Monetary and Economic Studies Vol.18, No.2 / December 2000

What Is Systemic Risk? Moral Hazard, Initial Shocks, and Propagation

James Dow

This paper discusses different aspects of the notion of systemic risk. It contains a selective survey of the research on related topics, a review of some case studies of financial crises and failures, and a discussion pointing toward the importance of moral hazard as a key element of systemic risk. The main ideas studied are the links between capital structure theory and bank capital regulation, and moral hazard and agency theory at the level of the individual trader, the financial firm, and the overall financial system. Another important idea is the co-determination of asset prices and bank solvency. My main focus is on moral hazard as a potentially fruitful area for future research. Although existing research emphasizes the powerful propagation mechanisms whereby a small initial shock can be amplified by the financial system, I suggest that moral hazard, together with leverage at the level of the individual firm, can cause a large shock to the financial system.

Keywords: Systemic risk; Moral hazard; Bank solvency; Financial system stability; Bank capital regulation

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2000 Bank of Japan All Rights Reserved.

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