by Ethan Cohen-Cole, CFP faculty associate
Among the many lessons that emerged from the financial crisis, two are particularly salient. The first of these is that the interconnectedness of financial institutions is a potential catalyst for systemic risk in the economy as a whole. The commonly cited example is that the failure of a bank can lead to the financial distress of creditor banks, which in turn can lead to distress of their own creditors, etc.
The second lesson is that financial incentives are an important factor in risk taking behavior. Here the commonly cited example are the compensation packages of loan officers and executives; if connected to total loan volume and not to risk, this was potentially a large contributor to the crisis.
This paper links these two factors to suggest that systemic risk may itself emerge from incentive effects. Long before a bank actually defaults, if it faces a shock, the incentives of interconnected institutions are to change their behavior. For example, changes in asset values can lead creditor institutions to change margin requirements. In a formal game theoretic model, we show that these incentives can lead to the magnification and spread of shocks across the economy, even in the absence of a full default.
The full paper is available for download here.