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The long-run effects of risk: an equilibrium approach

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  • van der Kwaak, Christiaan
  • Madeira, João
  • Palma, Nuno

Abstract

Advanced economies tend to have large financial sectors which can be vulnerable to crises. We employ a DSGE model with banks featuring limited liability to investigate how risk shocks in the financial sector affect long-run macroeconomic outcomes. With full deposit insurance, banks expand balance sheets when risk increases, leading to higher investment and output. With no deposit insurance, we observe substantial drops in long-run credit provision, investment, and output. Reducing moral hazard by lowering the fraction of reimbursed deposits in case of bank default increases the probability of bank default in equilibrium. The long-run probability of bank default under a regime with no deposit insurance is more than 50% higher than under a regime with full deposit insurance for high levels of risk. These differences provide a novel argument in favor of deposit insurance. Our welfare analysis finds that increased risk always reduces welfare, except when there is full deposit insurance and deadweight costs from default are small.

Suggested Citation

  • van der Kwaak, Christiaan & Madeira, João & Palma, Nuno, 2022. "The long-run effects of risk: an equilibrium approach," CEPR Discussion Papers 15841, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:15841
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    2. Quintero-V, Juan C., 2025. "Measuring the impact of changing deposit insurance coverage levels: Findings from Colombia," Journal of Banking & Finance, Elsevier, vol. 175(C).
    3. Gasparini, Tommaso & Lewis, Vivien & Moyen, Stéphane & Villa, Stefania, 2026. "Risky firms and fragile banks: implications for macroprudential policy," Journal of International Money and Finance, Elsevier, vol. 160(C).

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    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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