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Systemic risk in the financial sector; a review and synthesis

Author

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  • Michiel Bijlsma

    (CPB Netherlands Bureau for Economic Policy Analysis)

  • Jeroen Klomp

    (CPB Netherlands Bureau for Economic Policy Analysis)

  • Sijmen Duineveld

    (CPB Netherlands Bureau for Economic Policy Analysis)

Abstract

In a financial crisis, an initial shock gets amplified while it propagates to other financial intermediaries, ultimately disrupting the financial sector. We review the literature on such amplification mechanisms, which create externalities from risk taking. We distinguish between two classes of mechanisms: contagion within the financial sector and pro-cyclical connection between the financial sector and the real economy.Regulation can diminish systemic risk by reducing these externalities. However, regulation of systemic risk faces several problems. First, systemic risk and its costs are difficult to quantify. Second, banks have strong incentives to evade regulation meant to reduce systemic risk. Third, regulators are prone to forbearance. Finally, the inability of governments to commit not to bail out systemic institutions creates moral hazard and reduces the market’s incentive to price systemic risk.Strengthening market discipline can play an important role in addressing these problems, because it reduces the scope for regulatory forbearance, does not rely on complex information requirements, and is difficult to manipulate.

Suggested Citation

  • Michiel Bijlsma & Jeroen Klomp & Sijmen Duineveld, 2010. "Systemic risk in the financial sector; a review and synthesis," CPB Document 210.rdf, CPB Netherlands Bureau for Economic Policy Analysis.
  • Handle: RePEc:cpb:docmnt:210.rdf
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    1. Coen Teulings & Frits Bos, 2010. "CPB and Dutch fiscal policy in view of the financial crisis and ageing," CPB Document 218.rdf, CPB Netherlands Bureau for Economic Policy Analysis.

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    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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