Market Discipline and Systemic Risk
Alan D. Morrison, Ansgar Walther
Management Science · 2020 · Volume 66 · Issue 2
Abstract
We analyze a general equilibrium model in which financial institutions generate endogenous systemic risk. 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. This paper was accepted by Gustavo Manso, finance.
Keywords
Systemic risk, market discipline, return correlation, macro-prudential regulation
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