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Related Experiment Videos

Inside money, procyclical leverage, and banking catastrophes.

Charles D Brummitt1, Rajiv Sethi2, Duncan J Watts3

  • 1Department of Mathematics, University of California Davis, Davis, California, United States of America; Complexity Sciences Center, University of California Davis, Davis, California, United States of America.

Plos One
|August 20, 2014
PubMed
Summary

Bank liabilities can trigger asset price collapse and insolvency. Even without new shocks, a banking crisis can occur, highlighting the risks of inside money and investor beliefs.

Related Experiment Videos

Area of Science:

  • Financial economics
  • Banking theory
  • Systemic risk

Background:

  • Banks and investors share asset value beliefs but have different goals.
  • Bank liabilities (inside money) can influence asset prices and solvency.

Purpose of the Study:

  • To model the interaction between banks and investors.
  • To analyze how inside money issuance affects asset prices and bank insolvency.
  • To explore the role of belief shocks in financial crises.

Main Methods:

  • Agent-based modeling of bank-investor interactions.
  • Analysis of portfolio adjustments and trade dynamics.
  • Application of catastrophe theory to model price discontinuities.

Main Results:

  • Positive belief shocks lead banks to buy assets, financed by issuing inside money.
  • Negative shocks cause banks to sell assets, potentially leading to multiple equilibria and price collapse.
  • A severe negative shock can trigger a discontinuous drop in asset prices and bank insolvency.
  • Capital requirements can mitigate crises but may exacerbate price declines; central bank interventions aim to stabilize expectations.

Conclusions:

  • The issuance of inside money by banks, influenced by investor beliefs, can lead to financial instability and bank runs.
  • Financial crises can occur even with neutral or returning belief shocks due to the dynamics of inside money and asset sales.
  • Policy interventions like capital requirements and asset price supports have complex effects on crisis prevention and severity.