Banks, Credibility and Macroeconomic Evolution after a Production Shock

One of the important functions of financial intermediation is intertemporal risk smoothing. This paper studies the effects of a production shock in a closed economy and compares 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 absence of a proper regulation. Paradoxically, it is the credibility of banks that makes bank-based economies fragile. A necessary and sufficient condition for successfull bailout schemes is proposed.