We explore a model of the interaction between banks and outside investors in
which the ability of banks to issue inside money (short-term liabilities
believed to be convertible into currency at par) can generate a collapse in
asset prices and widespread bank insolvency. The banks and investors share a
common belief about the future value of certain long-term assets, but they have
different objective functions; changes to this common belief result in
portfolio adjustments and trade. Positive belief shocks induce banks to buy
risky assets from investors, and the banks finance those purchases by issuing
new short-term liabilities. Negative belief shocks induce banks to sell assets
in order to reduce their chance of insolvency to a tolerably low level, and
they supply more assets at lower prices, which can result in multiple
market-clearing prices. A sufficiently severe negative shock causes the set of
equilibrium prices to contract (in a manner given by a cusp catastrophe),
causing prices to plummet discontinuously and banks to become insolvent.
Successive positive and negative shocks of equal magnitude do not cancel;
rather, a banking catastrophe can occur even if beliefs simply return to their
initial state. Capital requirements can prevent crises by curtailing the
expansion of balance sheets when beliefs become more optimistic, but they can
also force larger price declines. Emergency asset price supports can be
understood as attempts by a central bank to coordinate expectations on an
equilibrium with solvency.
%0 Journal Article
%1 Brummitt2014Inside
%A Brummitt, Charles D.
%A Sethi, Rajiv
%A Watts, Duncan J.
%D 2014
%E Preis, Tobias
%J PLoS ONE
%K systemic-risk banks financial-markets
%N 8
%P e104219+
%R 10.1371/journal.pone.0104219
%T Inside Money, Procyclical Leverage, and Banking Catastrophes
%U http://dx.doi.org/10.1371/journal.pone.0104219
%V 9
%X We explore a model of the interaction between banks and outside investors in
which the ability of banks to issue inside money (short-term liabilities
believed to be convertible into currency at par) can generate a collapse in
asset prices and widespread bank insolvency. The banks and investors share a
common belief about the future value of certain long-term assets, but they have
different objective functions; changes to this common belief result in
portfolio adjustments and trade. Positive belief shocks induce banks to buy
risky assets from investors, and the banks finance those purchases by issuing
new short-term liabilities. Negative belief shocks induce banks to sell assets
in order to reduce their chance of insolvency to a tolerably low level, and
they supply more assets at lower prices, which can result in multiple
market-clearing prices. A sufficiently severe negative shock causes the set of
equilibrium prices to contract (in a manner given by a cusp catastrophe),
causing prices to plummet discontinuously and banks to become insolvent.
Successive positive and negative shocks of equal magnitude do not cancel;
rather, a banking catastrophe can occur even if beliefs simply return to their
initial state. Capital requirements can prevent crises by curtailing the
expansion of balance sheets when beliefs become more optimistic, but they can
also force larger price declines. Emergency asset price supports can be
understood as attempts by a central bank to coordinate expectations on an
equilibrium with solvency.
@article{Brummitt2014Inside,
abstract = {{We explore a model of the interaction between banks and outside investors in
which the ability of banks to issue inside money (short-term liabilities
believed to be convertible into currency at par) can generate a collapse in
asset prices and widespread bank insolvency. The banks and investors share a
common belief about the future value of certain long-term assets, but they have
different objective functions; changes to this common belief result in
portfolio adjustments and trade. Positive belief shocks induce banks to buy
risky assets from investors, and the banks finance those purchases by issuing
new short-term liabilities. Negative belief shocks induce banks to sell assets
in order to reduce their chance of insolvency to a tolerably low level, and
they supply more assets at lower prices, which can result in multiple
market-clearing prices. A sufficiently severe negative shock causes the set of
equilibrium prices to contract (in a manner given by a cusp catastrophe),
causing prices to plummet discontinuously and banks to become insolvent.
Successive positive and negative shocks of equal magnitude do not cancel;
rather, a banking catastrophe can occur even if beliefs simply return to their
initial state. Capital requirements can prevent crises by curtailing the
expansion of balance sheets when beliefs become more optimistic, but they can
also force larger price declines. Emergency asset price supports can be
understood as attempts by a central bank to coordinate expectations on an
equilibrium with solvency.}},
added-at = {2019-06-10T14:53:09.000+0200},
archiveprefix = {arXiv},
author = {Brummitt, Charles D. and Sethi, Rajiv and Watts, Duncan J.},
biburl = {https://www.bibsonomy.org/bibtex/29d1b2381e22dbde9f8b841b209f9c6c6/nonancourt},
citeulike-article-id = {13098023},
citeulike-linkout-0 = {http://dx.doi.org/10.1371/journal.pone.0104219},
citeulike-linkout-1 = {http://arxiv.org/abs/1403.1637},
citeulike-linkout-2 = {http://arxiv.org/pdf/1403.1637},
day = 19,
doi = {10.1371/journal.pone.0104219},
editor = {Preis, Tobias},
eprint = {1403.1637},
interhash = {300cfb5aab1544eb08cf08251f85d4b8},
intrahash = {9d1b2381e22dbde9f8b841b209f9c6c6},
issn = {1932-6203},
journal = {PLoS ONE},
keywords = {systemic-risk banks financial-markets},
month = aug,
number = 8,
pages = {e104219+},
posted-at = {2014-03-10 09:42:32},
priority = {2},
timestamp = {2019-07-31T13:48:52.000+0200},
title = {{Inside Money, Procyclical Leverage, and Banking Catastrophes}},
url = {http://dx.doi.org/10.1371/journal.pone.0104219},
volume = 9,
year = 2014
}