The Safer, the Riskier: A Model of Financial Instability and Bank Leverage
AbstractWe 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 InfoPaper 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.
Length: 24 pages
Date of creation: Mar 2014
Date of revision:
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Bank run; Financial crisis; Maturity mismatch;
Find related papers by JEL classification:
- E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
- G01 - Financial Economics - - General - - - Financial Crises
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2014-03-15 (All new papers)
- NEP-BAN-2014-03-15 (Banking)
- NEP-MAC-2014-03-15 (Macroeconomics)
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