Financial Systems, Micro-Systemic Risks and Central Bank Policy : An Analytical Taxonomy of the Literature

This paper reviews and categorises the literature on micro-systemic risks and on optimal policies designed to mitigate these risks. Micro-systemic risks are risks to the financial system that occur when the interaction of a bank with other banks or with financial markets, can propagate an initially localised shock to the whole financial system and can prevent the latter from fulfilling its intermediation and distributional roles. The severe episodes of financial crises that have plagued economies - developed and emerging markets alike - have made more compelling, the need for policymakers such as central banks, to develop prudential tools as part of crisis prevention and crisis management policies. We review the success of these policies under different theoretical paradigms. The paper ends with a brief synopsis of financial accelerator models which stress on how imperfections in financial markets may magnify the swings and intensity of business cycles and have a more entrenched impact on the macroeconomy.