We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced … against the benefit of equity in attenuating risk-shifting. However, faced with socially-costly correlated bank failures …, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which …

We develop a theory of optimal bank leverage in which the benefit of debt in inducing loan monitoring is balanced … against the benefit of equity in attenuating risk-shifting. However, faced with socially-costly correlated bank failures …, regulators bail out creditors. Anticipation of this generates multiple equilibria, including one with systemic risk in which …

risk in which all banks choose inefficiently high leverage to fund correlated assets and market discipline is compromised … ; systemic risk ; bailout ; forbearance ; moral hazard ; capital requirements …

. Anticipation of this generates an equilibrium featuring systemic risk in which all banks choose inefficiently high leverage to fund …

risk in which all banks choose inefficiently high leverage to fund correlated assets and market discipline is compromised …

monitor managers and make sure they exert the effort necessary to reduce default risk. This gives rise to moral hazard. In …. If these become too high, investors give up on incentives, and default risk rises. Thus, moral hazard gives rise to … endogenous crises and fat tails in the distribution of aggregate default risk. Our model fits the stylized facts of the MBS …

the results from the model to cast light on (i) the conflicting empirical evidence on the risk-incentives tradeoff found …