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Bank Overleverage and Macroeconomic Fragility

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  • Ryo Kato
  • Takayuki Tsuruga
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Abstract

This paper develops a dynamic general equilibrium model that explicitly includes a banking sector engaged in a maturity mismatch. We demonstrate that rational competitive banks take on excessive risks systemically, resulting in overleverage and ine¢ ciently high crisis probabilities. The model accounts for the bank’s seemingly over-optimistic outlook about their own solvency and the asset prices, compared to the social optimum. The result calls for policy intervention to reduce the high crisis probabilities. To this end, the government can commit to bailing out banks through public supply of liquidity or a low-interest rate policy. As opposed to the intention of the government, however, expectations of a bailout could incentivize banks to be even more overleveraged, leaving the economy exposed to higher crisis probabilities.

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File URL: http://www.econ.kyoto-u.ac.jp/projectcenter/Paper/e-12-002.pdf
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Bibliographic Info

Paper provided by Graduate School of Economics Project Center, Kyoto University in its series Discussion papers with number e-12-002.

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Length: 60 pages
Date of creation: Apr 2012
Date of revision: Mar 2013
Handle: RePEc:kue:dpaper:e-12-002

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Related research

Keywords: Financial crisis; Liquidity shortage; Maturity mismatch; Credit externalities; Financial regulation;

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References

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  1. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  2. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-64, March.
  3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  4. 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.
  5. Olivier Jeanne & Anton Korinek, 2010. "Managing Credit Booms and Busts: A Pigouvian Taxation Approach," NBER Working Papers 16377, National Bureau of Economic Research, Inc.
  6. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, Oxford University Press, vol. 127(1), pages 57-95.
  7. Guido Lorenzoni, 2007. "Inefficient Credit Booms," NBER Working Papers 13639, National Bureau of Economic Research, Inc.
  8. Enrique Mendoza & Javier Bianchi, 2010. "Overborrowing, financial crises and ‘macro-prudential’ taxes," Proceedings, Federal Reserve Bank of San Francisco, issue Oct.
  9. Kato, Ryo, 2006. "Liquidity, infinite horizons and macroeconomic fluctuations," European Economic Review, Elsevier, vol. 50(5), pages 1105-1130, July.
  10. Césaire Meh & Kevin Moran, 2008. "The Role of Bank Capital in the Propagation of Shocks," Working Papers 08-36, Bank of Canada.
  11. Reinhart, Carmen & Rogoff, Kenneth, 2009. "Banking Crises: An Equal Opportunity Menace," CEPR Discussion Papers 7131, C.E.P.R. Discussion Papers.
  12. Naohisa Hirakata & Nao Sudo & Kozo Ueda, 2009. "Chained Credit Contracts and Financial Accelerators," IMES Discussion Paper Series 09-E-30, Institute for Monetary and Economic Studies, Bank of Japan.
  13. Douglas W. Diamond & Raghuram Rajan, 2011. "Illiquid Banks, Financial Stability, and Interest Rate Policy," NBER Working Papers 16994, National Bureau of Economic Research, Inc.
  14. Javier Bianchi, 2010. "Credit Externalities: Macroeconomic Effects and Policy Implications," American Economic Review, American Economic Association, vol. 100(2), pages 398-402, May.
  15. Ryo Kato & Takayuki Tsuruga, 2011. "The Safer, the Riskier:A Model of Bank Leverage and Financial Instability," Discussion papers e-10-014, Graduate School of Economics Project Center, Kyoto University.
  16. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
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Cited by:
  1. Anton Korinek & Olivier Jeanne, 2013. "Macroprudential Regulation Versus Mopping Up After the Crash," 2013 Meeting Papers 405, Society for Economic Dynamics.

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