Endogenous Risk-Exposure and Systemic Instability Chong Shu - PowerPoint PPT Presentation

Endogenous Risk-Exposure and Systemic Instability Chong Shu University of Southern California FDIC-JFSR Annual Bank Conference September 13, 2019

Do highly connected financial networks contribute to systemic stability or systemic fragility? Connected-Fragility: Connected-Stability:  Network also induces a  Provide a co-insurance propagation mechanism to mechanism against shocks. spread the loss. (Acemoglu et al., 2015) (Allen and Gale, 2000; Freixas et al., 2000) 2

Motivation Literature assumed exogenous shocks. They studied how shocks are propagated. However, banks’ exposure to which particular shock is an endogenous choice variable. In this paper, I endogenize banks’ ex-ante choice of risk exposure. The standard intuition about the stabilizing effect of financial networks reverses with endogenous risk- taking. 3

Model & Equilibrium 4

Model Bank 1 Bank 4 retail depositors Risky Project: Success or Bank 2 Bank 3 Failure 5

Supermodularity Lemma 6

When bank succeeds (with probability ) When bank fails (with probability ) Bank will choose safe project if 7

Risk-taking Externality Proposition 8

Network Structure • complete / ring • core-periphery; central clearing counterparty 9

Network Structure – network completeness Proposition 10

Network Structure – network completeness Proposition 11

Network Structure – Central Clearing Counterparties Proposition 12

Network Structure – Central Clearing Counterparties Proposition 13

Summary 14

What’s skipped… 15

Thanks! chongshu@usc.edu 16