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Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System

  • Edouard Challe

    (Department of Economics, Ecole Polytechnique - Polytechnique - X - CNRS, Banque de France, CREST - Centre de Recherche en Économie et Statistique - INSEE - École Nationale de la Statistique et de l'Administration Économique)

  • Benoit Monjon

    (Centre de recherche de la Banque de France - Banque de France)

  • Xavier Ragot

    (Centre de recherche de la Banque de France - Banque de France, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics)

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 the opacity of the financial sector, outside providers of funds cannot distinguishing "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 (following, e.g., capital inflows) lowers interest rates and raises the number of imprudent intermediaries (the risk-taking channel of low interest rates). 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 (the gambling-for-resurection channel of falling equity).

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Date of creation: 07 Sep 2012
Handle: RePEc:hal:wpaper:hal-00719952
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