Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System
43 Pages Posted: 20 Aug 2012
Date Written: August 20, 2012
We analyze the risk-taking behavior of heterogeneous intermediaries that are protected by limited liability and choose both their amount of leverage and the risk exposure of their portfolio. Due to the opacity of the financial sector, outside providers of funds cannot distinguish 'prudent' intermediaries from 'imprudent' ones that voluntarily hold high-risk portfolios and expose themselves to the risk of bankruptcy.
We show how the number of imprudent intermediaries is determined in equilibrium jointly with the interest rate, and how both ultimately depend on the cross-sectional distribution of intermediaries’ capital. One implication of our analysis is that an exogenous increase in the supply of funds to the intermediary sector (following, e.g., capital inflows) lowers interest rates and raises the number of imprudent intermediaries (the risk-taking channel of low interest rates). Another one is that easy financing may lead an increasing number of intermediaries to gamble for resurrection following a bad shock to the sector’s capital, again raising economy wide systemic risk (the gambling-for-resurrection channel of falling equity).
Keywords: risk shifting, portfolio correlation, systemic risk, financial opacity
JEL Classification: E44, G01, G20
Suggested Citation: Suggested Citation