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.