Imes Discussion Paper Series Institute for Monetary and Economic Studies Bank of Japan

This paper discusses different aspects of the notion of systemic risk. It contains a selective survey of the research on related topics, a review of some case studies of financial crises and failures, and a discussion pointing towards the importance of moral hazard as a key element of systemic risk. The main ideas studied are the links between: capital structure theory and bank capital regulation; moral hazard and agency theory at the level of the individual trader, the financial firm, and the overall financial system. Another important idea is the co-determination of asset prices and bank solvency. My main focus is on moral hazard as a potentially fruitful area for future research. Although existing research emphasizes the powerful propagation mechanisms whereby a small initial shock can be amplified by the financial system, I suggest that moral hazard, together with leverage at the level of the individual firm, can cause a large shock to the financial system. * London Business School (E-mail: [email protected] / Home Page: http://www.lbs.ac.uk/faculty/jdow) This paper was prepared for the Bank of Japan. I thank Urs Birchler of the Swiss National Bank, Xavier Freixas of Universitat Pompeu Fabra, Shuji Kobayakawa of the Bank of Japan, Stephen Schaefer of London Business School, Oren Sussman of Ben Gurion University, and an anonymous referee, for helpful comments on an earlier draft. Any opinions expressed in this paper are my own and do not represent the views of any of the institutions or people referred to here.