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Interest rates and financial fragility

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  • Li, Yang

Abstract

How do the interest rates banks earn on their assets affect the susceptibility of the banking system to a self-fulfilling run by depositors? I study this question in a version of the model of Diamond and Dybvig (1983) with limited commitment and a non-trivial portfolio choice. I show that the relationship between these interest rates and financial fragility is often non-monotone. For example, a small increase in the return on illiquid investment (or a small increase in the term premium) may raise banks’ susceptibility to a run, while a larger increase would make the banking system more stable. The same is true for changes in short-term rates, holding the longer-term rates fixed. I provide a precise characterization of these comparative statics of financial fragility.

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  • Li, Yang, 2017. "Interest rates and financial fragility," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 195-205.
    • Handle: RePEc:eee:dyncon:v:82:y:2017:i:c:p:195-205
    DOI: 10.1016/j.jedc.2017.06.009
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    Cited by:

    1. Keister, Todd & Mitkov, Yuliyan, 2023. "Allocating losses: Bail-ins, bailouts and bank regulation," Journal of Economic Theory, Elsevier, vol. 210(C).
    2. Toni Ahnert & Kartik Anand & Philipp Johann König, 2024. "Real Interest Rates, Bank Borrowing, and Fragility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(6), pages 1545-1571, September.
    3. Ryuichiro Izumi, 2021. "Opacity: Insurance and Fragility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 40, pages 146-169, April.
    4. Gao, Jiahong & Reed, Robert R., 2021. "Sunspot bank runs and fragility: The role of financial sector competition," European Economic Review, Elsevier, vol. 139(C).
    5. Ryuichiro Izumi & Yang LI, 2024. "Rapid Bank Runs and Delayed Policy Responses," Wesleyan Economics Working Papers 2024-006, Wesleyan University, Department of Economics.
    6. Ryuichiro Izumi & Yang Li, 2021. "Financial Stability with Fire Sale Externalities," Wesleyan Economics Working Papers 2021-002, Wesleyan University, Department of Economics.
    7. Gao, Jiahong & Reed, Robert R., 2024. "Increasing returns to scale and financial fragility," Journal of Mathematical Economics, Elsevier, vol. 111(C).
    8. Sim, Khai Zhi, 2023. "Monetary and fiscal coordination in preventing bank failures and financial contagion," Journal of Macroeconomics, Elsevier, vol. 75(C).
    9. Voellmy, Lukas, 2024. "Preventing runs under sequential revelation of liquidity needs," Journal of Economic Dynamics and Control, Elsevier, vol. 158(C).

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    More about this item

    Keywords

    Bank runs; Excess liquidity; Financial fragility; Portfolio choice; Term premium;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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