New Economics Papers
on Banking
Issue of 2011‒03‒26
23 papers chosen by
Christian Calmès, Université du Québec en Outaouais

  1. Capital Regulation and Tail Risk By Enrico Perotti; Lev Ratnovski; Razvan Vlahu
  2. On the (non-)equivalence of capital adequacy and monetary policy: A response to Cechetti and Kohler By Stan du Plessis; Gideon du Rand
  3. Interest Rates After The Credit Crunch: Multiple-Curve Vanilla Derivatives and SABR By Marco Bianchetti; Mattia Carlicchi
  4. Money, Financial Stability and Efficiency By Franklin Allen; Elena Carletti; Douglas Gale
  5. A Pigovian Approach to Liquidity Regulation By Enrico Perotti; Javier Suarez
  6. Dynamic hedging of portfolio credit derivatives By Rama Cont; Yu Hang Kan
  7. Securitization is not that evil after all By Ugo Albertazzi; Ginette Eramo; Leonardo Gambacorta; Carmelo Salleo
  8. BASEL III: long-term impact on economic performance and fluctuations By Paolo Angelini; Laurent Clerc; Vasco Cúrdia; Leonardo Gambacorta; Andrea Gerali; Alberto Locarno; Roberto Motto; Werner Roeger; Skander Van den Heuvel; Jan Vlcek
  9. Risk Management of Risk under the Basel Accord: Forecasting Value-at-Risk of VIX Futures By Chia-Lin Chang; Juan-Ángel Jiménez-Martín; Michael McAleer; Teodosio Pérez-Amaral
  10. Mapping systemic risk in the international banking network By Garratt, Rodney; Mahadeva, Lavan; Svirydzenka, Katsiaryna
  11. Observation Driven Mixed-Measurement Dynamic Factor Models with an Application to Credit Risk By Drew Creal; Bernd Schwaab; Siem Jan Koopman; Andre Lucas
  12. Debit card interchange fees generally lead to cash-promoting cross-subsidisation By Leinonen, Harry
  13. Short-term borrowing for long-term projects: Are family businesses more susceptible to 'irrational' financing choices? By Peters, Bettina; Westerheide, Peter
  14. Bank efficiency in transition economies: recent evidence from South-Eastern Europe By Fang, Yiwei; Hasan, Iftekhar; Marton, Katherin
  15. Roles of Outside Directors in Cooperative Financial Institutions By Yamori, Nobuyoshi; Harimaya, Kozo; Tomimura, Kei
  16. To switch or not to switch - Can individual lending do better in micronance than group lending? By Helke Waelde
  17. The Impact of Microfinance on the Informal Credit Market: an Adverse Selection Model By Timothée Demont
  18. Service quality gap analysis in private sector bank - a customer perspective. By A.Ananth, -; R.Ramesh, -; Dr.B.Prabaharan, -
  19. Measuring the systemic importance of interconnected banks By Nikola Tarashev; Mathias Drehmann
  20. Product market relationships and cost of bank loans: evidence from strategic alliances By Fang, Yiwei; Francis , Bill; Hasan , Iftekhar; Wang, Haizhi
  21. Unobservable savings, risk sharing and default in the financial system By Panetti, Ettore
  22. Endogenous Response to the ‘Network Tax’ By José Pedro Fique
  23. Financial liberalization and contagion with unobservable savings By Panetti, Ettore

  1. By: Enrico Perotti (University of Amsterdam, Duisenberg school of finance, and CEPR); Lev Ratnovski (International Monetary Fund); Razvan Vlahu (Dutch Central Bank)
    Abstract: The paper studies risk mitigation associated with capital regulation, in a context when banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. When capital raising is costly, poorly capitalized banks may limit risk to avoid breaching the minimal capital ratio. A bank with higher capital has less
    Keywords: Bank Regulation; Risk Shifting; Capital Requirements; Tail Risk; Systemic Risk
    JEL: E6 F3 F4 G2 G3 O16
    Date: 2011–02–17
  2. By: Stan du Plessis (Department of Economics, University of Stellenbosch); Gideon du Rand (Department of Economics, University of Stellenbosch)
    Abstract: The instrument problem in monetary policy is back on the agenda. Until recently interest rate policy was widely thought to be sufficient for the attainment of appropriate monetary policy goals. No longer. In the wake of the international financial crisis there is much pressure on monetary authorities to incorporate the goal of financial stability more explicitly in policy. This requires an expansion of the instruments typically used by central banks. Cechetti and Kohler (2010) recently considered this new version of the instrument problem in monetary policy by analysing the distinct role and potential for co-ordinating (i) interest rates and (ii) capital adequacy requirements. In this paper we connect this modern debate with an earlier version of the instrument problem, famously discussed by Poole (1970). Then, as now (we claim), the main message of the analysis is the non-equivalence of these instruments and the structural features of the economy on the basis of which one would prefer a particular combination of these instruments. These results are demonstrated with a set of simulations. We also offer a theoretical criticism of the modelling approach used by Cechetti and Kohler (2010).
