Working Paper: CEPR ID: DP12689
Authors: Alan Morrison; Ansgar Walther
Abstract: We analyze a general equilibrium model in which financial institutions generate endogenous systemic risk, even in the absence of any government support. Banks optimally select correlated investments and thereby expose themselves to fire sale risk so as to sharpen their incentives. Systemic risk is therefore a natural consequence of banks' fundamental role as delegated monitors. Our model sheds light on recent and historical trends in measured systemic risk. Technological innovations and government-directed lending can cause surges in systemic risk. Strict capital requirements and well-designed government asset purchase programs can combat systemic risk.
Keywords: systemic risk; market discipline; return correlation; macroprudential regulation
JEL Codes: G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| banks' investment choices (G11) | systemic risk (E44) |
| correlated investments (G11) | systemic risk (E44) |
| correlated investments (G11) | incentives for high-quality investments (G31) |
| strategic selection of investments (G11) | mitigation of moral hazard (G52) |
| regulatory measures (G18) | influence on equilibria (D50) |
| equilibria (D50) | systemic risk levels (E44) |
| correlated investments (G11) | fire sale risks (G33) |