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Financial Firm Bankruptcy And Systemic Risk

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Executive Summary

Financial firm distress often leads to regulatory intervention, along the lines of "Too big to fail" (TBTF) policies. Despite the moral hazard implications of such actions, regulators often fear that the collapse of a financial firm will lead to negative spillovers into the real side of the economy. The mechanism by which financial crises connect these firms to the economy is not well understood, but two oft-cited channels are domino effects (counterparty risk) and the effects of fire sales on markets, which may transmit to the economy through a financial accelerator. In this paper the authors analyze the policy responses for avoiding systemic risk while considering the role of these two factors.

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