Collective Moral Hazard and the Interbank Market

Levent Altinoglu and Joseph Stiglitz

No 29807, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The concentration of risk within the financial system leads to systemic instability. We propose a theory to explain the structure of the financial system and show how it alters the risk taking incentives of financial institutions when the government optimally intervenes during crises. By issuing interbank claims, risky institutions endogenously become too interconnected to fail. This concentrated structure enables institutions to share the risk of systemic crises in a privately optimal way, but leads to excessive risk taking even by peripheral institutions. Interconnectedness and excessive risk taking reinforce one another. Macroprudential regulation which limits the interconnectedness of risky institutions improves welfare.

JEL-codes: E44 E61 G01 G18 G28 (search for similar items in EconPapers)
Date: 2022-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-fdg, nep-fmk, nep-mac and nep-rmg
Note: EFG
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Published as Levent Altinoglu & Joseph E. Stiglitz, 2023. "Collective Moral Hazard and the Interbank Market," American Economic Journal: Macroeconomics, vol 15(2), pages 35-64.

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Journal Article: Collective Moral Hazard and the Interbank Market (2023)
Working Paper: Collective Moral Hazard and the Interbank Market (2020)
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