Equilibrium Analysis, Banking and Financial Instability

Oxford Finance Research Centre Working Paper No. 2003-FE-08

32 Pages Posted: 19 May 2003

See all articles by Dimitrios P. Tsomocos

Dimitrios P. Tsomocos

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

Date Written: March 2003

Abstract

This paper first extends the canonical General Equilibrium with Incomplete Markets (GEI) model with money and default to allow for competitive banking and financial instability. Second, it introduces capital requirements for the banking sector to assess the short and medium term macroeconomic consequences of the proposed New Basel Accord. Monetary Equilibria with Commercial Banks and Default (MECBD) exist and financial instability and default emerge as equilibrium phenomena. A non-trivial quantity theory of money is derived and the term structure of interest rates incorporates both the 'expectations' and the 'liquidity preference' hypotheses. Thus, monetary, fiscal and regulatory policies necessarily generate real effects. Non-neutrality relies upon the real and nominal determinacy of MECBD. A version of the liquidity trap holds and the Diamond-Dybvig (1983) result is a special case. Finally, because of the presence of capital requirements for banks, a trade off exists between regulatory policy and efficiency. The model provides a useful analytical device for policy analysis of situations in which crisis prevention and management become necessary to reduce the risks and costs of financial instability.

Keywords: Financial instability, competitive banking, capital requirements, Basel accord, regulation, incomplete markets, default, non-neutrality, Gains-to-Trade

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

Suggested Citation

Tsomocos, Dimitrios P., Equilibrium Analysis, Banking and Financial Instability (March 2003). Oxford Finance Research Centre Working Paper No. 2003-FE-08, Available at SSRN: https://ssrn.com/abstract=389362 or http://dx.doi.org/10.2139/ssrn.389362

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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