Asset prices and twin crises

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. (c) 2008 Elsevier Ltd. All rights reserved.