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

Ryo Kato and Takayuki Tsuruga

Discussion papers from Graduate School of Economics Project Center, Kyoto 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 runs; Great moderation; Financial crisis; Maturity mismatch (search for similar items in EconPapers)
JEL-codes: E3 G01 G21 (search for similar items in EconPapers)
Pages: 23 pages
Date: 2011-02
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:kue:dpaper:e-10-014

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