The limits of market discipline: proprietary trading and aggregate risk
AbstractMarket 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 InfoPaper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1013.
Date of creation: 2011
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