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Maintaining Confidence

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  • David Murphy
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    Abstract

    This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure. We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress. Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

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    File URL: http://www.lse.ac.uk/fmg/workingPapers/specialPapers/PDF/SP216.pdf
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    Bibliographic Info

    Paper provided by Financial Markets Group in its series FMG Special Papers with number sp216.

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    Date of creation: Dec 2012
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    Handle: RePEc:fmg:fmgsps:sp216

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    Web page: http://www.lse.ac.uk/fmg/

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    1. Frank Packer & Nikola Tarashev, 2011. "Rating methodologies for banks," BIS Quarterly Review, Bank for International Settlements, June.
    2. Darrell Duffie, 2010. "The failure mechanics of dealer banks," BIS Working Papers 301, Bank for International Settlements.
    3. Darrell Duffie, 2010. "The Failure Mechanics of Dealer Banks," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 51-72, Winter.
    4. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
    5. Claudio E. V. Borio & Kostas Tsatsaronis, 2006. "Risk in financial reporting: status, challenges and suggested directions," BIS Working Papers 213, Bank for International Settlements.
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