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

15 th International Conference The Society for Computational Economics Computing in Economics and Finance Financial System Architecture and Systematic Risk José Jorge Cef.up Centre for Economics and Finance at the University of Porto

Motivation Model Equilibrium Results Conclusion 2

Motivation Model Equilibrium Results Conclusion • 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 3

Motivation Model Equilibrium Results Conclusion 60 50 40 30 10 10 USD 20 10 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 -10 -20 Real debt securities Real loans 4 US Corporate Debt Securities and Bank Loans (Davis, 2001)

Motivation Model Equilibrium Results Conclusion 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 or 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. 5

Motivation Model Equilibrium Results Conclusion Public Information on the Real Sector (Direct finance) r D − n Net return is � Fundamentals perfectly correlated across firms ( ) α r ~ N r , 1 / D D � n : mass of non investors � Investment complementarities, synergies. � Endogenous. 6

Motivation Model Equilibrium Results Conclusion Households - Private information ( ) ω = + ε ε β r with ~ N 0 , 1 / iid across agents i D i i � Update beliefs on r D (posterior) α + βω r [ ] D i ρ ≡ ω = E r | i D i α + β 7

Motivation Model Equilibrium Results Conclusion Date 0 Date 1 Date 2 Public information 1.1 Nature selects the Projects are is available. fundamentals (r D ). implemented. 1.2 Private information Returns are becomes available. realized and financial claims are settled. 1.3 Investment decisions are taken. 8

Motivation Model Equilibrium Results Conclusion E[r D | � i ] Recall: EU = E[r D - n| � i ] E[n| � i ] � i = updated belief of agent i � T Non investors Investors Pessimistic Optimistic 9

Motivation Model Equilibrium Results Conclusion Public Information on the Financial Sector (Intermediated Finance) r B − n Net return is ( ) = + α σ − with r r r r B B B D D ( ) σ r ~ N r , hence: B B B FI offers perfectly correlated returns but different risk. 10 σ < α 1 / Definition: Safe Security means B

Motivation Model Equilibrium Results Conclusion E[r D | � i ] = expected r D given belief � i E[r B | � i ] = expected return r B given belief � i E[n| � i ] � i = updated belief of agent i � T � I Non investors Investors in Investors in direct intermediated finance finance 11 Pessimistic Optimistic

Motivation Model Equilibrium Results Conclusion Financial Architecture 12

Motivation Model Equilibrium Results Conclusion 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. 13

Motivation Model Equilibrium Results Conclusion Welfare = E[(1-n)×(1+r-n)+n] 2.3 0.8 Welfare E[r-n] 2.1 0.6 1.9 0.4 1.7 0.2 Welfare E[r-n] 1.5 0 1.3 -0.2 1.1 -0.4 0.9 -0.6 -10 -10 -8 -8 -6 -6 -4 -4 -2 -2 0 0 2 2 4 4 6 6 8 8 10 10 ρ T 14 α = β = = 0 . 25 , 4 , r 0 . 6 D

Motivation Model Equilibrium Results Conclusion � ’= 0.4963 α = β = = 0 . 25 , 4 , 0 . 6 r 15 D

Motivation Model Equilibrium Results Conclusion 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. 16

End of Presentation Thank you! 17