FIAPTIFSR · Financial Institutions and Agency Problems: Theoretical Implications for Financial Stability and Regulation

The emphasis of this research project is to model explicitly financial institutions (commercial banks) characterized by moral hazard. That is, a situation where banks invest depositors' money in risky assets, obtaining high rewards in case of success but shifting the losses to the depositors in case of failure. The incorporation of moral hazard into the behavior of financial institutions has been largely ignored in finance, and it is likely to have major implications. Our focus is on financial stability. The first question to address is under which conditions fragile financial networks (that is, financial system characterized by crises) are desirable. It has been taken for granted that financial fragility is best avoided. This project wants to understand the robustness of this a-priori. The vision that financial crises are not best avoided has been underplayed in the theoretical debate. Further, this project will analyze what are the incentives for banks to establish coinsurance mechanisms to prevent liquidity crisis and the efficiency of these devices. The incorporation of moral hazard has also important implication for regulation. The extant regulation literature has maintained an exclusive focus on banking capital requirements, ignoring the interaction between moral hazard and the design of deposit contract. The project will analyze if a market solution of the banks' moral hazard can exist. Finally, the appropriate form of regulation will be analyzed in an international environment.