Financial systems, micro-systemic risks and Central Bank policy: an analytical taxonomy of the literature

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Moheeput, Ashwin (2008)
  • Publisher: University of Warwick, Department of Economics
  • Subject: HB | HG

This paper reviews and categorises the literature on micro-systemic risks and on optimal policies designed to mitigate these risks. Micro-systemic risks are risks to the financial system that occur when the interaction of a bank with other banks or with financial markets, can propagate an initially localised shock to the whole financial system and can prevent the latter from fulfilling its intermediation and distributional roles. The severe episodes of financial crises that have plagued economies - developed and emerging markets alike - have made more compelling, the need for policymakers such as central banks, to develop prudential tools as part of crisis prevention and crisis management policies. We review the success of these policies under different theoretical paradigms. The paper ends with a brief synopsis of financial accelerator models which stress on how imperfections in financial markets may magnify the swings and intensity of business cycles and have a more entrenched impact on the macroeconomy.
  • References (1)

    [1]Aghion,P., P.Bolton and M.Dewatripont (2000): “Contagious bank failures in a free banking system”, European Economic Review, 44, 713-718 [4]Allen, F. and D.Gale (1998): “Optimal Financial Crises”, Journal of Finance, 53(4), 1245-1284 [5]Allen, F. and D.Gale (2000): “Financial Contagion”, Journal of Political Economy, 108, 1-33 [6]Allen, F. and D.Gale (2004): “Financial intermediaries and Financial Markets, Econometrica, Vol.72, No.4, 1023-1061 [18]Diamond, D. and P.Dybvig (1983): “Bank Runs, Deposit Insurance and Liquidity”, Journal of Political Economy, 91(3): 401-419 [20]Diamond, D. and R.Rajan (2001): “Liquidity Risk, Liquidity Creation and Financial Fragility: a theory of Banking”, Journal of Political Economy, 109(2), 287-327 [37]Matutes, C. and X. Vives(1996): “Competition for deposits, fragility and insurance”, Journal of Financial intermediation, 5, 184-216 [38]Morris, S. and H.S.Shin (1998): “Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks”, American Economic Review, 88(3), 597-597

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