Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System

43 Pages Posted: 20 Aug 2012

See all articles by Edouard Challe

Edouard Challe

Ecole Polytechnique

Benoit Mojon

Banque de France

Xavier Ragot

Paris School of Economics (PSE); Banque de France

Date Written: August 20, 2012

Abstract

We analyze the risk-taking behavior of heterogeneous intermediaries that are protected by limited liability and choose both their amount of leverage and the risk exposure of their portfolio. Due to the opacity of the financial sector, outside providers of funds cannot distinguish 'prudent' intermediaries from 'imprudent' ones that voluntarily hold high-risk portfolios and expose themselves to the risk of bankruptcy.

We show how the number of imprudent intermediaries is determined in equilibrium jointly with the interest rate, and how both ultimately depend on the cross-sectional distribution of intermediaries’ capital. One implication of our analysis is that an exogenous increase in the supply of funds to the intermediary sector (following, e.g., capital inflows) lowers interest rates and raises the number of imprudent intermediaries (the risk-taking channel of low interest rates). Another one is that easy financing may lead an increasing number of intermediaries to gamble for resurrection following a bad shock to the sector’s capital, again raising economy wide systemic risk (the gambling-for-resurrection channel of falling equity).

Keywords: risk shifting, portfolio correlation, systemic risk, financial opacity

JEL Classification: E44, G01, G20

Suggested Citation

Challe, Edouard and Mojon, Benoit and Ragot, Xavier, Equilibrium Risk Shifting and Interest Rate in an Opaque Financial System (August 20, 2012). Banque de France Working Paper No. 391, Available at SSRN: https://ssrn.com/abstract=2132408 or http://dx.doi.org/10.2139/ssrn.2132408

Edouard Challe (Contact Author)

Ecole Polytechnique ( email )

Ecole Polytechnique
Department of Economics
Paris, 75005
France

Benoit Mojon

Banque de France ( email )

Paris
France

Xavier Ragot

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014 75014
France

Banque de France

Paris
France

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