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Endogenous Response to the ‘Network Tax’

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  • José Pedro Fique

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    (Faculdade de Economia da Universidade do Porto and LIAAD, INESC-Porto)

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    Abstract

    The turmoil in the financial markets that had its roots in the 2007 US subprime crisis prompted government action all over the world motivated by contagion concerns, leaving a heavy bill for the tax payers to pick up. We find that a contributory regime based on contagion risk exposure changes the trade-off between liquidity coinsurance and counterparty risk that motivates the formation of the financial network in the first place, potentially leading to a less connected architecture. Furthermore, if that regime bestows the weight of the levy on both borrower and lender it has the potential to shift the system towards safer grounds. Since we model bank interactions as a network formation game, we are able to provide an account of the changes that come into play with the introduction of tax, which can be a fundamental factor in the design process of the policy function.

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    File URL: http://www.fep.up.pt/investigacao/workingpapers/11.03.16_wp408.pdf
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    Bibliographic Info

    Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 408.

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    Length: 26 pages
    Date of creation: Mar 2011
    Date of revision:
    Handle: RePEc:por:fepwps:408

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    Keywords: Financial Network; Regulation; Counterparty Risk; Liquidity Coinsurance;

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    1. Acharya, Viral V. & Yorulmazer, Tanju, 2007. "Too many to fail--An analysis of time-inconsistency in bank closure policies," Journal of Financial Intermediation, Elsevier, vol. 16(1), pages 1-31, January.
    2. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research.
    3. Ana Babus, 2006. "The Formation of Financial Networks," Tinbergen Institute Discussion Papers 06-093/2, Tinbergen Institute.
    4. Allen, Franklin & Carletti, Elena, 2008. "The role of liquidity in financial crises," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 379-412.
    5. Matthew O. Jackson & Asher Wolinsky, 1994. "A Strategic Model of Social and Economic Networks," Discussion Papers 1098, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
    7. Sheri Markose & Simone Giansante & Mateusz Gatkowski & Ali Rais Shaghaghi, 2010. "Too Interconnected To Fail: Financial Contagion and Systemic Risk In Network Model of CDS and Other Credit Enhancement Obligations of US Banks," Working Papers 033, COMISEF.
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