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FIIE-6: Systemic risks and runs
Systemic Risk-Shifting in Financial Networks
1MIT; 2University of Capetown; 3Deutsche Bundesbank; 4University of Cambridge
Banks face different but potentially correlated risks from outside the financial system. Financial connections can help hedge these risks, but also create the means by which shocks can propagate. We examine this tradeoff in the context of a new stylised fact we present: German banks are more likely to have financial connections when they face more similar risks—potentially undermining the hedging role of financial connections and contributing to systemic risk. We find that such patterns are socially suboptimal, but can be explained by risk-shifting. Risk-shifting motivates banks to correlate their failures with their counterparties even though it creates systemic risk.
Operating Leverage, Coordination Failures, and Systematic Risk
McGill University, Canada
We study an economy where demand spillovers make firms' production decisions strategic complements. Firms have access to an increasing returns to scale technology and choose their operating leverage ex ante trading off higher
fixed costs for lower variable costs. Operating leverage governs firms exposures to an aggregate labor productivity shock, the only source of uncertainty in the economy. In equilibrium, firms' operating leverage is too high because firms do not internalize that an economy with higher aggregate operating leverage is more likely to fall into a self-fulfilling equilibrium with inefficiently low output after a bad productivity shock. Welfare losses coming from firms' failure to coordinate production ex post are amplified by suboptimal risk-taking ex ante. Excessive operating leverage contributes to systematic risk by magnifying the impact of productivity shocks onto aggregate output.
A Dynamic Model of Systemic Bank Runs
HKUST, Hong Kong S.A.R. (China)
This paper develops a tractable dynamic model to study bank runs in a financial system, featuring the linkage between bank runs and asset market prices. The model speaks to the evolution of a systemic crisis. In our model economy, there are many banks with interactions in an asset market, which gives rise to a coordination problem among creditors of different banks, besides a coordination problem among creditors of the same bank. We analyze how the coordination problems in the system interact with asset prices and characterize the dynamics. The model explains empirical facts and gives new policy implications.
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