A macroeconomic model with …nancial intermediation is developed in which the intermediaries (banks) can issue outside equity as well as short term debt. This makes bank risk exposure an endogenous choice. The goal is to have a model that can not only capture a crisis when banks are highly vulnerable to risk, but can also account for why banks adopt such a risky balance sheet in the …rst place. We use the model to assess quantitatively how perceptions of fundamental risk and of government credit policy in a crisis a¤ect the vulnerability of the …nancial system ex ante. We also study the e¤ects of macro-prudential policies designed to o¤set the incentives for risk-taking. We thank Philippe Bacchetta and Elu Von Thadden for helpful comments. Gertler and Kiyotaki also wish to acknoweldge the support of the NSF. 1
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