On Endogenous Risk, the Amplification Effects of Financial Systems and Macro Prudential Policies

The recent global financial crisis has put the spotlight on macro prudential policies to protect firms and households from problems emanating from the financial sector. Frictions in financial markets including information asymmetries and their implications may amplify shocks and deepen financial crises. In this paper we propose a framework of analysis that combines exogenous and endogenous risks; the latter we see as stemming from these frictions.

We argue that endogenous risks may be systemic and costly. We then employ a database of corporate bond spreads across emerging markets and find evidence that endogenous risks are present and have amplified the effects of financial crises. We also find evidence that larger financial systems exacerbate the impact of crises and that weaker financial systems exacerbate the impact particularly of banking crises.

We discuss the policy implications of our results and suggest that policy makers should monitor time varying systemic risks using both price and quantity signals and take actions in the good times to mitigate potential amplifying effects at times of stress.

IDB, Giovanni Majnoni (Banca d’Italia) and Andrew Powell (IDB)1. May, 2011.

All opinions expressed in this paper are of the exclusive responsibility of the authors and do not
necessarily reflect the opinions of the Banca d’Italia or the Inter American Development Bank. We wish to thank Oscar Becerra for invaluable research assistance. Contact: Giovanni Majnoni:giovanni.majnoni@bancaditalia.it

On Endogenous Risk, the Amplification Effects of Financial Systems and Macro Prudential Policies