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Equilibrium risk shifting and interest rate in an opaque financial system

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  • Challe, Edouard
  • Mojon, Benoit
  • Ragot, Xavier

Abstract

We analyse the risk-taking behaviour of heterogenous intermediaries that are protected by limited liability and choose both their amount of leverage and the risk exposure of their portfolio. Due to the opacity of the financial sector, outside providers of funds cannot distinguish “prudent” intermediaries from those “imprudent” ones that voluntarily hold high-risk portfolios and expose themselves to the risk of bankrupcy. We show how the number of imprudent intermediaries is determined in equilibrium jointly with the interest rate, and how both ultimately depend on the cross-sectional distribution of intermediaries' capital. One implication of our analysis is that an exogenous increase in the supply of funds to the intermediary sector lowers interest rates and raises the number of imprudent intermediaries. Another one is that easy financing may lead an increasing number of intermediaries to gamble for resurection following a bad shock to the sector's capital, again raising economywide systemic risk.

Suggested Citation

  • Challe, Edouard & Mojon, Benoit & Ragot, Xavier, 2013. "Equilibrium risk shifting and interest rate in an opaque financial system," European Economic Review, Elsevier, vol. 63(C), pages 117-133.
  • Handle: RePEc:eee:eecrev:v:63:y:2013:i:c:p:117-133 DOI: 10.1016/j.euroecorev.2013.07.003
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    Cited by:

    1. Simon Dubecq & Benoit Mojon & Xavier Ragot, 2015. "Risk Shifting with Fuzzy Capital Constraints," International Journal of Central Banking, International Journal of Central Banking, vol. 11(1), pages 71-101, January.
    2. Matheron, J. & Antipa, P., 2014. "Interactions between monetary and macroprudential policies," Financial Stability Review, Banque de France, issue 18, pages 225-240, April.
    3. Barthélemy, J. & Marx, M., 2012. "Generalizing the Taylor Principle: New Comment," Working papers 403, Banque de France.
    4. E. Mengus, 2014. "International Bailouts: Why Did Banks' Collective Bet Lead Europe to Rescue Greece?," Working papers 502, Banque de France.
    5. repec:eee:ememar:v:31:y:2017:i:c:p:116-140 is not listed on IDEAS
    6. Cociuba, Simona E. & Shukayev, Malik & Ueberfeldt, Alexander, 2016. "Collateralized borrowing and risk taking at low interest rates," European Economic Review, Elsevier, vol. 85(C), pages 62-83.
    7. Chen, Minghua & Wu, Ji & Jeon, Bang Nam & Wang, Rui, 2017. "Monetary policy and bank risk-taking: Evidence from emerging economies," Emerging Markets Review, Elsevier, pages 116-140.

    More about this item

    Keywords

    Risk shifting; Portfolio correlation; Financial opacity;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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