We present a model of multiple banks with endogenous risk choices in an economy, where delegated monitoring by an active market in subordinate debt helps in containing systemic risk shifting by banks. Ex ante anticipation of greater regulatory forbearance, in case of joint failures, incentivize banks to keep their portfolios highly concentrated so as to succeed and fail simultaneously. However, when depositors are insured, regulatory forbearance is minimal and banks do not have incentives for failing together. Also, subordinate debt can penalize banks for increasing asset correlations since the payoffs to the subordinate debt are negatively influenced by higher correlations. The featuring of deposit insurance along with subordinate debt incentivizes banks to choose lower asset correlations among themselves as their respective optimal strategies. Therefore, the choice of lower asset correlations by the banks mutually represents a Nash equilibrium with reduced systemic risk endogenously.
|Journal||International Journal of Economic Perspectives|
|Publisher||International Economic Society|