Asset Prices and Twin Crises

Recent emerging market crises have been characterized by two key features: (i) banking crises generally precede currency crises, and (ii) asset prices decline in advance of currency crises. This paper argues that asset prices provide a key link between banking and currency crises. It is shown that a prospective currency crisis due to an unanticipated increase in the public debt triggers an asset price decline. Banks' exposure to asset prices in turn deteriorates their balance sheets and precipitates a banking crisis. Under the assumption of government bailout of banks, it is shown that the `twin' crises are self-fulfilling and their time-line follows (i) and (ii) described above. The timing of currency crisis is decreasing in the ratio of government's bailout to banks' loss of capital.