    Keywords: Monetary policy, Instrument problem, Interest rates, Alternative monetary policy instruments, Balance sheet operations, Policy co-ordination
    JEL: E52 E58 E61
    Date: 2011
  3. By: Marco Bianchetti; Mattia Carlicchi
    Abstract: We present a quantitative study of the markets and models evolution across the credit crunch crisis. In particular, we focus on the fixed income market and we analyze the most relevant empirical evidences regarding the divergences between Libor and OIS rates, the explosion of Basis Swaps spreads, and the diffusion of collateral agreements and CSA-discounting, in terms of credit and liquidity effects. We also review the new modern pricing approach prevailing among practitioners, based on multiple yield curves reflecting the different credit and liquidity risk of Libor rates with different tenors and the overnight discounting of cash flows originated by derivative transactions under collateral with daily margination. We report the classical and modern no-arbitrage pricing formulas for plain vanilla interest rate derivatives, and the multiple-curve generalization of the market standard SABR model with stochastic volatility. We then report the results of an empirical analysis on recent market data comparing pre- and post-credit crunch pricing methodologies and showing the transition of the market practice from the classical to the modern framework. In particular, we prove that the market of Interest Rate Swaps has abandoned since March 2010 the classical Single-Curve pricing approach, typical of the pre-credit crunch interest rate world, and has adopted the modern Multiple-Curve CSA approach, thus incorporating credit and liquidity effects into market prices. The same analysis is applied to European Caps/Floors, finding that the full transition to the modern Multiple-Curve CSA approach has retarded up to August 2010. Finally, we show the robustness of the SABR model to calibrate the market volatility smile coherently with the new market evidences.
    Date: 2011–03
  4. By: Franklin Allen; Elena Carletti; Douglas Gale
    Abstract: Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed.
    Date: 2011
  5. By: Enrico Perotti (University of Amsterdam, Duisenberg school of finance, and CEPR); Javier Suarez (CEMFI, and CEPR)
    Abstract: This paper discusses liquidity regulation when short-term funding enables credit growth but generates negative systemic risk externalities. It focuses on the relative
    Keywords: Systemic risk; Liquidity risk; Liquidity requirements; Liquidity risk levies; Macroprudential regulation
    JEL: G21 G28
    Date: 2011–02–17
  6. By: Rama Cont (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII); Yu Hang Kan (Center for Financial Engineering, Columbia University - Columbia University)
    Abstract: We compare the performance of various hedging strategies for index collateralized debt obligation (CDO) tranches across a variety of models and hedging methods during the recent credit crisis. Our empirical analysis shows evidence for market incompleteness: a large proportion of risk in the CDO tranches appears to be unhedgeable. We also show that, unlike what is commonly assumed, dynamic models do not necessarily perform better than static models, nor do high-dimensional bottom-up models perform better than simpler top-down models. When it comes to hedging, top-down and regression-based hedging with the index provide significantly better results during the credit crisis than bottom-up hedging with single-name credit default swap (CDS) contracts. Our empirical study also reveals that while significantly large moves—“jumps”—do occur in CDS, index, and tranche spreads, these jumps do not necessarily occur on the default dates of index constituents, an observation which shows the insufficiency of some recently proposed portfolio credit risk models.
