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Equity Capital, Bankruptcy Risk and the Liquidity Trap

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  • Oren Levintal

    ()
    (Bar-Ilan University)

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
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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. Olivier Jeanne & Lars E. O. Svensson, 2007. "Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank," American Economic Review, American Economic Association, vol. 97(1), pages 474-490, March.
  2. 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.
  3. 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.
  4. Gauti B. Eggertsson, 2005. "Great expectations and the end of the depression," Staff Reports 234, Federal Reserve Bank of New York.
  5. Mitsuhiro Fukao, 2003. "Financial Sector Profitability and Double-Gearing," NBER Chapters, in: Structural Impediments to Growth in Japan, pages 9-36 National Bureau of Economic Research, Inc.
  6. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  7. 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.
  8. Auerbach, Alan J. & Obstfeld, Maurice, 2012. "The Case for Open-Market Purchases in a Liquidity Trap," Center for International and Development Economics Research, Working Paper Series qt84s7d8c8, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  9. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  10. Dell'Ariccia, Giovanni & Detragiache, Enrica & Rajan, Raghuram, 2008. "The real effect of banking crises," Journal of Financial Intermediation, Elsevier, vol. 17(1), pages 89-112, January.
  11. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  12. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Avoiding Liquidity Traps," CEPR Discussion Papers 2948, C.E.P.R. Discussion Papers.
  13. Franklin Allen & Douglas Gale, . "Arbitrage, Short Sales and Financial Innovation," Rodney L. White Center for Financial Research Working Papers 10-89, Wharton School Rodney L. White Center for Financial Research.
  14. 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.
  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. 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.
  17. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  18. Makowski, Louis, 1983. "Competitive Stock Markets," Review of Economic Studies, Wiley Blackwell, vol. 50(2), pages 305-30, April.
  19. Xavier Gabaix, 2008. "Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-finance," American Economic Review, American Economic Association, vol. 98(2), pages 64-67, May.
  20. 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.
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