Preliminary Draft – Comments are Welcome

Financial crises often involve amplification effects whereby adverse developments in financial markets and in the real economy mutually reinforce each other and lead to a feedback cycle of falling asset prices, deteriorating balance sheets and tightening financing conditions. This paper shows that individual agents do not internalize that their actions lead to such systemic amplification effects when finacing constraints in the economy are binding. This gives rise to a systemic externality: individual agents un-dervalue the social benefits of liquidity in relaxing economy-wide financing constraints and take on too much systemic risk in their financing and investment decisions. We derive a social pricing kernel that quantitatively captures how financial reg-ulators can adjust capital adequacy requirements for systemic risk. We also show that banks face socially insufficient incentives to raise more capital during crises, that bailouts which are anticipated can be ineffective, and that expectational errors are considerably more costly during crises than in normal times. Furthermore, we analyze channels of financial contagion, we explain why decentralized agents will take insuffi