The long-run effects of risk: an equilibrium approach

Joao Madeira, Nuno Palma and Christiaan van der Kwaak

No 15841, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Advanced economies tend to have large financial sectors which can be vulnerable to crises. We employ a DSGE model with banks featuring limited liability to investigate how risk shocks in the financial sector affect long-run macroeconomic outcomes. With full deposit insurance, banks expand balance sheets when risk increases, leading to higher investment and output. With no deposit insurance, we observe substantial drops in long-run credit provision, investment, and output. Reducing moral hazard by lowering the fraction of reimbursed deposits in case of bank default increases the probability of bank default in equilibrium. In equilibrium, the long-run probability of bank default under a regime with no deposit insurance is quadrupled with respect to the case where half of deposits are reimbursed by the government. These differences provide a novel argument in favor of deposit insurance. Our welfare analysis finds that increased risk reduces welfare, except when there is full deposit insurance.

Keywords: Costly state verification; deposit insurance; endogenous leverage; Financial Intermediation; investment; limited liability; Regulation; risk (search for similar items in EconPapers)
JEL-codes: E22 E44 G21 O16 (search for similar items in EconPapers)
Date: 2021-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cwa, nep-dge, nep-fdg, nep-ias and nep-mac
References: Add references at CitEc
Citations: Track citations by RSS feed

Downloads: (external link)
http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=15841 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: The Long-Run Effects of Risk: An Equilibrium Approach (2023)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:15841

Ordering information: This working paper can be ordered from
http://www.cepr.org/ ... rs/dp.php?dpno=15841

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().