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Systemic loops and liquidity regulation

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  • Aldasoro, Iñaki
  • Faia, Ester

Abstract

Banks are typically exposed to spirals between liquidity scarcity and solvency risk. We build a network model of optimizing banks featuring contagion on both sides of balance sheets: runs on short term liabilities and banks’ liquidity hoarding induce liquidity freezes; fire sale externalities and interconnected debt defaults produce asset risk. We use the model, which is calibrated to European data via simulated method of moments, to study the effects of phase-in increases of liquidity coverage ratios. Interestingly we find that the systemic risk profile of the system is not improved and might even deteriorate. Based on those insights we propose an alternative approach: differential (across banks) application of coverage ratios based on a systemic importance ranking help to mitigate the externalities and deliver a much more stable system.

Suggested Citation

  • Aldasoro, Iñaki & Faia, Ester, 2016. "Systemic loops and liquidity regulation," Journal of Financial Stability, Elsevier, vol. 27(C), pages 1-16.
    • Handle: RePEc:eee:finsta:v:27:y:2016:i:c:p:1-16
    DOI: 10.1016/j.jfs.2016.08.008
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    Cited by:

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    4. Yiannis Anagnostopoulos & Jackie Kabeega, 2019. "Insider perspectives on European banking challenges in the post-crisis regulation environment," Journal of Banking Regulation, Palgrave Macmillan, vol. 20(2), pages 136-158, June.
    5. D’Orazio, Paola & Popoyan, Lilit, 2019. "Fostering green investments and tackling climate-related financial risks: Which role for macroprudential policies?," Ecological Economics, Elsevier, vol. 160(C), pages 25-37.
    6. Aldasoro, Iñaki & Hüser, Anne-Caroline & Kok, Christoffer, 2022. "Contagion accounting in stress-testing," Journal of Economic Dynamics and Control, Elsevier, vol. 137(C).
    7. Qian, Meijun & Tanyeri, Başak, 2017. "Litigation and mutual-fund runs," Journal of Financial Stability, Elsevier, vol. 31(C), pages 119-135.
    8. Iñaki Aldasoro & Anne-Caroline Hüser & Christoffer Kok Sørensen, 2020. "Contagion Accounting," BIS Working Papers 908, Bank for International Settlements.
    9. Li, Boyao, 2022. "How does bank equity affect credit creation? Multiplier effects under Basel III regulations," Economic Analysis and Policy, Elsevier, vol. 76(C), pages 299-324.
    10. David Aikman & Daniel Beale & Adam Brinley-Codd & Anne-Caroline Hüser & Giovanni Covi & Caterina Lepore, 2023. "Macro-Prudential Stress Test Models: A Survey," IMF Working Papers 2023/173, International Monetary Fund.
    11. Axel Per Hedström & Gazi Salah Uddin & Md Lutfur Rahman & Bo Sjö, 2024. "Systemic risk in the Scandinavian banking sector," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 29(1), pages 581-608, January.
    12. T. R. Hurd, 2018. "Bank Panics And Fire Sales, Insolvency And Illiquidity," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(06), pages 1-30, September.
    13. de Mendonça, Helder Ferreira & Silva, Rafael Bernardo da, 2018. "Effect of banking and macroeconomic variables on systemic risk: An application of ΔCOVAR for an emerging economy," The North American Journal of Economics and Finance, Elsevier, vol. 43(C), pages 141-157.
    14. Cristina Zeldea, 2020. "Modeling the Connection between Bank Systemic Risk and Balance-Sheet Liquidity Proxies through Random Forest Regressions," Administrative Sciences, MDPI, vol. 10(3), pages 1-14, August.
    15. Li, Boyao, 2021. "Bank equity, interest payments, and credit creation under Basel III regulations," MPRA Paper 111269, University Library of Munich, Germany.
    16. T. R. Hurd, 2017. "Bank Panics and Fire Sales, Insolvency and Illiquidity," Papers 1711.05289, arXiv.org.
    17. Wang, Xiaoting & Hou, Siyuan & Shen, Jie, 2021. "Default clustering of the nonfinancial sector and systemic risk: Evidence from China," Economic Modelling, Elsevier, vol. 96(C), pages 196-208.
    18. Chen, Tingqiang & Wang, Yutong & Zeng, Qianru & Luo, Jun, 2020. "Network model of credit risk contagion in the interbank market by considering bank runs and the fire sale of external assets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 542(C).

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    More about this item

    Keywords

    Bank runs; Liquidity scarcity; Interconnections; Contagion; Phase-in;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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