    Keywords: hedging, credit default swaps, portfolio credit derivatives, index default swaps, collateralized debt obligations, portfolio credit risk models, default contagion, spread risk, sensitivity-based hedging, variance minimization
    Date: 2011–02–01
  7. By: Ugo Albertazzi (Bank of Italy); Ginette Eramo (Bank of Italy); Leonardo Gambacorta (Bank for International Settlements); Carmelo Salleo (European Systemic Risk Board Secretariat)
    Abstract: A growing number of studies on the US subprime market indicate that, due to asymmetric information, credit risk transfer activities have perverse effects on banks’ lending standards. We investigate a large part of the market for securitized assets (“prime mortgages”) in Italy, a country with a regulatory framework analogous to the one prevalent in Europe. Information on over a million mortgages consists of loan-level variables, characteristics of the originating bank and, most importantly, contractual features of the securitization deal, including the seniority structure of the ABSs issued by the Special Purpose Vehicle and the amount retained by the originator. We borrow a robust way to test for the effects of asymmetric information from the empirical contract theory literature (Chiappori and Salanié, 2000). Overall, our evidence suggests that banks can effectively counter the negative effects of asymmetric information in the securitization market by selling less opaque loans, using signaling devices (i.e. retaining a share of the equity tranche of the ABSs issued by the SPV) and building up a reputation for not undermining their own lending standards.
    Keywords: securitization, asymmetric information, signaling, reputation
    JEL: D82 G21
    Date: 2011–02
  8. By: Paolo Angelini; Laurent Clerc; Vasco Cúrdia; Leonardo Gambacorta; Andrea Gerali; Alberto Locarno; Roberto Motto; Werner Roeger; Skander Van den Heuvel; Jan Vlcek
    Abstract: We assess the long-term economic impact of the new regulatory standards (the Basel III reform), answering the following questions: 1) What is the impact of the reform on long-term economic performance? 2) What is the impact of the reform on economic fluctuations? 3) What is the impact of the adoption of countercyclical capital buffers on economic fluctuations? The main results are the following: 1) Each percentage point increase in the capital ratio causes a median 0.09 percent decline in the level of steady-state output, relative to the baseline. The impact of the new liquidity regulation is of a similar order of magnitude, at 0.08 percent. This paper does not estimate the benefits of the new regulation in terms of reduced frequency and severity of financial crisis, analyzed in Basel Committee on Banking Supervision (2010b). 2) The reform should dampen output volatility; the magnitude of the effect is heterogeneous across models; the median effect is modest. 3) The adoption of countercyclical capital buffers could have a more sizable dampening effect on output volatility.
    Keywords: Basel capital accord ; Business cycles ; Economic conditions ; Bank supervision ; Bank capital
    Date: 2011
  9. By: Chia-Lin Chang (Department of Applied Economics, Department of Finance, National Chung Hsing University); Juan-Ángel Jiménez-Martín (Department of Quantitative Economics, Complutense University of Madrid); Michael McAleer (Erasmus University Rotterdam, Tinbergen Institute, The Netherlands, and Institute of Economic Research, Kyoto University); Teodosio Pérez-Amaral (Department of Quantitative Economics, Complutense University of Madrid)
    Abstract: The Basel II Accord requires that banks and other Authorized Deposit-taking Institutions (ADIs) communicate their daily risk forecasts to the appropriate monetary authorities at the beginning of each trading day, using one or more risk models to measure Value-at-Risk (VaR). The risk estimates of these models are used to determine capital requirements and associated capital costs of ADIs, depending in part on the number of previous violations, whereby realised losses exceed the estimated VaR. McAleer, Jimenez-Martin and Perez- Amaral (2009) proposed a new approach to model selection for predicting VaR, consisting of combining alternative risk models, and comparing conservative and aggressive strategies for choosing between VaR models. This paper addresses the question of risk management of risk, namely VaR of VIX futures prices. We examine how different risk management strategies performed during the 2008-09 global financial crisis (GFC). We find that an aggressive strategy of choosing the Supremum of the single model forecasts is preferred to the other alternatives, and is robust during the GFC. However, this strategy implies relatively high numbers of violations and accumulated losses, though these are admissible under the Basel II Accord.
