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

24 Pages Posted: 6 Mar 2014 Last revised: 7 Mar 2014

See all articles by Ryo Kato

Ryo Kato

Asia University; TCER

Takayuki Tsuruga

Osaka University, Institute of Social and Economic Research

Date Written: March 1, 2014

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

JEL Classification: E3, G01, G21

Suggested Citation

Kato, Ryo and Tsuruga, Takayuki, The Safer, the Riskier: A Model of Financial Instability and Bank Leverage (March 1, 2014). CAMA Working Paper No. 26/2014, Available at SSRN: https://ssrn.com/abstract=2403607 or http://dx.doi.org/10.2139/ssrn.2403607

Ryo Kato

Asia University ( email )

5-8 Sakai, Musashisno
Tokyo, 1808629
Japan

TCER ( email )

Sankyo Building
Room 703, Main Building
Chiyoda-ku, Tokyo, 1-7-10
Japan

Takayuki Tsuruga (Contact Author)

Osaka University, Institute of Social and Economic Research ( email )

6-1 Mihogaoka
Ibaraki, 567-0047
Japan

HOME PAGE: http://www.iser.osaka-u.ac.jp/~tsuruga/

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