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Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System

Edouard Challe (), Benoit Mojon () and Xavier Ragot ()

Working papers from Banque de France

Abstract: We analyze the risk-taking behavior of heterogenous 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 bankrupcy. 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. (search for similar items in EconPapers)
JEL-codes: E44 G01 G20 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-mac
Date: 2012
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Related works:
Journal Article: Equilibrium risk shifting and interest rate in an opaque financial system (2013) Downloads
Working Paper: Equilibrium risk shifting and interest rate in an opaque financial system (2013)
Working Paper: Equilibrium risk shifting and interest rate in an opaque financial system (2013) Downloads
Working Paper: Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System (2012) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:bfr:banfra:391

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