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Efficient Asset Allocations in the Banking Sector and Financial Regulation

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  • Wolf Wagner

    (European Banking Centre, CentER, TILEC, and Department of Economics, Tilburg University)

Abstract

The failure of a bank or the case of a bank experiencing a crisis usually has negative spillovers for other banks in the economy, such as through informational contagion or an increased cost of borrowing. Such spillovers are likely to be higher when the other banks are close to failure as well. This paper shows that this gives rise to externalities among banks which arise from their portfolio choices. The reason is that the assets a bank holds on its balance sheet determine the situations in which a bank will be in a crisis, and thus whether this will be at a time when other banks are in a crisis as well. As a result, the equilibrium portfolio allocations in the economy are typically not efficient. Some banks may choose too correlated portfolios, but others may choose tooheterogeneous portfolios. The optimal regulatory treatment of banks is typically heterogeneous and may involve encouraging more correlation at already highly correlated banks but lowering correlation at other banks. Additional inefficiencies arise when bank failures also have implications outside the banking sector. Overall, the paper highlights a role for regulation in a financial system in which the costs of financial stress at institutions are interdependent. JEL Codes: G21, G28.

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Bibliographic Info

Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 5 (2009)
Issue (Month): 1 (March)
Pages: 75-95

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Handle: RePEc:ijc:ijcjou:y:2009:q:1:a:3

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  1. Perotti, Enrico C. & Suarez, Javier, 2002. "Last bank standing: What do I gain if you fail?," European Economic Review, Elsevier, vol. 46(9), pages 1599-1622, October.
  2. Isabel Schnabel & Hyun Song Shin, 2004. "Liquidity and Contagion: The Crisis of 1763," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 929-968, December.
  3. Acharya, Viral & Song Shin, Hyun & Yorulmazer, Tanju, 2009. "Endogenous choice of bank liquidity: the role of fire sales," Bank of England working papers 376, Bank of England.
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Cited by:
  1. Luca RICCETTI & Alberto RUSSO & Mauro GALLEGATI, 2011. "Leveraged Network-Based Financial Accelerator," Working Papers 371, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
  2. Gropp, Reint Eberhard & Kashyap, Anil K., 2008. "A New Metric for Banking Integration in Europe," ZEW Discussion Papers 08-102, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  3. Jin Cao & Gerhard Illing, 2010. "Regulation of systemic liquidity risk," Financial Markets and Portfolio Management, Springer, vol. 24(1), pages 31-48, March.
  4. Nijskens, Rob & Wagner, Wolf, 2011. "Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1391-1398, June.
  5. Toni Ahnert, 2014. "Rollover Risk, Liquidity and Macroprudential Regulation," Working Papers 14-23, Bank of Canada.

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