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Interest rates and financial fragility

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  • Li, Yang

Abstract

How do the interest rates banks earn on their assets affect the susceptibility of the banking system to a self-fulfilling run by depositors? I study this question in a version of the model of Diamond and Dybvig (1983) with limited commitment and a non-trivial portfolio choice. I show that the relationship between these interest rates and financial fragility is often non-monotone. For example, a small increase in the return on illiquid investment (or a small increase in the term premium) may raise banks’ susceptibility to a run, while a larger increase would make the banking system more stable. The same is true for changes in short-term rates, holding the longer-term rates fixed. I provide a precise characterization of these comparative statics of financial fragility.

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  • Li, Yang, 2017. "Interest rates and financial fragility," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 195-205.
  • Handle: RePEc:eee:dyncon:v:82:y:2017:i:c:p:195-205
    DOI: 10.1016/j.jedc.2017.06.009
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    Cited by:

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    More about this item

    Keywords

    Bank runs; Excess liquidity; Financial fragility; Portfolio choice; Term premium;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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