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Bank Risk within and across Equilibria

  • Itai Agur

This paper models a financial sector in which there is a feedback between individual bank risk and aggregate funding market problems. Greater individual risk taking worsens adverse selection problems on the market. But adverse selection premia on that market push up bank risk taking, leading to multiple equilibria. The model identifies shifts among equilibria as a function of parameter shocks. Measures that reduce individual bank default risk within an equilibrium can actually make the system as whole more sensitive to shocks. Risks may thus seem small and market risk premia low precisely when the system as whole is most fragile.

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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 305.

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Date of creation: Jul 2011
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Handle: RePEc:dnb:dnbwpp:305
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