Collective Moral Hazard and the Interbank Market
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.
File(s): File format is application/pdf https://www.federalreserve.gov/econres/feds/files/2020098pap.pdf
Part of Series: Finance and Economics Discussion Series
Publication Date: 2020-12-02