A Macro-Finance Treatise on Systemic Risk

Abstract

Systemic risk in the macro-finance context has garnered significant interest relatively recently and our understanding of it is limited. Systemic risk is a broad term used to describe economic and financial system breakdown. Its characterization can depend on the sources being explored. Fully understanding its nature is imperative, especially if we want to understand the causes and consequences of big economic meltdowns like the 2007-2009 financial crisis. Policies designed without proper understanding of systemic risk are likely to be either ineffective or have unforeseen ramifications. Thus, there is a need for a variety of models that explore different aspects of systemic risk. The first chapter of this dissertation studies systemic risk as it relates to financial innovation in a stationary equilibrium. The second chapter studies the transition dynamics aspect. Since these two chapters are based on the same underlying economic model, they are jointly introduced and concluded. In these chapters a heterogeneous agents model in continuous time, driven by jump-diffusion processes, is developed. Methods from the theory of Levy Processes and Feynman Path Integral are introduced. This approach allows for analytically exploring various properties of systemic risk. We derive explicit expressions of the financial sector's failure probability, its capital position at the random time of credit event, and the transition densities of the leverage and financial wealth distributions. We show that financial innovation can either increase or decrease systemic risk under some conditions. We characterize the notion of a leverage trap -- once the economy moves to high leverage systemic risk states, it tends to stay there. Financial innovation amplifies credit cycles. Transition speed increases (decreases) when the economy is leveraging up (deleveraging). The third chapter studies how asset price bubbles, market liquidity, and trading constraints affect systemic risk. We build an equilibrium model with heterogeneous agents in which market liquidity is modeled as a stochastic quantity impact from trading on the price. We introduce a different framework for analyzing rational asset price bubbles, which are shown to exist in equilibrium due to heterogeneous beliefs, heterogeneous preferences, and binding trading constraints. Positive price bubbles are larger in illiquid markets and when trading constraints are more binding. A realization of systemic risk, defined as the risk of market failure due to an exogenous shock to the economy, results in a significant loss of wealth as agents are unable to meet their trading constraints and default. Systemic risk is shown to increase as: (i) the fraction of agents seeing an asset price bubble increases, (ii) as the market becomes more illiquid, and (iii) as trading constraints are relaxed.