Financial Innovation, Macroeconomic Stability and Systemic Crises

Abstract

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and contains a clearly defined pecuniary externality associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, this externality is capable of generating a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past but potentially more severe. Copyright � Bank of England.

Systemic risk, international regulation, and the limits of coordination

“…9 For simplicity, I assume that the commitment problem is extreme (that is, banks cannot commit to pay any fraction of their production to global investors). Assuming a milder but sufficiently strong commitment problem where banks can commit a small fraction of their production, as in Lorenzoni (2008) and Gai et al (2008), does not change the results of this paper. On the other hand, if we complete the markets by allowing banks to borrow from global investors by pledging the future return stream from the assets, there would not be a reason for fire sales and the first best world would be established.…”

“…In my model, fire sales result from the combined effect of asset specificity and correlated shocks that hit an entire industry or economy. This idea, which originated in Williamson (1988) and Shleifer and Vishny (1992), was later employed by Lorenzoni (2008), Gai et al (2008), Korinek (2011), andStein (2012). These latter papers show that under the pecuniary externalities that arise from asset fire sales, there exists an inefficiently high level of borrowing and hence investment in risky assets in the decentralized equilibrium.…”

“…Because R ≥ P, this return would be maximized when γ i = 1. In other words, R ≥ P implies that banks Gai et al (2008) provide the leading example where this assumption is not imposed and multiple equilibria in the asset market are therefore considered. The authors assume that which equilibrium is chosen is determined by the ex-ante beliefs of agents.…”

“…For financial assets, the liquidity shock, cn i , can be generated by margin calls due to changing risk perceptions or appetite. 21 Following Lorenzoni (2008) and Gai et al (2008), I assume that banks have to restructure an asset before selling it. Basically, this means that banks receive the asset price P from global investors, use a part, c, to restructure the asset, and then deliver the restructured assets to global investors.…”

The future of financial markets: financial crisis avoidance

“…Although individual countries and the international organizations, particularly the BIS, were well aware of the need to consider aggregate issues and the importance of correlated risks and herding the balance of emphasis has been shown to be firmly wrong (Turner 2009). The Bank of England (Gai et al 2006(Gai et al , 2007(Gai et al , 2008 had already identified that banks underprovided for the systemic consequences of their risks, that their behaviour would tend to amplify shocks and that the increased macroeconomic stability was likely to reduce the chance of crises but increase the severity of any that did occur. However, the crisis hit before this work was fully developed and the stress tests intended could alter the preparedness of either Bank of England or the individual banks.…”