A Model to Analyse Financial Fragility

Goodhart, Charles, Sunirand, Pojanart and Tsomocos, Dimitrios (2006) A Model to Analyse Financial Fragility. Economic Theory, 27 (1). pp. 107-142.

Abstract

Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious interrelationships between banks, and to the appropriate design of prudential requirements and incentives to limit excessive risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability and economic efficiency.

Item Type: Article
Keywords: Financial fragility; Commerical banks; General equilibrium; Default; Incomplete markets; Monetary policy; Regulatory policy; finance
Subject(s): Finance
Date Deposited: 11 Feb 2012 18:02
Last Modified: 27 Feb 2017 10:15
Funders: N/A
URI: http://eureka.sbs.ox.ac.uk/id/eprint/1860

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