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The limits of market discipline: proprietary trading and aggregate risk

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  • Sylvain Champonnois

    (UCSD)

Abstract

Market discipline is the mechanism by which the adjustment of cost of capital to the level of risk feeds into managerial incentives and deters excessive risk-taking. We show that risk-taking by entrepreneurs and demand for risky securities by risk-neutral investors (e.g. fund managers or proprietary traders) are mutually reinforcing. Larger risk-neutral fund managers (relative to risk-averse investors) not only undermine market discipline and lead to more risk-taking, but they also benefit more from the upside of risk and become relatively larger if the project pays out, which leads to even more risk-taking in the next period. The model explains documented features of the business cycle: bubble-like asset prices (procyclical run-up in prices and procyclical underpricing of risk), shorter cycles and countercyclical leverage of the non-financial sector.

Suggested Citation

  • Sylvain Champonnois, 2011. "The limits of market discipline: proprietary trading and aggregate risk," 2011 Meeting Papers 1013, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:1013
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