Financial System Architecture and Systematic Risk Jos Jorge - - PowerPoint PPT Presentation

Financial System Architecture and Systematic Risk

José Jorge

Cef.up Centre for Economics and Finance at the University

• f Porto

15th International Conference Computing in Economics and Finance The Society for Computational Economics

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Motivation Model Conclusion Results Equilibrium

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• No external force maintains the swing. It is the internal dynamics of the bridge

that maintains the wobbling.

• There was an initial shock (a gust of wind?) that set the bridge in motion.

http://www.youtube.com/watch?v=eAXVa__XWZ8 http://www.youtube.com/watch?v=P0Fi1VcbpAI Tacoma Bridge

Motivation Model Conclusion Results Equilibrium

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US Corporate Debt Securities and Bank Loans (Davis, 2001)

Motivation Model Conclusion Results Equilibrium

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10 20 30 40 50 60 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 1010 USD

Real debt securities Real loans

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The Model

• A continuum of risk neutral households with unit

mass, indexed by i ∈ [0,1], each with one unit of

• funds. Households must decide whether to invest

their funds in direct finance, intermediated finance

• r not invest at all.
• A continuum of identical firms, with unit mass,

which have access to the same risky technology systematic risk.

• One representative financial intermediary which

issues financial securities to households.

Motivation Model Conclusion Results Equilibrium

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Public Information on the Real Sector (Direct finance) Net return is

Fundamentals perfectly correlated across firms n: mass of non investors

Investment complementarities, synergies. Endogenous. Motivation Model Conclusion Results Equilibrium

n rD −

( )

α / 1 , ~

D D

r N r

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Households - Private information Update beliefs on rD (posterior)

Motivation Model Conclusion Results Equilibrium

( )

agents across iid N with r

i i D i

β ε ε ω / 1 , ~ + =

[ ]

β α βω α ω ρ + + = ≡

i D i D i

r r E |

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Projects are implemented. Returns are realized and financial claims are settled. 1.1 Nature selects the fundamentals (rD). 1.2 Private information becomes available. 1.3 Investment decisions are taken. Public information is available.

Date 2 Date 1 Date 0

Motivation Model Conclusion Results Equilibrium

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Motivation Model Conclusion Results Equilibrium

i = updated belief of agent i Investors T Optimistic Pessimistic E[rD|i] Non investors E[n|i]

Recall: EU = E[rD- n|i]

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Public Information on the Financial Sector (Intermediated Finance) Net return is with hence: FI offers perfectly correlated returns but different risk. Definition: Safe Security means

( )

D D B B B

r r r r − + = σ α

Motivation Model Conclusion Results Equilibrium

n rB − ( )

B B B

r N r σ , ~

α σ / 1 <

B

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i = updated belief of agent i Investors in direct finance I T E[rB|i] = expected return rB given belief i Optimistic Pessimistic E[rD|i] = expected rD given belief i Non investors

Investors in intermediated finance

E[n|i]

Motivation Model Conclusion Results Equilibrium

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Financial Architecture

Motivation Model Conclusion Results Equilibrium

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I focus on coexistence in which banks offer safe securities

• People use public information to coordinate their

actions.

• FI “improves” the precision of public information.

Motivation Model Conclusion Results Equilibrium

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Welfare = E[(1-n)×(1+r-n)+n]

6 . , 4 , 25 . = = =

D

r β α

Motivation Model Conclusion Results Equilibrium

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2 4 6 8 10 0.9 1.1 1.3 1.5 1.7 1.9 2.1 2.3

ρ T

Welfare

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• 8
• 6
• 4
• 2

2 4 6 8 10

• 0.6
• 0.4
• 0.2

0.2 0.4 0.6 0.8 E[r-n] Welfare E[r-n]

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Motivation Model Conclusion Results Equilibrium ’= 0.4963

6 . , 4 , 25 . = = =

D

r β α

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Motivation Model Conclusion Results Equilibrium

Conclusion Regulation is desirable. New issues:

Structure of competition in FI sector is important for equilibrium. FI may divert resources from decentralized markets (namely stock exchanges) and reduce liquidity.

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End of Presentation Thank you!