On the occasion of the 65th birthday of Governor Klaus Liebscher and in recognition of his commitment to Austria’s participation in European monetary union and to the cause of European integration, the Oesterreichische Nationalbank (OeNB) established a “Klaus Liebscher Award”. It will be offered annually as of 2005 for up to two excellent scientific papers on European monetary union and European integration issues. The authors must be less than 35 years old and be citizens from EU member or EU candidate countries. The “Klaus Liebscher Award” is worth EUR 10,000 each. The winning papers of the fifth Award 2009 were written by Tarek A. Hassan and by Anton Korinek. Tarek A. Hassan’s paper is contained in Working Paper 154, while Anton Korinek’s contribution is presented in this Working Paper. The worst financial crises since the Great Depression has forced central bankers and policymakers across Europe and around the globe to take unprecedented policy measures to deal with systemic risk, i.e. the risk that the financial system ceases to perform its function of allocating capital to the most productive use because of financial difficulties among a significant number of financial institutions. This paper develops a parsimonious model of systemic risk in the form of amplification effects whereby 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. The paper shows that the free market equilibrium in such an environment is generically inefficient because constrained market participants do not internalize that their actions entail amplification effects. Therefore they undervalue the social benefits of liquidity during crises and take on too much systemic risk.
The author uses his framework to shed light on a number of current policy issues. He shows that banks face socially insufficient incentives to raise more capital during systemic crises, that bailouts which are anticipated can be ineffective, and that expectational errors are considerably more costly during crises than in normal times. Furthermore he develops an analytical framework for macro-prudential capital adequacy requirements that take into account systemic risk. The author also analyzes a new channel of financial contagion and explains why private agents will take insufficient precautions against contagion from other sectors in the economy.