Endogenous Risk-Exposure and Systemic Instability

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