Systemic Risk-taking Research Articles

Relative Wealth Concerns, Executive Compensation, and Managerial Risk-Taking

This paper theoretically examines how relative wealth concerns affect equilibrium contracting and systemic risk-taking. We find that such externalities can generate pay for luck as an equilibrium strategy. In expectation of pay for luck in other firms, tying managerial pay to luck provides insurance to managers against a compensation shortfall relative to executive peers. We also show that an effort-inducing mechanism exists: managers have additional incentives to exert effort in utilizing investment opportunities, which helps them keep up with their peers during industry movements; however, pay for luck that is efficient within firms can nonetheless exacerbate aggregate fluctuations, especially during periods of heightened market risk. (JEL D81, D82, D86, G51, M12, M52)

Monetary policy and systemic risk-taking in the Euro area investment fund industry: A structural factor-augmented vector autoregression analysis

Abundant references to threats to financial stability likely posed by systemic risk-taking in the euro area investment fund industry in an era of persistent low interest rates have not been accompanied by robust supportive empirical evidence. This is the first study that assesses the effects of euro area conventional and unconventional monetary policy shocks on coherent systemic risk measures applied to the investment fund industry. This research finds evidence of systemic risk-taking notably in the forms of contagion and increased vulnerability. It seems more material following conventional than unconventional monetary policy shocks. There is heterogeneity in the results, as the investment focus is important for assessing investment funds’ contribution to systemic risk. Fund types most affected by significant systemic risk-taking are bond funds, mixed funds and real estate funds. Some evidence of heightened vulnerability in equity funds is also present. Increase in leverage is part of the risk-taking mechanism. A key policy implication is that persistently accommodative monetary policy geared toward preserving price stability may face an intertemporal trade-off with financial stability, making it necessary to coordinate monetary and macroprudential policies.

Growth and Inflation Implications of Systemic Risk in the Euro Area Banking Industry: Lessons from the Financial Crisis

This study extends the work of Kabundi and Nadal De Simone’s (2019) measurement of systemic risk-taking in the euro area banking sector in two interrelated directions. First, it shows that all but one of the estimated systemic risk measures could have signaled with high accuracy the extreme macro-financial instability in the euro area that followed Lehman Brothers’ collapse. Second, the unravelling of systemic risk following a one-standard deviation shock to systemic risk affects GDP growth and inflation negatively with the latter displaying a more pronounced response than the former. There is heterogeneity in the strength of the responses across diverse forms of systemic risk and their time dimension. Systemic risk associated with banks’ interconnectedness and contagion plays a considerable role in depressing economic activity. Short-term systemic risk measures tend to portray stronger effects on output and inflation than their conditional forward counterparts. The systemic risk measures are potential candidates of a macroprudential-policy toolkit for calibrating policy instruments with thresholds that reflect policymakers’ risk preferences.

Monetary policy and systemic risk-taking in the euro area banking sector

Available empirical evidence on the significance of the (micro) risk-taking channel of monetary policy is not enough to indicate a threat to financial stability. Evidence of risk-taking with systemic risk implications is necessary. Statistical measures that capture systemic risk in all its forms within a structural factor-augmented vector autoregressive model suggest that conventional and unconventional monetary policies have resulted in systemic risk-taking in the euro area banking sector. Systemic risk has taken the form of an increase in the banking sector’s vulnerability via contagion and interconnectedness. Banks’ balance sheets, however, do not account for the full transmission from (micro) risk taking to systemic risk-taking. The main policy implication is that a persistently accommodative monetary policy may drive a monetary authority with a price stability mandate to consider a possible trade-off with financial stability. At a minimum, coordination between monetary and macro-prudential policies requires serious consideration.

(Systemic) Risk-taking in the Euro Area Investment Fund Industry

Abundant references to threats to financial stability likely posed by (systemic) risk-taking in the euro area investment fund industry in an era of historically persistent low interest rates have not been accompanied by robust supportive empirical evidence. This is the first study that assesses the effects of euro area conventional and unconventional monetary policy shocks on coherent systemic risk measures applied to the investment fund industry. This research finds evidence of systemic risk-taking notably in the forms of both contagion and increased vulnerability. It underpins the need to recognize and measure interconnectedness and contagion in systemic risk measurement. There is heterogeneity in the results as the investment focus is important for assessing investment funds’ contribution to systemic risk. Fund types most affected by significant systemic risk-taking are bond funds, mixed funds and real estate funds. Some evidence of heightened vulnerability in equity funds is also present. Overall, growth rates in assets managed tend to move in tandem with systemic risk-taking. Increases in leverage are part of the risk-taking mechanism under conventional monetary policy shocks. The main policy implication is that persistently accommodative monetary policy geared toward preserving price stability may face a trade-off with financial stability, making it necessary to coordinate monetary and macro-prudential policies.

