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

Ryo Kato and Takayuki Tsuruga

Economic Modelling, 2016, vol. 52, issue PA, 71-77

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.

Keywords: Bank run; Financial crisis; Maturity mismatch (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (6)

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Working Paper: The Safer, the Riskier: A Model of Financial Instability and Bank Leverage (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:52:y:2016:i:pa:p:71-77

DOI: 10.1016/j.econmod.2015.04.016

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