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Equity Capital, Bankruptcy Risk and the Liquidity Trap

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  • Oren Levintal

    () (Bar-Ilan University)

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    Abstract

    This paper explains the emergence of liquidity traps in the aftermath of large-scale financial crises, as happened in the US 1930s, Japan 1990s and recently in the US and Europe. The paper introduces a new balance sheet channel that links equity capital to the risk-free interest rate. When equity capital falls, bankruptcy risks rise. Firms become more vulnerable to external shocks, which makes financial disasters more likely to happen. Consequently, demand for safe assets increases, and the interest rate falls to the lower bound. Simulations show that the interest rate may stay at the lower bound for a long time.

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    File URL: http://econ.biu.ac.il/files/economics/working-papers/2012-07.pdf
    File Function: Working paper
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    Bibliographic Info

    Paper provided by Department of Economics, Bar-Ilan University in its series Working Papers with number 2012-07.

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    Length: 47 pages
    Date of creation: May 2012
    Date of revision:
    Handle: RePEc:biu:wpaper:2012-07

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    Postal: Faculty of Social Sciences, Bar Ilan University 52900 Ramat-Gan
    Phone: Phone: +972-3-5318345
    Fax: +972-3-7384034
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    Web page: http://econ.biu.ac.il
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    Related research

    Keywords: liquidity trap; financial crisis; rare disasters; equity capital; leverage; bankruptcy risk.;

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    1. Douglas Gale & Onur Özgür, 2005. "Are Bank Capital Ratios too High or too Low? Incomplete Markets and Optimal Capital Structure," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 690-700, 04/05.
    2. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
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    4. Makowski, Louis, 1983. "Competitive Stock Markets," Review of Economic Studies, Wiley Blackwell, vol. 50(2), pages 305-30, April.
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    7. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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    12. Mitsuhiro Fukao, 2002. "Financial Sector Profitability and Double-Gearing," NBER Working Papers 9368, National Bureau of Economic Research, Inc.
    13. Hoshi, Takeo & Kashyap, Anil K, 2010. "Will the U.S. bank recapitalization succeed? Eight lessons from Japan," Journal of Financial Economics, Elsevier, vol. 97(3), pages 398-417, September.
    14. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    15. Charles W. Calomiris & Berry Wilson, 2004. "Bank Capital and Portfolio Management: The 1930s "Capital Crunch" and the Scramble to Shed Risk," The Journal of Business, University of Chicago Press, vol. 77(3), pages 421-456, July.
    16. Hoshi, Takeo, 2001. "What Happened to Japanese Banks?," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(1), pages 1-29, February.
    17. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
    18. Hoshi, Takeo & Ito, Takatoshi, 2004. "Financial regulation in Japan: a sixth year review of the Financial Services Agency," Journal of Financial Stability, Elsevier, vol. 1(2), pages 229-243, December.
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