DP15841 The long-run effects of risk: an equilibrium approach
|Author(s):||João Madeira, Nuno Pedro G. Palma, Christiaan van der Kwaak|
|Publication Date:||February 2021|
|Keyword(s):||Costly state verification, deposit insurance, endogenous leverage, intermediation, investment, limited liability, Regulation, risk|
|JEL(s):||E22, E44, G21, O16|
|Programme Areas:||Monetary Economics and Fluctuations, Macroeconomics and Growth|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=15841|
Advanced economies tend to have large but unstable intermediation sectors. We employ a DSGE model with banks featuring limited liability to investigate how risk shocks in the financial sector affect long-run macroeconomic outcomes. With full deposit insurance, banks expand balance sheets when risk increases, leading to higher investment and output. With no deposit insurance, we observe substantial drops in long-run credit provision, investment, and output. These differences provide a novel argument in favor of deposit insurance. Finally, our welfare analysis finds that increased risk reduces welfare, except when there is full deposit insurance and deadweight costs are small.