Pecuniary externalities, bank overleverage, and macroeconomic fragility

Abstract

Pecuniary externalities in models with financial friction justify macroprudential policies for preventing excessive risk taking by economic agents. We extend the Diamond and Rajan model of banks with production factors and explore how a pecuniary externality affects a bank's leverage. We show that the laissez-faire banks in our model take on excessive risks compared with the constrained social optimum. Our numerical simulations suggest that the crisis probability is 2–3 percentage points higher in the laissez-faire economy than in the constrained social optimum.