The safer, the riskier: a model of financial instability and bank leverage

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. Show more