Capital Flows in the Financial System and Supply of Credit

This paper develops a model to study how capital flows in the financial system affect banks’ coordination problem in the credit supply process. The economy is susceptible to self-fulfilling credit freezes: banks abstain from lending when they fear that other banks will withhold lending, and the resultant credit contraction impedes economic growth. Capital flows across banks can alleviate the problem by enabling optimistic banks to borrow from pessimistic banks and extend more credit to the real economy. However, the equilibrium interest rate reveals public information about economic fundamentals and banks’ aggregate willingness to lend, increasing the fragility of the credit market. As a result, the economy can get stuck in an equilibrium where both interbank capital flows and the real credit supply freeze and they reinforce each other through a vicious feedback loop. Regulations addressing counterparty risks can help to maintain active capital flows in the financial system and stabilize the real credit market.