Systemic risk and economic growth

Friday, March 13, 2015: 6:15 PM
Moisa Altar, Ph.D , Doctoral School of Finance and Banking, Romanian - American University, Bucharest, Romania
Judita Samuel, Ph.D. , Department of Computer Science, Romanian - American University, Bucharest, Romania
Adam Altar-Samuel, Ph.D. Student , Department of Computer Science for Business Management, Romanian - American University, Bucharest, Romania
The recent global financial crisis has forced a re-examination of risk transmission in the financial sector and how it affects financial stability and economic growth.

In this paper we use advanced contingent claims analysis (CCA) to generate aggregate estimates of the joint default risk of multiple institutions as a conditional tail expectation,  using multivariate extreme value theory (EVT). In addition, the framework also helps quantify the individual contributions to systemic risk and contingent liabilities of the financial sector during times of stress.

A well-functioning financial system is critical for economic growth. A large and by now well established literature has shown the critical importance of the financial system for economic growth.

We analyze a standard growth model with financial frictions. The production function depends on macroeconomic risk. We consider a one sector small open economy populated by two types of agents: workers and entrepreneurs. We consider a continuum of heterogeneous entrepreneurs and a continuum of homogeneous workers.

We set up the economy in continuous time with an infinite horizon and no aggregate shocks, to focus on the properties of the transition paths.

In the framework of the model, financial development improves long-time economic growth through three channels: increasing the marginal productivity of generalized capital, raising the saving rate and efficiently converting savings to investment. The mechanisms of the first channel imply that financial development will make more financial support available to the efficient projects confronted with liquidity constraints, financial markets diversify risk and encourage enterprises to make use of more professional technology, and financial intermediations make capital flow into the projects with high social return. In the model, heterogeneous entrepreneurs face borrowing constraints which result in a misallocation of capital and reduced labor productivity. In the short-run, the optimal policy intervention of government by means of taxes and subsidies increases labor supply, resulting in higher entrepreneurial profits and faster accumulation of entrepreneurial wealth. The model generates endogenous dynamics of total factor productivity (TFP), and  financial frictions represent the transmission mechanism  for news shocks to drive aggregate TFP fluctuation.