Financial Institutions for an Unstable World

New York University, New York NY

Investigators

Abstract

There is a growing awareness that globalization, particularly the opening up of previously closed financial systems to global markets. has the potential to increase the exposure of financial systems to new and greater risks. The classical theory of risk sharing treats risks as exogenous (e.g., as states of nature). The new risks associated with globalization are largely endogenous. The traditional tools of financial economics can be used to describe and analyze these risks, but new models and new kinds of analysis are needed. Economists are now in a position to address questions about the optimal design and regulation of potentially unstable financial systems. This project addresses several problems in the area of economic policy, regulation and institutional design arising out of the recent work on financial crises. One difference between this work and much of the rest of the literature is that this project focuses on the microeconomic properties of financial institutions and markets that are crucial for understanding the phenomenon of financial fragility and endogenous instability. For the most part, first-generation models of financial crises analyze the behavior of a single representative bank, are partial equilibrium in nature and consist of a contracting problem followed by a coordination problem. In order to understand the origins of financial crises, we need models that describe complex, decentralized financial systems comprising both financial institutions and financial markets. This project develops such models of complex financial systems and uses this approach to explore four issues: optimal provision of liquidity when financial intermediaries are opaque; the relationship between aggregate uncertainty, financial fragility, and contagion; the relationship between monetary policy and asset prices; and the design of optimal currency areas.