Debt-Overhang Banking Crises

This paper studies how a worsening of the debt overhang distortion on bank lending can explain banking solvency crises that are accompanied by a plunge of bank asset values and by a severe contraction of lending and economic activity. Since the value of bank assets depends on economic prospects, a pessimistic view of the economy can be self-fulfilling and can trigger a financial crisis: If economic prospects are poor, bank asset values decline, the bank risk of default rises, and the associated debt overhang distortion worsens. The worsening of the distortion leads to a contraction in bank loans and a decline in economic activity, which confirms the initial pessimistic view. Signals of the existence of systemic risk include: a rise in the volatility and the presence of two modes in the probability distribution functions of the returns of bank-issued bonds and of portfolios of bank-issued bonds and equities; and a surge in the correlation between bank-issued bond returns. Macroprudential policy should limit the sensitivity of bank balance sheets to the aggregate economy and to the financial sector, using investment restrictions, capital requirements, and stress tests. In the event of a crisis, policy options include reducing the above sensitivity with commitments and guarantees, stimulating the economy, and restructuring bank capital and ownership.