Working Paper: NBER ID: w9806
Authors: Mario Draghi; Francesco Giavazzi; Robert C. Merton
Abstract: Discussions of financial risk often fail to distinguish between risks that are consciously borne and those that are not. To understand the breeding conditions for financial crises the prime focus of concern should not be simply on large risk-taking per se, but on the unintended, or unanticipated accumulation of large risks by individuals, institutions or governments, often through the lack of knowledge or understanding of the risks by stakeholders and overseers of those entities. This paper analyses specific situations in which significant unanticipated and unintended financial risks are accumulated. It focuses, in particular, on the implicit guarantees that governments extend to banks and other financial institutions, which may result in the accumulation, often unconscious from the viewpoint of the government, of unanticipated risks in the balance sheet of the public sector. The paper also discusses how risk exposures can be measured, hedged and transferred through the use of derivatives, swap contracts, and other contractual agreements with specific reference to emerging markets.
Keywords: financial risk; transparency; derivatives; government guarantees; financial crises
JEL Codes: F3; G1; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| implicit government guarantees to financial institutions (G28) | accumulation of unanticipated risks within the public sector's balance sheet (H12) |
| use of derivatives (G13) | enhanced risk management (G38) |
| expansion of derivatives markets (G19) | increase systemic vulnerability (F65) |