Systemic Risk in Finance
Abstract:
We study welfare of competitive equilibria in an economy with banks runs and costly fire sales, formalizing the importance of “animal spirits” for financial stability. These forces are not the product of irrationality, but a consequence of uncertainty of a self-fulfilling nature. Short-term debt issued by banks is safe, and thus functions as private money. Feedback between financial constraints and market prices results in a systemic externality not internalized by banks in the process of money creation: during credit booms aggregate short-term debt is excessive; during recessions it is insufficient. With a multi-stage game formulation we show that there are exactly two equilibria corresponding to a Boom-Bust scenarios.
Work is co-authored with Diego Fejer.