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Understanding Systemic Risk: The Trade-Offs between Capital, Short-Term Funding and Liquid Asset Holdings

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Author Info

  • Céline Gauthier
  • Zhongfang He
  • Moez Souissi

Abstract

We offer a multi-period systemic risk assessment framework with which to assess recent liquidity and capital regulatory requirement proposals in a holistic way. Following Morris and Shin (2009), we introduce funding liquidity risk as an endogenous outcome of the interaction between market liquidity risk, solvency risk, and the funding structure of banks. To assess the overall impact of different mix of capital and liquidity, we simulate the framework under a severe but plausible macro scenario for different balance-sheet structures. Of particular interest, we find that (1) capital has a decreasing marginal effect on systemic risk, (2) increasing capital alone is much less effective in reducing liquidity risk than solvency risk, (3) high liquid asset holdings reduce the marginal effect of increasing short term liability on systemic risk, and (4) changing liquid asset holdings has little effect on systemic risk when short term liability is sufficiently low.

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2010/11/wp10-29.pdf
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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 10-29.

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Length: 36 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bca:bocawp:10-29

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Keywords: Financial stability; Financial system regulation and policies;

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  1. Jorge A. Chan-Lau, 2006. "Fundamentals-Based Estimation of Default Probabilities: A Survey," IMF Working Papers 06/149, International Monetary Fund.
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