Equilibrium Analysis, Banking, Contagion and Financial Fragility

Bank of England Working Paper Series No. 175

56 Pages Posted: 30 May 2003

See all articles by Dimitrios P. Tsomocos

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Date Written: February 2003

Abstract

This paper contains a General Equilibrium model of an economy with Incomplete Markets (GEI) with money and default. The model is a simplified version of the real world consisting of a non-bank private sector, banks, a Central Bank, a government and a regulator. The model is used to analyse actions by policy makers and to identify policy relevant empirical work. Key analytical results are: A financially fragile system need not collapse; efficiency can be improved with policy intervention; and that a system with heterogeneous banks is more stable than one with homogeneous ones. Existence of monetary equilibria allows for positive default levels in equilibrium. It also characterises contagion and financial fragility as an equilibrium phenomenon.

A definition of financial fragility is proposed. Financial fragility occurs when aggregate profitability of the banking sector declines and defaults in the non-bank private and the banking sectors increase. Thus, equilibria with financial fragility require financial vulnerability in the banking sector and liquidity shortages in the non-bank private sector.

The model will be used as a basis to carry out empirical work on the costs of financial instability, to quantify the effectiveness of particular regulatory tools such as capital requirements, and to identify tradeoffs between increasing stability through action by authorities and the efficiency of the financial system.

JEL Classification: D52, E4, E5, G1, G2

Suggested Citation

Tsomocos, Dimitrios P., Equilibrium Analysis, Banking, Contagion and Financial Fragility (February 2003). Bank of England Working Paper Series No. 175, Available at SSRN: https://ssrn.com/abstract=381140 or http://dx.doi.org/10.2139/ssrn.381140

Dimitrios P. Tsomocos (Contact Author)

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

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