Efficient Asset Allocations in the Banking Sector and Financial Regulation
The failure of a bank or the case of a bank experiencing a crisis usually has negative spillovers for other banks in the economy, such as through informational contagion or an increased cost of borrowing. Such spillovers are likely to be higher when the other banks are close to failure as well. This paper shows that this gives rise to externalities among banks which arise from their portfolio choices. The reason is that the assets a bank holds on its balance sheet determine the situations in which a bank will be in a crisis, and thus whether this will be at a time when other banks are in a crisis as well. As a result, the equilibrium portfolio allocations in the economy are typically not efficient. Some banks may choose too correlated portfolios, but others may choose tooheterogeneous portfolios. The optimal regulatory treatment of banks is typically heterogeneous and may involve encouraging more correlation at already highly correlated banks but lowering correlation at other banks. Additional inefficiencies arise when bank failures also have implications outside the banking sector. Overall, the paper highlights a role for regulation in a financial system in which the costs of financial stress at institutions are interdependent. JEL Codes: G21, G28.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Perotti, Enrico C. & Suarez, Javier, 2002.
"Last bank standing: What do I gain if you fail?,"
European Economic Review,
Elsevier, vol. 46(9), pages 1599-1622, October.
- Acharya, Viral & Song Shin, Hyun & Yorulmazer, Tanju, 2009. "Endogenous choice of bank liquidity: the role of fire sales," Bank of England working papers 376, Bank of England.
- Isabel Schnabel & Hyun Song Shin, 2004. "Liquidity and Contagion: The Crisis of 1763," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 929-968, December.
When requesting a correction, please mention this item's handle: RePEc:ijc:ijcjou:y:2009:q:1:a:3. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Timo Laurmaa)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.