Bank Heterogeneity and Financial Stability
60 Pages Posted: 24 Sep 2020 Last revised: 10 Dec 2020
Date Written: August 31, 2020
We investigate stability of a financial system featuring interconnected fragile banks. In the model, banks face run risks and have to liquidate long-term assets in a common market to repay runners. Liquidation prices are depressed when many banks sell their assets simultaneously. When bank assets are homogeneous, their selling behaviors are synchronized, and the feedback loop between runs and fire sales is exacerbated. We show that differentiating banks to some extent enhances stability of all banks, even those whose asset performance ends up being weaker. We discuss implications for the design of financial architecture and government support during crises.
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation