Market Discipline and Systemic Risk
37 Pages Posted: 14 Feb 2018
Date Written: February 2018
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: macro-prudential regulation, market discipline, return correlation, systemic risk
JEL Classification: G01, G21
Suggested Citation: Suggested Citation