Curbing excessive financial risk in the economy: reputation is not enough

Abstract

We study the interaction between the financial and the real sector in a macroeconomy. Existing experiments about financial intermediaries either study the financial side in isolation, or model the real sector in reduced form. In our set-up, financial intermediation can generate macroeconomic risk in both the financial and real sectors. While financial intermediaries support the settlement of transactions in the real sector, they also undertake risky investments, which exhibit negative externalities onto the real sector in case of insolvency. In equilibrium, intermediaries take more risk than what would be socially optimal. We study how two prototypical institutions – one that facilitates the monitoring of intermediaries' activities and another that imposes collateral requirements on financial activity – can reduce this externality and increase overall efficiency by insulating the real sector from disruptions in trading activity. Observed performance is weak for the monitoring institution and strong for collateral requirements.