We propose a tractable model in which risk, at both the micro and macro levels, is endogenous and driven by incentives. In the model, each firm chooses the mean and the variance of its productivity process, as well as how it covaries with the productivity of other firms. Aggregate risk arises when firms select productivity processes that are correlated with one another. The theory predicts that larger firms and those with lower markups are less volatile and less correlated with aggregate productivity. We find support for these predictions in the data. Through their impact on risk-taking decisions, distortions such as taxes and markups can make GDP more volatile in equilibrium. In a calibrated version of the model, removing distortions significantly reduces GDP volatility.

We show that socially responsible investors can have a negative impact by slowing the pace of firm reform. Investors with broad prosocial preferences value acquiring dirty firms with high negative production externalities because they can reform these firms. The anticipation of trading gains for dirty firms decreases the incentive of current firm owners to reduce externalities proactively, potentially causing delay in reform. The presence of financial investors—alongside socially responsible investors—can exacerbate delay. Investment mandates through which socially responsible investors commit to paying a premium for green firms can incentivize reform in a timely manner.

We propose a model of the financial system in which banks are individually prone to runs and connected through fire sales. Strategic complementarities within and across banks amplify each other, making heterogeneity in bank risks a key factor shaping the fragility of each bank and the entire system. As long as different banks are interconnected, an increase in heterogeneity stabilizes all banks. Reductions in asset commonality, bank-specific disclosures, and even broad-based policies such as asset purchases and liquidity requirements can enhance stability by increasing bank heterogeneity.