Banks, short-term debt and financial crises: theory, policy implications and applications

Abstract

While the empirical association between a financial institution's, or country's, short-term borrowing and susceptibility to crises may, in fact, exist, the direction of causality is often precisely opposite to that traditionally suggested. Banks or countries that want to finance illiquid investments have to borrow short-term. Thus it is the increasing illiquidity of the investment being financed that necessitates short-term financing, and causes the susceptibility to crises. Once illiquid investments have been financed, a ban on short-term financing may precipitate a more severe crisis, while, a priori, it reduces investment. Banning short-term debt deals with symptoms rather than underlying causes.