Working Paper: CEPR ID: DP8556
Authors: Michael R. Wickens
Abstract: This paper takes the view that a major contributing factor to the financial crisis of 2008 was a failure to correctly assess and price the risk of default. In order to analyse default risk in the macroeconomy, a simple general equilibrium model with banks and financial intermediation is constructed in which default-risk can be priced. It is shown how the credit spread can be attributed largely to the risk of default and how excess loan creation may emerge due different attitudes to risk by borrowers and lenders. The model can also be used to analyse systemic risk due to macroeconomic shocks which may be reduced by holding collateral.
Keywords: default; financial crisis; financial intermediation; liquidity shortages; risk
JEL Codes: E44; E51; G12; G21; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| default risk (G33) | underpricing of mortgage loans (G21) |
| underpricing of mortgage loans (G21) | financial crisis (G01) |
| misjudged risk assessments by banks (G21) | excessive loan creation (E51) |
| default risk (G33) | credit spread (G19) |
| credit spread (G19) | loan rates (E43) |
| collateral (G33) | likelihood of default (G33) |
| underestimation of default risk (G33) | excessive leverage (G32) |
| risk perceptions of banks (G21) | risk perceptions of nonbank public (G21) |