Endogenous Risk-Exposure and Systemic Instability

65 Pages Posted: 28 Nov 2017 Last revised: 30 Sep 2023

See all articles by Chong Shu

Chong Shu

University of Utah - David Eccles School of Business

Date Written: September 30, 2023

Abstract

Most research on systemic stability assumes an economy in which banks are subject to exogenous shocks. However, in practice, banks choose their exposure to risk. I show that there exists a network risk-taking externality: the risk exposure choices made by connected banks are strategically complementary. Banks within financial networks, especially densely connected ones, become endogenously exposed to excessive risks. Moreover, when the threat of losing bank charters is sufficiently low, they tend to choose highly correlated risks. The theory offers several novel perspectives on policy debates. For example, the theory suggests that limiting a government bailout to interbank exposures can effectively reduce endogenous systemic risk.

Keywords: systemic risks, financial networks, moral hazard, asset substitution

JEL Classification: G21, G28, L14

Suggested Citation

Shu, Chong, Endogenous Risk-Exposure and Systemic Instability (September 30, 2023). USC-INET Research Paper No. 17-35, USC Marshall School of Business Research Paper, Available at SSRN: https://ssrn.com/abstract=3076076 or http://dx.doi.org/10.2139/ssrn.3076076

Chong Shu (Contact Author)

University of Utah - David Eccles School of Business ( email )

1645 E Campus Center Dr
Salt Lake City, UT 84112-9303
United States

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