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A Model to Analyse Financial Fragility

  • Dimitrios P Tsomocos
  • Charles A.E. Goodhart

Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious inter-relationships between banks, and to the appropriate design of prudential requirements and incentives to limit `excessive` risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 2003-FE-13.

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Date of creation: 01 Oct 2003
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Handle: RePEc:oxf:wpaper:2003-fe-13
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  1. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
  2. Dimitrios P. Tsomocos, 2003. "Equilibrium Analysis, Banking and Financial Instability," OFRC Working Papers Series 2003fe08, Oxford Financial Research Centre.
  3. Tomoyuki Nakajima & Herakles Polemarchakis, 2005. "Money and Prices Under Uncertainty," Review of Economic Studies, Oxford University Press, vol. 72(1), pages 223-246.
  4. Tobin, James, 1982. " The Commercial Banking Firm: A Simple Model," Scandinavian Journal of Economics, Wiley Blackwell, vol. 84(4), pages 495-530.
  5. Charles Goodhart, 1989. "Money, Information and Uncertainty: 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262071223, June.
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