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Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information

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  • Liliana Schumacher
  • Theodore M. Barnhill
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    Abstract

    This paper proposes and demonstrates a methodology for modeling correlated systemic solvency and liquidity risks for a banking system. Using a forward looking simulation of many risk factors applied to detailed balance sheets for a 10 bank stylized United States banking system, we analyze correlated market and credit risk and estimate the probability that multiple banks will fail or experience liquidity runs simultaneously. Significant systemic risk factors are shown to include financial and economic environment regime shifts to stressful conditions, poor initial loan credit quality, loan portfolio sector and regional concentrations, bank creditors'' sensitivity to and uncertainties regarding solvency risk, and inadequate capital. Systemic banking system solvency risk is driven by the correlated defaults of many borrowers, other market risks, and inter-bank defaults. Liquidity runs are modeled as a response to elevated solvency risk and uncertainties and are shown to increase correlated bank failures. Potential bank funding outflows and contractions in lending with significant real economic impacts are estimated. Increases in equity capital levels needed to reduce bank solvency and liquidity risk levels to a target confidence level are also estimated to range from 3 percent to 20 percent of assets. For a future environment that replicates the 1987-2006 volatilities and correlations, we find only a small risk of U.S. bank failures focused on thinly capitalized and regionally concentrated smaller banks. For the 2007-2010 financial environment calibration we find substantially elevated solvency and liquidity risks for all banks and the banking system.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/263.

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    Length: 49
    Date of creation: 01 Nov 2011
    Date of revision:
    Handle: RePEc:imf:imfwpa:11/263

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    Related research

    Keywords: Banking systems; Credit risk; Economic models; External shocks; probability; banking; banking system; bank failures; probabilities; calibration; correlations; bank solvency; bank default; bank failure; banks balance sheet; bank assets; bank defaults; banks with assets; bank loan; bank loans; bank creditors; bank of england; probability of default; bank failure rates; deposit insurance; foreign exchange; mortgage loan; banking panics; bank capital; bank runs; banking crises; calibrations; normal distribution; bank lending; bank for international settlements; samples; bank portfolios; bank funding; bank liquidity; banking supervision; banks ? assets; monetary authority; bank holding companies; bank risk; bank holding; random samples; correlation; bank equity; interbank market; bank credit; bank_failure; bank_failure_rate; surveys; bank borrowers; bank system; normal distributions; bank liabilities; bank clients; bank panics; horizontal axis; bank asset; bank borrowing; bank governors; random error; banks ? asset; capital requirement; bank risks; bank deposits; arithmetic; bank exposure; bank equity capital; liquidity ratio; banks ? solvency; bank losses; national bank; real estate loan; simulation results; banking system assets; investment bank; random variables; federal deposit insurance; present value; bank managers; correlation analysis; bank regulators; loan concentration; time series; banks ? balance sheets; bank of canada;

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    1. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
    2. David Aikman & Piergiorgio Alessandri & Bruno Eklund & Prasanna Gai & Sujit Kapadia, & Elizabeth Martin, & Nada Mora & Gabriel Sterne & Matthew Willison, 2011. "Funding Liquidity Risk in a Quantitative Model of Systemic Stability," Central Banking, Analysis, and Economic Policies Book Series, in: Rodrigo Alfaro (ed.), Financial Stability, Monetary Policy, and Central Banking, edition 1, volume 15, chapter 12, pages 371-410 Central Bank of Chile.
    3. Viral V. Acharya & João A. C. Santos & Tanju Yorulmazer, 2010. "Systemic risk and deposit insurance premiums," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 89-99.
    4. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2009. "A Theory of Liquidity and Regulation of Financial Intermediation," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 973-992.
    5. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
    6. Gary B. Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," NBER Working Papers 15223, National Bureau of Economic Research, Inc.
    7. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed, not frozen: the Federal Funds market in the financial crisis," Staff Reports 437, Federal Reserve Bank of New York.
    8. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2006. "Valuation in Over-the-Counter Markets," NBER Working Papers 12020, National Bureau of Economic Research, Inc.
    9. Joshua D. Coval & Erik Stafford, 2005. "Asset Fire Sales (and Purchases) in Equity Markets," NBER Working Papers 11357, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Borio, Claudio & Drehmann, Mathias & Tsatsaronis, Kostas, 2014. "Stress-testing macro stress testing: Does it live up to expectations?," Journal of Financial Stability, Elsevier, vol. 12(C), pages 3-15.
    2. Leo de Haan & Jan Willem van den End, 2012. "Bank liquidity, the maturity ladder, and regulation," DNB Working Papers 346, Netherlands Central Bank, Research Department.
    3. Hsu, S. & Li, J. & Qin, Y., 2013. "Shadow Banking and Systemic Risk in Europe and China," CITYPERC Working Paper Series 2013-02, Department of International Politics, City University London.
    4. Rodolfo Maino & Kalin Tintchev, 2012. "From Stress to Costress," IMF Working Papers 12/53, International Monetary Fund.
    5. Kalin Tintchev, 2013. "Connected to Whom? International Interbank Borrowing During the Global Crisis," IMF Working Papers 13/14, International Monetary Fund.

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