Tag Archives: systemic risk

Forthcoming in the Review of Finance: “A Wake-Up Call Theory of Contagion”

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“A wake-up call theory or contagion” with Toni Ahnert

  • Abstract: We offer a theory of financial contagion based on the information choice of investors after observing a financial crisis elsewhere. We study global coordination games of regime change in two regions linked by an initially unobserved macro shock. A crisis in region 1 is a wake-up call to investors in region 2. It induces them to reassess the regional fundamental and acquire information about the macro shock. Contagion can occur even after investors learn that region 2 has no ex-post exposure to region 1. We explore normative and testable implications of the model. In particular, our results rationalize evidence about contagious currency crises and bank runs after wake-up calls and provide some guidance for future empirical work. (D83, F3, G01, G21)
The value of information v and the proportion of informed investors n2 with and without a wake-up call, f ∈ {1, 0}. The figure shows (1) the strategic complementarity in information choices and (2) the intermediate range of information costs for which we establish information acquisition only after a wake-up call.
  • Keywords: wake-up call, information choice, financial crises, contagion, bank run, global games, regime change, fundamental re-assessment.

New BIS Working Paper No. 923 “Optimal Bank Leverage and Recapitalization in Crowded Markets”

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“Optimal Bank Leverage and Recapitalization in Crowded Markets” with Mike Mariathasan (BIS Working Paper No. 923, January 2021; Builds on older paper “Fire Sale Bank Recapitalizations”: 09/2015)

  • Abstract: We study optimal bank leverage and recapitalization in general equilibrium when the supply of specialized investment capital is imperfectly elastic. Assuming incomplete insurance against capital shortfalls and segmented financial markets, ex-ante leverage is inefficiently high, leading to excessive insolvencies during systemic capital shortfall events. Recapitalizations by equity issuance are individually and socially optimal. Additional frictions can turn asset sales individually but not necessarily socially optimal. Our results hold for different bankruptcy protocols and we offer testable predictions for banks’ capital structure management. Our model provides a rationale for macroprudential capital regulation that does not require moral hazard or informational asymmetries. (D5, D6, G21, G28)
This figure depicts for a given level of leverage (horizontal axis) the market-clearing price for specialized investment capital and the threshold level of bank portfolio risk below which liability side recapitalizations (red) and asset side recapitalizations (blue) are feasible.
  • Keywords: bank capital, recapitalization, macroprudential regulation, incomplete markets, financial market segmentation, constrained inefficiency.
  • Also available as Riksbank Working Paper No. 312