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Systemic Risk: Amplification Effects, Externalities, and Policy Responses

  • Anton Korinek

    (4118F Tydings Hall, University of Maryland, College Park, MD 20742,USA,)

The worst financial crises since the Great Depression has forced central bankers and policymakers across Europe and around the globe to take unprecedented policy measures to deal with systemic risk, i.e. the risk that the financial system ceases to perform its function of allocating capital to the most productive use because of financial difficulties among a significant number of financial institutions. This paper develops a parsimonious model of systemic risk in the form of amplification effects whereby adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. The paper shows that the free market equilibrium in such an environment is generically inefficient because constrained market participants do not internalize that their actions entail amplification effects. Therefore they undervalue the social benefits of liquidity during crises and take on too much systemic risk. We use our framework to shed light on a number of current policy issues. We show that banks face socially insufficient incentives to raise more capital during systemic crises, that bailouts which are anticipated can be ineffective, and that expectational errors are considerably more costly during crises than in normal times. Furthermore we develop an analytical framework for macro-prudential capital adequacy requirements that take into account systemic risk. We also analyze a new channel of financial contagion and explain why private agents will take insufficient precautions against contagion from other sectors in the economy.

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Paper provided by Oesterreichische Nationalbank (Austrian Central Bank) in its series Working Papers with number 155.

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Length: 31
Date of creation: 14 May 2009
Date of revision:
Handle: RePEc:onb:oenbwp:155
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  1. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P. Tsomocos, 2003. "Procyclicality and the new Basel Accord–banks’ choice of loan rating system," LSE Research Online Documents on Economics 24863, London School of Economics and Political Science, LSE Library.
  2. Bernanke, Ben & Gertler, Mark, 1990. "Financial Fragility and Economic Performance," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 87-114, February.
  3. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
  4. Gordy, Michael B. & Howells, Bradley, 2006. "Procyclicality in Basel II: Can we treat the disease without killing the patient?," Journal of Financial Intermediation, Elsevier, vol. 15(3), pages 395-417, July.
  5. Guido Lorenzoni, 2008. "Inefficient Credit Booms," Review of Economic Studies, Oxford University Press, vol. 75(3), pages 809-833.
  6. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  7. Krishnamurthy, Arvind, 2003. "Collateral constraints and the amplification mechanism," Journal of Economic Theory, Elsevier, vol. 111(2), pages 277-292, August.
  8. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  9. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  10. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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