Externalities and Financial Crisis – Enough to Cause Collapse?
After the boom in US subprime lending came the bust – with a run on US shadow banks. The magnitude of boom and bust were, it seems, amplified by two significant externalities triggered by aggregate shocks: the endogeneity of bank equity due to mark-to-market accounting and of bank liquidity due to ‘fire-sales’ of securitised assets. We show how adding a systemic ‘bank run’ to the canonical model of Adrian and Shin allows for a tractable analytical treatment – including the counterfactual of complete collapse that forces the Treasury and the Fed to intervene.
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