Harvard University - Department of Economics; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
Robert W. Vishny
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
April 29, 2009
We propose a theory of financial intermediaries operating in markets influenced by investor sentiment. In our model, banks make loans, securitize these loans, trade in them, or hold cash. They can also borrow money, using their security holdings as collateral. We embed such banks in a stylized financial market, in which securitized loans may be mispriced, and investigate how banks allocate limited capital among the various activities, as well as how they choose their capital structure. Banks maximize profits, and there are no conflicts of interest between bank shareholders and creditors. The theory explains the cyclical behavior of credit and investment, but also accounts for the fundamental instability of banks operating in financial markets, especially when banks use leverage.
Number of Pages in PDF File: 45
Keywords: securitization, leverage, crisis, cycle
JEL Classification: G21, E32, G33
Date posted: April 29, 2009
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