Debt-overhang banking crises: Detecting and preventing systemic risk

This paper shows how the debt-overhang distortion on bank lending can generate a self-fulfilling-expectations banking crisis accompanied by a plunge in the value of banks’ assets and a contraction of bank lending and economic activity. Moral hazard in banking adds an additional channel that can generate multiple equilibria, worsen the debt-overhang distortion, and deepen the crisis. Some signals of systemic risk include: high volatility and the presence of two modes in the probability distribution functions of the returns on bank-issued bonds and on portfolios of bank-issued bonds and equities; and high correlation between the returns on bank-issued bonds. Macroprudential regulation should discourage the exposure of banks to the economic and financial cycle by raising the capital requirements for banks with more cyclical assets.