Dynamic Interaction Between Asset Prices and Bank Behavior: A Systemic Risk Perspective

TL;DR

This paper presents a toy model analyzing how asset prices and bank behaviors interact dynamically, highlighting conditions that lead to simultaneous individual and systemic defaults during financial crises.

Contribution

It introduces a simplified model capturing the interaction between asset and credit risks, providing insights into systemic risk escalation during financial turmoil.

Findings

Both risks increase during severe financial turmoil

Conditions for simultaneous individual and systemic defaults are identified

Model highlights the dynamic interaction between asset prices and bank behavior

Abstract

Systemic risk in banking systems remains a crucial issue that it has not been completely understood. In our toy model, banks are exposed to two sources of risks, namely, market risk from their investments in assets external to the banking system and credit risk from their lending in the interbank market. By and large, both risks increase during severe financial turmoil. Under this scenario, the paper shows the conditions under which both the individual and the systemic default tend to coincide.