Endogenous Risk Exposure and Systemic Instability

Most research on systemic stability assumes an economy where 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. The theory offers several novel perspectives on policy debates. For instance, it suggests that limiting government bailouts to interbank exposures can effectively reduce endogenous systemic risk. This paper was accepted by Kay Giesecke, finance. Funding: This work was financially supported by the USC Dornsife Institute for New Economic Thinking Fellowship, the Marshall PhD Fellowship, and European Finance Association Doctoral Tutorial Best Paper Prize. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.01519 .

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Publication Details

Journal
Management Science
Published
2024-10-08
DOI
https://doi.org/10.1287/mnsc.2022.01519
Citations
4
Primary Topic
Banking stability, regulation, efficiency
Type
article
Field-Weighted Citation Impact
1.62
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article

Endogenous Risk Exposure and Systemic Instability

Chong Shu
4 citations
Management Science
Banking stability, regulation, efficiency
1.62
article

Endogenous Risk Exposure and Systemic Instability

Chong Shu
article en
4 citations

Abstract

Most research on systemic stability assumes an economy where 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. The theory offers several novel perspectives on policy debates. For instance, it suggests that limiting government bailouts to interbank exposures can effectively reduce endogenous systemic risk. This paper was accepted by Kay Giesecke, finance. Funding: This work was financially supported by the USC Dornsife Institute for New Economic Thinking Fellowship, the Marshall PhD Fellowship, and European Finance Association Doctoral Tutorial Best Paper Prize. Supplemental Material: The online appendix is available at https://doi.org/10.1287/mnsc.2022.01519 .

Management ScienceVol. 71(7)
University of Utah (US)
Openalex Percentile: Top 15%
Banking stability, regulation, efficiency
1.62
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