Rollover Risk as Market Discipline: A Two-Sided Inefficiency

Abstract

Why does the market discipline that banks face seem too weak during good times and too strong during bad times? Using a global games approach in a general equilibrium setting, this paper shows that rollover risk as a disciplining device is effective only if all banks face purely idiosyncratic risk. However, if banks’ assets are correlated, a two-sided inefficiency arises: Good aggregate states have banks taking excessive risks, while bad aggregate states suffer from costly fire sales. The driving force behind this inefficiency is an amplifying feedback loop between asset values and market discipline. This feedback loop operates in both good and bad aggregate states, but with opposite effects.

Keywords: global games, rollover risk, market discipline, fire sales

JEL Classification: C73, D53, G01, G21, G24, G32