- ECONOMETRICA Journal
- March 2017
Digital Object Identifier (DOI)
International Standard Serial Number (ISSN)
Electronic International Standard Serial Number (EISSN)
- We present a model of the relationship between real interest rates, credit spreads,and the structure and risk of the banking system. Banks intermediate between en-trepreneurs and investors, and can monitor entrepreneurs' projects. We characterizethe equilibrium for a fixed aggregate supply of savings, showing that safer entrepreneurswill be funded by nonmonitoring banks and riskier entrepreneurs by monitoring banks.We show that an increase in savings reduces interest rates and spreads, and increasesthe relative size of the nonmonitoring banking system and the probability of failure ofmonitoring banks. We also show that the dynamic version of the model exhibits endoge-nous boom and bust cycles, and rationalizes the existence of countercyclical risk premiaand the connection between low interest rates, tight credit spreads, and the buildup ofrisks during booms.