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Systemic risk-taking: amplification effects, externalities, and regulatory responses

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  • Korinek, Anton

Abstract

This paper analyzes the efficiency of risk-taking decisions in an economy that is prone to systemic risk, captured by financial amplification effects that occur in response to strong adverse shocks. It shows that decentralized agents who have unconstrained access to a complete set of Arrow securities choose to expose themselves to such risk to a socially inefficient extent because of pecuniary externalities that are triggered during financial amplification. The paper develops an externality pricing kernel that quantifies the state-contingent magnitude of such externalities and provides welfaretheoretic foundations for macro-prudential policy measures to correct the distortion. Furthermore, it derives conditions under which agents employ ex-ante risk markets to fully undo any expected government bailout. Finally, it finds that constrained market participants face socially insufficient incentives to raise more capital during episodes of financial amplification. JEL Classification: E44, G13, G18, D62, H23

Suggested Citation

  • Korinek, Anton, 2011. "Systemic risk-taking: amplification effects, externalities, and regulatory responses," Working Paper Series 1345, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20111345
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp1345.pdf
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    References listed on IDEAS

    as
    1. Anton Korinek, 2009. "Systemic Risk: Amplification Effects, Externalities, and Policy Responses," Working Papers 155, Oesterreichische Nationalbank (Austrian Central Bank).
    2. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 841-879.
    3. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
    4. Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, vol. 58(2), pages 867-893, April.
    5. repec:onb:oenbwp:y::i:155:b:1 is not listed on IDEAS
    6. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-248, April.
    7. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
    8. Shleifer, Andrei & Vishny, Robert W, 1997. "The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    9. Jeanne, Olivier & Korinek, Anton, 2019. "Managing credit booms and busts: A Pigouvian taxation approach," Journal of Monetary Economics, Elsevier, vol. 107(C), pages 2-17.
    10. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    11. Efraim Benmelech & Nittai K. Bergman, 2011. "Bankruptcy and the Collateral Channel," Journal of Finance, American Finance Association, vol. 66(2), pages 337-378, April.
    12. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
    13. Gordy, Michael B. & Howells, Bradley, 2006. "Procyclicality in Basel II: Can we treat the disease without killing the patient?," Journal of Financial Intermediation, Elsevier, vol. 15(3), pages 395-417, July.
    14. Guido Lorenzoni, 2008. "Inefficient Credit Booms," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 75(3), pages 809-833.
    15. Ben Bernanke & Mark Gertler, 1990. "Financial Fragility and Economic Performance," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 105(1), pages 87-114.
    16. John Geanakoplos & Heracles M. Polemarchakis, 1985. "Existence, Regularity, and Constrained Suboptimality of Competitive Allocations When the Asset Market Is Incomplete," Cowles Foundation Discussion Papers 764, Cowles Foundation for Research in Economics, Yale University.
    17. John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
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    20. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    bailout neutrality; externality pricing kernel; financial amplification; macroprudential regulation; systemic externalities; systemic risk;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies

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