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The safer, the riskier: A model of financial instability and bank leverage

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  • Kato, Ryo
  • Tsuruga, Takayuki

Abstract

We examine the role of bank leverage to explain why the 2007–2008 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.

Suggested Citation

  • Kato, Ryo & Tsuruga, Takayuki, 2016. "The safer, the riskier: A model of financial instability and bank leverage," Economic Modelling, Elsevier, vol. 52(PA), pages 71-77.
  • Handle: RePEc:eee:ecmode:v:52:y:2016:i:pa:p:71-77
    DOI: 10.1016/j.econmod.2015.04.016
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    Keywords

    Bank run; Financial crisis; Maturity mismatch;

    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

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