Market Discipline and Systemic Risk

Morrison, Alan and Walther, Ansgar Market Discipline and Systemic Risk. Management Science. (Accepted)

Abstract

We analyze a general equilibrium model in which financial institutions generate endogenous systemic risk. Banks optimally select correlated investments and thereby expose themselves to re-sale risk so as to sharpen their incentives. Systemic risk is therefore a natural consequence of banks' fundamental role as delegated monitors. Our model sheds light on recent and historical trends in measured systemic risk. Technological innovations and government-directed lending can cause surges in systemic risk. Strict capital requirements and well-designed government asset purchase programs can combat systemic risk.

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