate economic activity. A durable asset serves as a productive input and as a collateral for loans. The propagation mechanism of a negative productivity shock is enhanced and prolonged through the interaction of credit constraints and asset prices, where the bank loan and the investment are squeezed by a higher bank capital-asset ratio for lending and at the same time, a stricter collateral requirement for borrowing. The model explains why banking crises often coincide with depression in the asset markets. The results also bear policy implications for the debates over regulatory bank capital adequacy and credit control policies. (C) 2001 Elsevier Science B.V. All rights reserved.