Systemic Loops and Liquidity Regulation

39 Pages Posted: 4 Nov 2015

See all articles by Iñaki Aldasoro

Iñaki Aldasoro

Bank for International Settlements (BIS)

Ester Faia

Goethe University Frankfurt; Centre for Economic Policy Research (CEPR)

Date Written: November 2015

Abstract

Risk contagion in the banking sector occurs through interconnections on the asset side or through liquidity spirals affecting the liability side. We build a network model of optimizing banks featuring contagion on both sides of banks' balance sheets. To already existing asset side channels (liquidity hoarding, interbank exposures and fire sales of common assets) we add a critical liability side channel of contagion, namely bank runs triggered by information coordination akin to global games. The model is calibrated to the network of large European banks by a simulated method of moments approach and by using the real-world interbank matrix as a prior for the maximum entropy estimation of the model-based interbank matrix. We use the model 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) increases in coverage ratios based on systemic importance rankings help to mitigate the externalities and deliver a much more stable system.

Keywords: bank runs, contagion, interconnections, liquidity scarcity, phase-ins

JEL Classification: C63, D85, G21, G28, L14

Suggested Citation

Aldasoro, Iñaki and Faia, Ester, Systemic Loops and Liquidity Regulation (November 2015). CEPR Discussion Paper No. DP10918, Available at SSRN: https://ssrn.com/abstract=2685675

Iñaki Aldasoro (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Ester Faia

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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