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The limits of market discipline: proprietary trading and aggregate risk

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  • Sylvain Champonnois

    (UCSD)

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    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.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1013.

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    Date of creation: 2011
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    Handle: RePEc:red:sed011:1013

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    1. Zhiguo He & Arvind Krishnamurthy, 2008. "A Model of Capital and Crises," NBER Working Papers 14366, National Bureau of Economic Research, Inc.
    2. Patrick Bolton & Ernst-Ludwig von Thadden, 1998. "Blocks, Liquidity, and Corporate Control," Journal of Finance, American Finance Association, vol. 53(1), pages 1-25, 02.
    3. Landier, Augustin & Sraer, David & Thesmar, David, 2010. "Going for broke: New Century Financial Corporation, 2004-2006," TSE Working Papers 10-199, Toulouse School of Economics (TSE).
    4. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-44, September.
    5. Allen, Franklin & Gale, Douglas, 2000. "Bubbles and Crises," Economic Journal, Royal Economic Society, vol. 110(460), pages 236-55, January.
    6. Boot, Arnoud W. A. & Schmeits, Anjolein, 2000. "Market Discipline and Incentive Problems in Conglomerate Firms with Applications to Banking," Journal of Financial Intermediation, Elsevier, vol. 9(3), pages 240-273, July.
    7. Challe Edouard & Ragot Xavier, 2011. "Bubbles and Self-Fulfilling Crises," The B.E. Journal of Macroeconomics, De Gruyter, vol. 11(1), pages 1-38, May.
    8. Alessandro Barbarino & Boyan Jovanovic, 2004. "Shakeouts and Market Crashes," NBER Working Papers 10556, National Bureau of Economic Research, Inc.
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