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

Ryo Kato and Takayuki Tsuruga

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: 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.

Keywords: Bank run; Financial crisis; Maturity mismatch (search for similar items in EconPapers)
JEL-codes: E3 G01 G21 (search for similar items in EconPapers)
Pages: 24 pages
Date: 2014-03
New Economics Papers: this item is included in nep-ban and nep-mac
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Journal Article: The safer, the riskier: A model of financial instability and bank leverage (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2014-26

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