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Financial innovation, macroeconomic stability and systemic crises

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  • Prasanna Gai
  • Sujit Kapadia
  • Stephen Millard
  • Ander Perez

Abstract

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and captures the spillovers associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, these spillovers can potentially generate a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past, but potentially more severe.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 340.

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Date of creation: Feb 2008
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Handle: RePEc:boe:boeewp:340

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  1. Morris, S & Song Shin, H, 1996. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks," Economics Papers 126, Economics Group, Nuffield College, University of Oxford.
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  8. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
  9. Luca Benati, 2004. "Evolving post-World War II UK economic performance," Bank of England working papers 232, Bank of England.
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  11. Philippe Aghion & Abhijit Banerjee & Thomas Piketty, 1999. "Dualism And Macroeconomic Volatility," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1359-1397, November.
  12. Raghuram G. Rajan, 2005. "Has financial development made the world riskier?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
  13. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 2000. "Currency Crises and Monetary Policy in an Economy with Credit Constraints," Working Papers 00.07, Swiss National Bank, Study Center Gerzensee.
  14. Hoggarth, Glenn & Reis, Ricardo & Saporta, Victoria, 2002. "Costs of banking system instability: Some empirical evidence," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 825-855, May.
  15. Patrick McGuire & Eli Remolona & Kostas Tsatsaronis, 2005. "Time-varying exposures and leverage in hedge funds," BIS Quarterly Review, Bank for International Settlements, March.
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  17. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
  18. Franklin Allen & Douglas Gale, 2007. "Systemic Risk and Regulation," NBER Chapters, in: The Risks of Financial Institutions, pages 341-376 National Bureau of Economic Research, Inc.
  19. Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 809-833.
  20. Prasanna Gai & Peter Kondor & Nicholas Vause, 2006. "Procyclicality, collateral values and financial stability," Bank of England working papers 304, Bank of England.
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Citations

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Cited by:
  1. Kara, Gazi, 2013. "Systemic Risk, International Regulation, and the Limits of Coordination," Finance and Economics Discussion Series 2013-87, Board of Governors of the Federal Reserve System (U.S.).
  2. Piergiorgio Alessandri & Prasanna Gai & Sujit Kapadia & Nada Mora & Claus Puhr, 2009. "Towards a Framework for Quantifying Systemic Stability," International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 47-81, September.
  3. Lucas Bretschger & Vivien Kappel, 2010. "Market concentration and the likelihood of financial crises," CER-ETH Economics working paper series 10/138, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
  4. David Aikman & Piergiorgio Alessandri & Bruno Eklund & Prasanna Gai & Sujit Kapadia & Elizabeth Martin & Nada Mora & Gabriel Sterne & Matthew Willison, 2009. "Funding Liquidity Risk in a Quantitative Model of Systemic Stability," Working Papers Central Bank of Chile 555, Central Bank of Chile.
  5. Marcus Miller & Joseph Stiglitz, 2010. "Leverage and Asset Bubbles: Averting Armageddon with Chapter 11?," Economic Journal, Royal Economic Society, vol. 120(544), pages 500-518, 05.
  6. Mirakhor, Abbas & Krichene, Noureddine, 2009. "The Recent Crisis: Lessons for Islamic Finance," MPRA Paper 56022, University Library of Munich, Germany.
  7. David Mayes, 2011. "The future of financial markets: financial crisis avoidance," Empirica, Springer, vol. 38(1), pages 77-101, February.
  8. repec:dgr:uvatin:2010052 is not listed on IDEAS
  9. Mariano Beltrani & Juan Cuattromo, 2012. "Redefining Monetary Policy Limits: Towards an Expansion of its Role in Economic Development," Ensayos Económicos, Central Bank of Argentina, Economic Research Department, vol. 1(67), pages 121-168, December.
  10. Rasmus Kattai, 2010. "Credit risk model for the Estonian banking sector," Bank of Estonia Working Papers wp2010-01, Bank of Estonia, revised 04 Feb 2010.
  11. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers 229, Bank for International Settlements.
  12. Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 809-833.
  13. da Silva, Marcos Soares & Divino, Jose Angelo, 2013. "The role of banking regulation in an economy under credit risk and liquidity shock," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 266-281.

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