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The Safer, the Riskier: A Model of Financial Instability and Bank Leverage

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  • Ryo Kato
  • Takayuki Tsuruga
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Abstract

We examine the role of bank leverage to explain why the 2007-08 financial crisis unfolded at a time when the economy appears to be less fragile to crisis risks. To this end, we extend the model introduced by Diamond and Rajan (2012) to a variant where the probability of financial crises varies endogenously. In our model, aggregate liquidity shock plays a key role in precipitating a crisis because high liquidity demand in a highly leveraged banking system is likely to expose the economy to greater crisis risks. We consider an example of a “safe” environment where liquidity demand tends to be low on average. Using numerical analysis, we show that the “safer” environment could incentivize banks to raise their leverage, resulting in a banking system that is more vulnerable to liquidity shocks.

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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2014-26.

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Length: 24 pages
Date of creation: Mar 2014
Date of revision:
Handle: RePEc:een:camaaa:2014-26

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Keywords: Bank run; Financial crisis; Maturity mismatch;

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