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A theory of balance sheet crisis

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  • Bo, Wang

Abstract

This paper develops a balance sheet crisis theory to explain how equity collateralization and mark-to-market (MTM) accounting amplify systemic fragility through endogenous feedback loops. By modelling the interplay between liquidity shocks, asset valuations, and strategic trader behaviour, we demonstrate that liquidity injections exert dual stabilizing effects: a direct channel that offsets funding shortfalls and an indirect channel that boosts collateral values, thereby relaxing borrowing constraints. Formalizing this mechanism through a liquidity multiplier, we show that each unit of liquidity provision reduces financial fragility by more than one unit-a non-linear effect magnified by rising equity collateralization. Our framework challenges traditional models that prescribe proportional interventions, rationalizing the oversized scale of post-crisis policies like the 2020 Fed Corporate Credit Facilities. By integrating Minskian financial instability with modern market microstructure, we advocate for dynamic, collateral-adjusted liquidity frameworks to pre-empt systemic crises.

Suggested Citation

  • Bo, Wang, 2026. "A theory of balance sheet crisis," Finance Research Letters, Elsevier, vol. 87(C).
    • Handle: RePEc:eee:finlet:v:87:y:2026:i:c:s1544612325023724
    DOI: 10.1016/j.frl.2025.109123
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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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