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

This paper develops a simple macroeconomic model of systemic risk in the form of financial accelerator effects: 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. We show that decentralized agents choose to expose themselves to financial accelerator effects to a socially inefficient extent and do not take on sufficient insurance against systemic risk even if given access to a complete ex-ante insurance market. We use the framework to shed light on a number of current policy issues: First, we develop a new analytical framework of macro-prudential capital adequacy requirements that take into account systemic risk by employing an externality pricing kernel. Second, we show that agents employ ex-ante risk markets to fully undo any expected government bailout. Finally, we find that constrained market participants face socially insufficient incentives to raise more capital during systemic crises.