Collective Moral Hazard and the Interbank Market

60 Pages Posted: 7 Dec 2020

See all articles by Levent Altinoglu

Levent Altinoglu

Board of Governors of the Federal Reserve System

Joseph E. Stiglitz

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December, 2020

Abstract

The concentration of risk within financial system is considered to be a source of systemic instability. We propose a theory to explain the structure of the financial system and show how it alters the risk taking incentives of financial institutions. We build a model of portfolio choice and endogenous contracts in which the government optimally intervenes during crises. By issuing financial claims to other institutions, relatively risky institutions endogenously become large and interconnected. This structure enables institutions to share the risk of systemic crisis in a privately optimal way, but channels funds to relatively risky investments and creates incentives even for smaller institutions to take excessive risks. Constrained efficiency can be implemented with macroprudential regulation designed to limit the interconnectedness of risky institutions.

Keywords: Systemic risk, systemically important financial institutions (SIFI), Interbank markets, Financial crises, Bailouts, Macroprudential supervision

JEL Classification: E61, G01, G18, G21, G28

Suggested Citation

Altinoglu, Levent and Stiglitz, Joseph E., Collective Moral Hazard and the Interbank Market (December, 2020). FEDS Working Paper No. 2020-98, Available at SSRN: https://ssrn.com/abstract=3743232 or http://dx.doi.org/10.17016/FEDS.2020.098

Levent Altinoglu (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Joseph E. Stiglitz

Columbia University - Columbia Business School, Finance ( email )

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