Essays on systemic risk

Abstract

The theme of this dissertation is economic stability. In the first chapter I show that interbank connections also have a positive effect on financial stability, via the bank-run channel. This is because they provide risk-sharing benefits to short-term creditors (outsiders), thus incentivizing them to ‘run on the bank’ less frequently. I argue that there is a trade-off between risk-sharing and cascading losses, both of which have an effect on stability. My novelty is the link I make between long-term welfare and financial stability.

In view of the risk from the domino effect, policy makers sought to reduce credit exposures between Systemically Important Financial Institutions (SIFIs). One such policy was an amendment to the U.S. bankruptcy code in 2005-6. which expanded the exclusion of derivative positions from mandatory stay. Since this policy has two opposing effects, the question whether it was beneficial for financial stability is empirical. In the second chapter of this dissertation I ask exactly that question. I describe the challenges to identification, and document what had actually happened to financial stability in the four years period before the financial crisis.

The final chapter deals with the question: how is it that economic outcomes can be highly volatile, while changes in economic fundamentals seem to be rather small? I develop a novel amplification mechanism that is closely related to the existence of multiple equilibria. I apply techniques from the global games literature in a macroeconomic model, showing that an economy with nominal wage rigidity exhibits a knife-edge property with erratic fluctuations around a threshold.