Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses

Abstract

This paper develops a simple model of systemic risk in the form of financial accelerator effects whereby adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. The paper shows that the free market equilibrium in such an environment is generically inefficient because constrained market participants do not internalize that their actions entail amplification effects. Therefore they undervalue the social benefits of liquidity during crises and take on too much systemic risk. We use our framework to shed light on a number of current policy issues. First, we draw lessons for the ex-ante regulation of systemic risk: we develop a new analytical framework of macro-prudential capital adequacy requirements that take into account systemic risk. Second, we show that banks face socially insufficient incentives to raise more capital during systemic crises. We also analyze channels of financial contagion and explain why private agents will take insufficient precautions against contagion from other sectors in the economy.

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