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Risk Shifting, Asset Bubbles, and Self-fulfilling Crises

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  • Challe, Edouard
  • Ragot, Xavier

Abstract

Financial crisis are often associated with an endogenous credit reversal fol- lowed by a fall in asset prices and failures of financial institutions. To account for this sequence of events, this paper constructs a model where the excess risk-taking of portfolio investors leads to a bubble in asset prices (in the spirit of Allen and Gale, Economic Journal, 2000), and where the supply of credit to these investors is endogenous. First, we show that changes in the composition and riskiness of investors' portfolio as total lending varies may cause the ex ante return on loans to increase with the amount of total lending, thereby creating the potential for multiple (Pareto-ranked) equilibria associated with different levels of lending, asset prices, and output. We then embed this mechanism into a 3-period model where the low-lending equilibrium is selected with positive probability at the intermediate date. This event is associated with a inefficient liquidity dry-up, a market crash, and widespread failures of borrowers.

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Bibliographic Info

Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/2712.

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Date of creation: Dec 2005
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Handle: RePEc:dau:papers:123456789/2712

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Related research

Keywords: Financial crises; Credit market imperfections; self-fulfilling expectations;

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  1. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  2. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  3. V. V. Chari & Patrick J. Kehoe, 2003. "Hot Money," Levine's Bibliography 506439000000000415, UCLA Department of Economics.
  4. Kaminsky, Graciela L & Reinhart, Carmen M, 1998. "Financial Crises in Asia and Latin America: Then and Now," American Economic Review, American Economic Association, American Economic Association, vol. 88(2), pages 444-48, May.
  5. Paul Povel & Michael Raith, 2004. "Optimal Debt with Unobservabable Investments," RAND Journal of Economics, The RAND Corporation, vol. 35(3), pages 599-616, Autumn.
  6. Graciela Laura Kaminsky, 1999. "Currency and Banking Crises," IMF Working Papers 99/178, International Monetary Fund.
  7. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 103(3), pages 441-63, August.
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