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The Safer, the Riskier: A Model of Financial Instability and Bank Leverage

  • Ryo Kato
  • Takayuki Tsuruga

We 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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File URL: https://cama.crawford.anu.edu.au/sites/default/files/publication/cama_crawford_anu_edu_au/2014-03/26_2014_kato_tsuruga.pdf
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Paper 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.

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Length: 24 pages
Date of creation: Mar 2014
Date of revision:
Handle: RePEc:een:camaaa:2014-26
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  1. Olivier Jeanne & Anton Korinek, 2010. "Managing Credit Booms and Busts: A Pigouvian Taxation Approach," NBER Working Papers 16377, National Bureau of Economic Research, Inc.
  2. Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
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  4. Jean Tirole & Emmanuel Farhi, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," Working Papers 2009.57, Fondazione Eni Enrico Mattei.
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  8. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates
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  9. Amil Dasgupta, 2004. "Financial Contagion Through Capital Connections: A Model of the Origin and Spread of Bank Panics," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1049-1084, December.
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  13. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
  14. Gertler, Mark & Kiyotaki, Nobuhiro & Queralto, Albert, 2012. "Financial crises, bank risk exposure and government financial policy," Journal of Monetary Economics, Elsevier, vol. 59(S), pages S17-S34.
  15. Gary Gorton, 1986. "Banking panics and business cycles," Working Papers 86-9, Federal Reserve Bank of Philadelphia.
  16. Douglas W. Diamond & Raghuram G. Rajan, 2012. "Illiquid Banks, Financial Stability, and Interest Rate Policy," Journal of Political Economy, University of Chicago Press, vol. 120(3), pages 552 - 591.
  17. Luc Laeven & Fabián Valencia, 2013. "Systemic Banking Crises Database," IMF Economic Review, Palgrave Macmillan, vol. 61(2), pages 225-270, June.
  18. Angela Maddaloni & Jose-Luis Peydro, 2011. "Bank Risk-taking, Securitization, Supervision, and Low Interest Rates: Evidence from the Euro-area and the U.S. Lending Standards," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2121-2165.
  19. Jeremy C. Stein, 2012. "Monetary Policy as Financial Stability Regulation," The Quarterly Journal of Economics, Oxford University Press, vol. 127(1), pages 57-95.
  20. Gary B. Gorton & Andrew Metrick, 2012. "Who Ran on Repo?," NBER Working Papers 18455, National Bureau of Economic Research, Inc.
  21. Gabriel Jiménez & Steven Ongena & José Luis Peydró & Jesús Saurina, 2009. "Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit risk-taking?," Working Papers 0833, Banco de España;Working Papers Homepage.
  22. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Banking Crises: An Equal Opportunity Menace," NBER Working Papers 14587, National Bureau of Economic Research, Inc.
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