Bank Risk Within and Across Equilibria
IMF Working Papers, July 2, 2014
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Bibliographic details
- Authors: Itai Agur
- Published: July 2, 2014
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498306515.001
Summary findings
- The global financial crisis highlighted that the financial system can be most vulnerable when it seems most stable.
- The paper models non-linear dynamics in banking where small shocks can lead from an equilibrium with few bank defaults straight to a full freeze.
- The mechanism is based on amplification between adverse selection on banks' funding market and moral hazard in bank monitoring.
- Results imply trade-offs between regulators' microprudential desire to shield individual weak banks and the macroprudential consequences of doing so.
- Limiting bank reliance on wholesale funding always reduces systemic risk, but limiting the correlation between bank portfolios does not.
Mechanism and dynamics
- Non-linear dynamics: small shocks can produce large systemic shifts (from few defaults to full freeze).
- Amplification channel: interaction between adverse selection in banks' funding market and moral hazard in bank monitoring drives the transition across equilibria.
Policy implications and recommendations
- Regulators face a trade-off between microprudential interventions (shielding individual weak banks) and potential adverse macroprudential consequences.
- Policy that limits bank reliance on wholesale funding is recommended because it always reduces systemic risk.
- Policies aimed solely at limiting correlation between bank portfolios are not effective at reducing systemic risk according to the model.
Content in this bundle
- Bank Risk Within and Across Equilibria; by Itai Agur; IMF Working Paper No. 14/116; July 1, 2014