Bank Asset Problems and Financial Stability

Abstract

We study a bank failure mechanism from the bank asset side. Every bank loan is modelled by two contracts connecting three agents: entrepreneurs, a bank, and household depositors. We make one new assumption for each agent. The first bank asset problem emerges when bad loans impair a bank’s regulatory capital ratio. The second bank asset problem arises through bank capital depleting recovery or insufficient household recovery. Our model has predictions on (1) bank collapses in 2023, (2) large banks purchasing distressed MBS and endamaging financial stability in 2008, (3) the Libor scandal, (4) balance sheet misreporting, and (5) cross-borrower spillovers.

Presented by John Chu