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.