As the recent Mexican crisis vividly illustrates, Latin American countries often go through boom-bust cycles caused by both domestic policies and external shocks. Such cycles are typically magnified by weak bank-ing systems which intermediate large capital inflows. This paper develops a simple optimizing model to analyze how the banking sector affects the propagation of shocks. In particular, we show how the world business cycle and shocks to the banking system affect output and employment through fluctuations in bank credit. We also analyze the countercyclical use of re-serve requirements. Econometric evidence for Chile and Mexico supports the main predictions of the model.