BANKS, CREDIBILITY AND MACROECONOMIC EVOLUTION AFTER A PRODUCTION SHOCK

One of the important functions of financial intermediation is intertemporal risk smoothing. In this paper we study the effects of a production shock in a closed economy and compare the abilities of market-based and bank-based financial systems in processing the shock. The analysis of the shock propagation indicates that a competitive banking system may collapse in the absence of a proper regulation. Paradoxically, it is the credibility of banks that makes bank-based economies fragile. A necessary and sufficient condition for successful bailout schemes is proposed. © 2010 The Author. The Manchester School © 2010 Blackwell Publishing Ltd and The University of Manchester.