Systemic risk in the financial sector; a review and synthesis

Michiel Bijlsma, Jeroen Klomp and Sijmen Duineveld

No 210, CPB Document from CPB Netherlands Bureau for Economic Policy Analysis

Abstract: In a financial crisis, an initial shock gets amplified while it propagates to other financial intermediaries, ultimately disrupting the financial sector. We review the literature on such amplification mechanisms, which create externalities from risk taking. We distinguish between two classes of mechanisms: contagion within the financial sector and pro-cyclical connection between the financial sector and the real economy.Regulation can diminish systemic risk by reducing these externalities. However, regulation of systemic risk faces several problems. First, systemic risk and its costs are difficult to quantify. Second, banks have strong incentives to evade regulation meant to reduce systemic risk. Third, regulators are prone to forbearance. Finally, the inability of governments to commit not to bail out systemic institutions creates moral hazard and reduces the market’s incentive to price systemic risk.Strengthening market discipline can play an important role in addressing these problems, because it reduces the scope for regulatory forbearance, does not rely on complex information requirements, and is difficult to manipulate.

JEL-codes: G01 G28 (search for similar items in EconPapers)
Date: 2010-07
New Economics Papers: this item is included in nep-ban, nep-cta, nep-fmk, nep-reg and nep-rmg
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:cpb:docmnt:210

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