Equilibrium Analysis, Banking, Contagion and Financial
Fragility
Dimitrios Tsomocos
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.
Keywords:
Financial fragility, contagion, competitive banking, capital requirements,
incomplete markets, default.
JEL Classification: D52, E4, E5, G1,
G2.
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