A Macroeconomic Model of Endogenous Systemic Risk Taking

A Macroeconomic Model of Endogenous Systemic Risk Taking D. Martinez-Miera and J. Suarez Discussion Rafal Raciborski DG ECFIN, European Commission Norges Bank, Oslo, 29 - 30 November 2012 Disclaimer The views expressed are the authors alone and

do not necessarily correspond to those of the European Commission. Context It's been almost 5 years that the world has been in the financial and economic crisis with its causes still not yet fully understood but with a contribution of the financial sector generally unquestioned Most economists would agree the financial sector (banks in particular) may contribute to and perhaps

generate systemic risk This paper Discusses one particular channel via which systemic risk may originate in the banking sector Idea most closely linked to the 'risk-shifting literature Embeds it into a general equilibrium model May be disputed whether the systemic risk is truly endogenous; more on it later

Solves nonlinearly to discuss optimal bank capital requirements The model: general idea General result (Jensen&Meckling, 1976; Stiglitz&Weiss, 1981; Allen&Gale, 2000): Limited liability non-convexities in the profit maximizer's problem The maximizer may then prefer a riskier project, pushing its risk on other agents (=risk shifting)

Banks protected by deposit insurance (limited liability) they like riskier projects But: riskier behavioursystemic risk Assume that riskier projects are systematically linked The model: available projects 2 types of projects: 1. Less risky projects (in terms of its variance and its mean): idiosyncratic risk 2. More risky projects: risk perfectly correlated

Higher variance of the risky projects to induce riskshifting in the banks Correlation of risky projects=systemic risk Lower unconditional mean of the risky project probably makes things harder; conveys the idea of systemic risk being "bad" The model: equilibrating force Due to limited liability banks like riskier projects; why don't we observe only the riskier ones being chosen (share of risky projects x=1)? Crucial variable: stochastic marginal value of

one unit of a banker's wealth Upon the realization of the systemic risk: Wealth of 'risky banks' is wiped out Scarce driven up for save banks: last bank standing effect (in the spirit of Perotti&Suarez, 2002) In equilibrium banks indifferent between projects x Welfare Banks agency problem affects negatively the

economy via 2 channels: Static losses: picking inefficient projects Dynamic losses: loss of bank equity (and, hence, lending capacity) in the event of a systemic shock Measurement: All agents risk neutral; but GDP does not reflect welfare well GDP (=added value) excludes capital losses Does output (y=GDP+undepreciated K) correlate perfectly with welfare in your model?

Capital requirements Increased capital requirements make capital scarcer ( higher) higher incentive to choose safer projects higher proportion of bank equity invested in safer projects But, banks lending capacity reduced lower average efficiency Trade-off optimal Results

For the benchmark calibration: With low =7% fraction of capital invested in systemic projects very large (70%) Systemic shocks very painful (31% drop of GDP) Optimal large (14%) Optimal welfare higher by about 1% Number of extensions Interesting perverse results Minor remarks (I)

You assume a pooling equilibrium Are there other types of equilibria? If so, how do we know yours is the relevant one? One of your main contributions: quantitative results (high optimal ); but your model very stylized. For example: Crucial role of the slope of It would be less steep if labour were variable Minor remarks (II)

An issue with calibration? You assume 35% depreciation in failed firms For =7%, 70% of all projects are systemic This gives 35%70%=25% capital depreciation in the economy in the event of a systemic shock Also the fall in GDP (30%) very large Develop the sensitivity analysis The choices for the values of [] and are quite tentative.

General equilibrium? Is systemic risk endogenous? Yes: share of bad projects x=f(,regulation) No: systemically-risky projects are always there to be picked only the severity of the crisis endogenous I believe we cannot do w/o opening the black box see next 2 slides Take the black box as given

What are the systemic projects? Allen&Gale (2000): oil shock convincing, but with a limited application (Norway!) Your footnote 1: housing bust: Is it systemic? What makes it so? Was it (before 2007) considered risky? (The notion that house prices never fall) Even so: Is it plausible? Convince the reader! What happens in your model if you have 2 types of risky projects: identical payoffs, but projects of

the 2nd type independent Bring your channel to the data Systemic Banking Crises facts (Boissay et al.): a) SBCs are rare and deep b) SBCs are closely linked to credit developments Ad. a) Your model can obviously match it, but: by imposing exogenous prob. of a systemic crisis endogenous risk correlation in recessions, Brunnermeier&Sannikov, 2011 (parsimony)

Ad. b) Nothing to say about it again, endogenous link (Boissay et al., 2012) hard to make policy advice w/o a crucial channel Need to open up the black box Interesting perverse effect? Your results sensitive to the exogenous probability of a systemic crisis Benchmark: =0.03

One view: makes your results fragile Alternative view: innovations that make the economy safer () make crises deeper Worth exploring?

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