“Strategic Risk Taking with Systemic Externalities”

Finance

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Abstract

This paper studies strategic risk taking of highly-levered financial institutions within a structural model of credit risk. We consider a context in which systemic default induces externalities that amplify the cost of financial distress. This represents a source of strategic interaction and mandates an analysis of financial institutions' asset allocations in coalescence. We derive a unique strategic equilibrium in which two heterogeneous institutions adopt polarized and stochastic risk exposures, without sacrificing full diversification. In the presence of systemic externalities, both financial firms are concerned with maintaining sufficient wealth in adverse states. To this purpose, the conservative institution reduces its risk exposure, whereas the aggressive institution optimally gambles on positive and negative outcomes by taking long and short positions in risky securities over time. This equilibrium mechanism increases the likelihood of a systemic crisis.