Working Paper: NBER ID: w29807
Authors: Levent Altinoglu; Joseph E. Stiglitz
Abstract: The concentration of risk within the financial system leads to systemic instability. We propose a theory to explain the structure of the financial system and show how it alters the risk taking incentives of financial institutions when the government optimally intervenes during crises. By issuing interbank claims, risky institutions endogenously become too interconnected to fail. This concentrated structure enables institutions to share the risk of systemic crises in a privately optimal way, but leads to excessive risk taking even by peripheral institutions. Interconnectedness and excessive risk taking reinforce one another. Macroprudential regulation which limits the interconnectedness of risky institutions improves welfare.
Keywords: No keywords provided
JEL Codes: E44; E61; G01; G18; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government intervention during crises (H12) | risk-taking incentives of financial institutions (G21) |
| Interconnectedness of financial institutions (F65) | excessive risk-taking (G41) |
| Risk-sharing among institutions (G21) | exacerbates systemic risk (F65) |
| Interconnectedness and excessive risk-taking (F65) | excessive risk-taking (G41) |
| Optimal macroprudential regulation limits interconnectedness of risky institutions (F65) | improves welfare (D60) |