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See Kiyotaki and Gertler (2010) and Christiano and Ikeda (2010) for surveys of frictions in models of banking. Bernanke, Gertler and Gilchrist (1999) and this paper rely on asymmetric information and costly state verification to model financial frictions. Gertler and Karadi (2010) and Meh and Moran (2010) are models of moral hazard.
Any value of capital is profit maximizing.
Future versions of this model will also allow for bank holdings of government securities. In the present model these are assumed to remain in zero net supply (see below).
The coefficients are mi = 0.7, mπ = 2.0 and mygr = 0.25, where the latter is a coefficient on output growth rather than on the output gap.
The figure refers to capital investment funds as corporates.
This analysis is done purely as a thought experiment that helps us understand the nature of optimal prudential rules. It is hard to think how, in practice, a usable empirical counterpart of σt could be identified.
Technically, the risk of a bank going bankrupt is not zero but extremely close to zero. Formally, for depositors to perceive their returns as completely safe one would have to assume implicit government deposit insurance for the residual risk.