Market Discipline and Systemic Risk

Alan Morrison and Ansgar Walther

No 12689, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: 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: Systemic risk; Market discipline; Return correlation; Macro-prudential regulation (search for similar items in EconPapers)
JEL-codes: G01 G21 (search for similar items in EconPapers)
Date: 2018-02
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-rmg
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