Equilibrium risk shifting and interest rate in an opaque financial system

We analyse the risk-taking behaviour of heterogenous intermediaries that are protectedby limited liability and choose both their amount of leverage and the risk exposure of theirportfolio. Due to the opacity of the financial sector, outside providers of funds cannotdistinguish“prudent” intermediaries from those“imprudent” ones that voluntarily holdhigh-risk portfolios and expose themselves to the risk of bankrupcy. We show how thenumber of imprudent intermediaries is determined in equilibrium jointly with theinterest rate, and how both ultimately depend on the cross-sectional distribution ofintermediaries'capital. One implication of our analysis is that an exogenous increase inthe supply of funds to the intermediary sector lowers interest rates and raises the numberof imprudent intermediaries. Another one is that easy financing may lead an increasingnumber of intermediaries to gamble for resurection following a bad shock to the sector'scapital, again raising economywide systemic risk