    Keywords: Median strategy, Value-at-Risk (VaR), daily capital charges, violation penalties, optimizing strategy, aggressive risk management, conservative risk management, Basel II Accord, VIX futures, global financial crisis (GFC).
    JEL: G32 G11 C53 C22
    Date: 2011–03
  10. By: Garratt, Rodney (University of California); Mahadeva, Lavan (Bank of England); Svirydzenka, Katsiaryna (Graduate Institute, Geneva)
    Abstract: Systemic risk among the network of international banking groups arises when financial stress threatens to criss-cross many national boundaries and expose imperfect international co-ordination. To assess this risk, we apply an information theoretic map equation due to Martin Rosvall and Carl Bergstrom to partition banking groups from 21 countries into modules. The resulting modular structure reflects the flow of financial stress through the network, combining nodes that are most closely related in terms of the transmission of stress. The modular structure of the international banking network has changed dramatically over the past three decades. In the late 1980s four important financial centres formed one large supercluster that was highly contagious in terms of transmission of stress within its ranks, but less contagious on a global scale. Since then the most influential modules have become significantly smaller and more broadly contagious. The analysis contributes to our understanding as to why defaults in US sub-prime mortgages had such large global implications.
    Keywords: Networks; international banking groups; systemic risk; information theory.
    JEL: F20 F30
    Date: 2011–03–02
  11. By: Drew Creal (University of Chicago, Booth School of Business); Bernd Schwaab (European Central Bank); Siem Jan Koopman (VU University Amsterdam); Andre Lucas (VU University Amsterdam)
    Abstract: We propose a dynamic factor model for mixed-measurement and mixed-frequency panel data. In this framework time series observations may come from a range of families of parametric distributions, may be observed at different time frequencies, may have missing observations, and may exhibit common dynamics and cross-sectional dependence due to shared exposure to dynamic latent factors. The distinguishing feature of our model is that the likelihood function is known in closed form and need not be obtained by means of simulation, thus enabling straightforward parameter estimation by standard maximum likelihood. We use the new mixed-measurement framework for the signal extraction and forecasting of macro, credit, and loss given default risk conditions for U.S. Moody's-rated firms from January 1982 until March 2010.
    Keywords: panel data; loss given default; default risk; dynamic beta density; dynamic ordered probit; dynamic factor model
    JEL: C32 G32
    Date: 2011–02–21
  12. By: Leinonen, Harry (Bank of Finland Research)
    Abstract: Cards and cash are competing payment instruments at point-of-sale. The twosided market platform theory, based on general benefit assumptions, supports the use of multilateral interchange fees for card payments as a means of promoting the use of cards. However, analysis of the issue from the concrete processing cost viewpoint leads to the opposite conclusion: collection of debit card interchange fees by issuers results in subsidisation of cash and so actually promotes the use of cash instead of cards. Banks use card interchange revenues to cover cash distribution costs. For merchants, interchange fees increase payment costs and thus reduce the possibilities to pass through to customers the cost savings flowing from card efficiency. Moreover, because of high merchant fees due to high interchange fees, merchants are also more reluctant to accept payment cards. An MIF based on the tourist level approach will result in all parties being indifferent between cash and cards and thereby delay the realisation of the cost benefits of increased debit card usage. The resent actions of authorities to increase transparency and reduce cross-subsidisation seem to point in the right direction – towards more efficient resource allocation in payments.