Monetary Policy and Systemic Risk-taking in the Euro Area Banking Sector

Available empirical evidence on the significance of the (micro) risk-taking channel of monetary policy is not sufficient to indicate a threat to financial stability. This research has the objective of determining whether conventional and unconventional monetary policies have resulted in systemic risk-taking. To that end, it uses statistical measures that capture systemic risk in the banking sector of the euro area in all its forms allowing for the time-varying non-linearities and feedback effects typical of financial markets. The methodology is a structural factor-augmented vector autoregressive (FAVAR) model. The main result is that there is systemic risk-taking in the euro area banking sector. It takes the form of an increase in the banking sector’s vulnerability via contagion and interconnectedness. Banks’ balance sheets, however, do not account for the full transmission from (micro) risk taking to systemic risk-taking confirming the importance of accounting for time-varying non-linearities and feedback effects. The main policy implication is that persistently accommodative monetary policy geared toward preserving price stability may face a trade-off with financial stability. In that case, monetary policy will require coordination with macro-prudential policy.

Monetary Policy and Long-Run Systemic Risk-Taking

As an extension to the literature on the risk-taking channel of monetary policy, this paper studies the existence of a systemic risk-taking channel (SRTC) in the Eurozone, through an original macroeconomic perspective based on causality measures. Because the SRTC is effective after an “incubation period”, we make a distinction between short and long-term causality, following the methodology proposed by Dufour and Taamouti (2010). We find that causality from monetary policy to systemic risk, while not significant in the very short term, robustly represents 75 to 100% of the total dependence between the two variables in the long run. Reverse causality is rejected: systemic risk did not influence the policy of the European Central Bank before the global financial crisis. However, central banks must be aware that a too loose monetary policy stance may be conducive to a build-up of systemic risk.

Monetary policy and long-run systemic risk-taking

As an extension to the literature on the risk-taking channel of monetary policy, this paper studies the existence of a systemic risk-taking channel (SRTC) in the Eurozone, through an original macroeconomic perspective based on causality measures. Because the SRTC is effective after an “incubation period”, we make a distinction between short and long-term causality, following the methodology proposed by Dufour and Taamouti (2010). We find that causality from monetary policy to systemic risk, while not significant in the very short term, robustly represents 75 to 100% of the total dependence between the two variables in the long run. Reverse causality is rejected: systemic risk did not influence the policy of the European Central Bank before the global financial crisis. However, central banks must be aware that a too loose monetary policy stance may be conducive to a build-up of systemic risk.

Stand-alone vs systemic risk-taking of financial institutions

Purpose This study investigates the risk-taking behavior of financial institutions in the USA. Specifically, differences between taking risks that affect primarily the shareholders of the institution and risks contributing to the overall systemic risk of the financial sector are examined. Additionally, differences between risk-taking before, during and after the financial crisis of 2007/2008 are examined. Design/methodology/approach To analyze the determinants of stand-alone and systemic risk, a generalized linear model including size, governance, charter value, business cycle, competition and control variables is estimated. Furthermore, Granger causality tests are conducted. Findings The results show that systemic risk has a positive effect on valuation and that corporate governance has no significant effect on risk-taking. The influence of competition is conditional on the state of the economy and the risk measure used. Systemic risk Granger-causes idiosyncratic risk but not vice versa. Research limitations/implications The major limitations of this study are related to the analyzed subset of large financial institutions and important risk-culture variables being omitted. Practical implications The broad policy implication of this paper is that systemic risk cannot be lowered by market discipline due to the moral hazard problem. Therefore, regulatory measures are necessary to ensure that individual financial institutions are not endangering the financial system. Originality/value This study contributes to the empirical literature on bank risk-taking in several ways. First, the characteristics of systemic risk and idiosyncratic risk are jointly analyzed. Second, the direction of causality of these two risk measures is examined. Moreover, this paper contributes to the discussion of the effect of competition on risk-taking.

Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking

Given the recent empirical evidence on peer effects in CEO compensation, this paper theoretically examines how relative wealth concerns, in which a manager’s satisfaction with his own compensation depends on the compensation of other managers, affect the equilibrium contracting strategy and managerial risk-taking. We find that such externalities can generate pay-for-luck as an efficient compensation vehicle in equilibrium. In expectation of pay-for-luck in other firms, tying managerial pay to luck provides insurance to managers against a compensation shortfall relative to executive peers during market fluctuations. When all firms pay for luck, we show that an effort-inducing mechanism exists: managers have additional incentives to exert effort in utilizing investment opportunities, which helps them keep up with their peers during industry movements. In addition, we show that compensation arrangements involving pay-for-luck that are efficient from the shareholders’ perspective can nonetheless exacerbate aggregate fluctuations in the real economy by incentivizing excessive systemic risk-taking, especially in periods of heightened risk.

Systemic Risk-Taking at Banks: Evidence from the Pricing of Syndicated Loans

textabstractPublic guarantees extended during systemic crises can affect the relative pricing of risks in the financial system. Studying the market for syndicated loans, we find that banks require lower compensation for aggregate risk than for idiosyncratic risk, consistent with systemic risk-taking due to guarantees. The underpricing of aggregate risk is concentrated among banks that benefit more from exposure to public guarantees and disappears for non-bank lenders not protected by these guarantees. Estimates from loan spread regressions imply a sizeable guarantee that is passed onto borrowers, but also distortions in the economy’s capital allocation.

Bank Systemic Risk-Taking and Loan Pricing: Evidence From Syndicated Loans

In this paper we document evidence of systemic risk taking from syndicated loan pricing. Using U.S. syndicated loan data, we find that the borrower's idiosyncratic risk is positively priced whereas systematic risk is negatively related to loan spreads, controlling for firm, loan and bank specific variables. We argue that the underpricing of systematic risk relative to idiosyncratic risk suggests banks' preference for investing in systematic risk which increases interbank correlation and systemic risk of banks. We relate the incentive for systemic risk-taking to the too-many-to-fail guarantee. We further show that small and lowly correlated banks underprice systematic risk relative to big and more correlated banks.

Love for Correlation, Bank Systemic Risk-Taking and Loan Pricing in Syndicated Loans

In this paper we document evidence of systemic risk taking from syndicated loan markets. Using U.S. syndicated loan data, we nd that the borrower’s idiosyncratic risk is positively priced whereas systematic risk is negatively related to loan spreads, controlling for rm, loan and bank specic variables. We argue that the underpricing of systematic risk relative to idiosyncratic risk suggests banks’ preference for investing in systematic risk which increases interbank correlation and systemic risk of banks. We relate the incentive for systemic risk taking to the ‘Too-many-to-fail’ guarantee and the associated collective moral hazard of ‘love for correlation’. We further show that small and less correlated banks underprice systematic risk relative to big and more correlated banks. JEL classication : G21, G32

Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses

This paper develops a simple macroeconomic model of systemic risk in the form of financial accelerator effects: adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. We show that decentralized agents choose to expose themselves to financial accelerator effects to a socially inefficient extent and do not take on sufficient insurance against systemic risk even if given access to a complete ex-ante insurance market. We use the framework to shed light on a number of current policy issues: First, we develop a new analytical framework of macro-prudential capital adequacy requirements that take into account systemic risk by employing an externality pricing kernel. Second, we show that agents employ ex-ante risk markets to fully undo any expected government bailout. Finally, we find that constrained market participants face socially insufficient incentives to raise more capital during systemic crises. About the Author: Anton Korinek joined the University of Maryland as an assistant professor of economics in 2007, after receiving his Ph.D. from Columbia University. His research focuses on international finance and macroeconomics, with special emphasis on financial crises. In his current work, he focuses on capital controls and macroprudential regulation as policy measures that are designed to reduce the risk of financial crises. Anton Korinek is also a consultant and visiting scholar at the World Bank and the IMF.

Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses

This paper develops a simple macroeconomic model of systemic risk in the form of financial accelerator effects: adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. We show that decentralized agents choose to expose themselves to financial accelerator effects to a socially inefficient extent and do not take on sufficient insurance against systemic risk even if given access to a complete ex-ante insurance market. We use the framework to shed light on a number of current policy issues: First, we develop a new analytical framework of macro-prudential capital adequacy requirements that take into account systemic risk by employing an externality pricing kernel. Second, we show that agents employ ex-ante risk markets to fully undo any expected government bailout. Finally, we find that constrained market participants face socially insufficient incentives to raise more capital during systemic crises.