    Keywords: interchange fee; cross-subsidies in payments
    JEL: G14 G38 L14 L42 L51
    Date: 2011–03–11
  13. By: Peters, Bettina; Westerheide, Peter
    Abstract: There are noticeable differences between the roles that various forms of credit financing play in family businesses and in other businesses. Family businesses take out more often bank loans specifically to finance investments and innovations, and they particularly often resort to the short-term and relatively expensive option of an overdraft. How can we explain these differences in financing choices? Do family businesses tend to use shorter-term, more expensive sources of financing because they face more restrictions than other or are there other motives such as financial independence at play? Our econometric approach to these issues is to study the financing behaviour and creditworthiness. For both of these aspects, we compare family businesses with non-family-run businesses that otherwise have the same characteristics. Our results do not confirm that family businesses are faced by stronger financial constraints but they indicate that family firms are prepared to accept higher financing costs in order to preserve their financial independence. --
    Keywords: Corporate financing,innovation,family businesses,financing restrictions
    JEL: G32 G31 M14
    Date: 2011
  14. By: Fang, Yiwei (Lally School of Management and Technology, New York); Hasan, Iftekhar (Lally School of Management and Technology, New York, and Bank of Finland Research); Marton, Katherin (Fordham University, New York)
    Abstract: This study examines the cost and profit efficiency of banking sectors in six transition countries of South-Eastern Europe over the period 1998–2008. Using the stochastic frontier approach, our analysis reveals that the average cost efficiency of SEE banks is 68.59% and the average profit efficiency is 53.87%. The second-stage regressions on the determinants of bank efficiency further show that foreign banks are associated with higher profit efficiency but moderately lower cost efficiency. Government banks are associated with lower profit efficiency. The efficiency gap between foreign banks, domestic private banks and government banks, however, has narrowed over time. We also find that the degree of individual banks’ competitiveness has a positive association with both cost and profit efficiency. Finally, institutional development, proxied by progress in banking reforms, privatization and corporate governance restructuring, also has a positive impact on bank efficiency.
    Keywords: transition banking; bank efficiency; foreign ownership; institutional development
    JEL: G21 P30 P34 P52
    Date: 2011–03–14
  15. By: Yamori, Nobuyoshi; Harimaya, Kozo; Tomimura, Kei
    Abstract: As the governance of financial institutions is becoming an important issue, there are many papers empirically investigating the governance issues of banks, which are stock companies. However, cooperative structured financial institutions (co-ops), which have a unique governance structure different from stock companies, play a substantial role in the Japanese banking markets, and, therefore, it is worth examining whether some governance scheme developed for stock companies are effective at cooperative financial institutions. Our results showed that the presence of outside directors at co-ops (“Shinkin Banks”) contributes to an improvement in efficiency.
    Keywords: Corporate Governance; Outside Directors; Cooperative; Shinkin.
    JEL: G28 G21
    Date: 2011–03–18
  16. By: Helke Waelde (Department of Economics, Johannes Gutenberg-Universitaet Mainz, Germany)
    Abstract: These days it has been witnessed, that banks o¤er individual loans instead of group loans and develop products based on individual liability in developing coun- tries. In order to study this surprising turn, we expand the conventional approach on decision making of individuals. A social prestige function is introduced that re- ‡ects the non-monetary impacts of group membership on the individual and on her decisions. If a borrower possesses more than a critical level of wealth, it is optimal for her to switch to individual borrowing. From a welfare perspective, a mixture of individual and group loans is desirable. However, the average borrower switches from group to individual lending too soon.
    JEL: E43 E52 E58 D44
    Date: 2011–03–07
  17. By: Timothée Demont (Center for Research in the Economics of Development, University of Namur)
    Abstract: This paper looks at ‘the other side’ of the much-celebrated microfinance revolution, namely its potential impact on the conditions of access to credit for nonmembers (the residual market). It uses a standard adverse selection framework to show the advantage of group lending as a single innovative lending technology, and then to assess how the apparition of this new type of lenders might change the equilibria on rural credit markets, taking into account the reaction of other lenders. We find that two antagonist effects coexist: a standard competition effect and a selection effect. While the former tends to lower the residual market rate, the latter raises the cost of borrowing outside microfinance institutions (MFIs) due to a worsening of the pool of borrowers. The relative weights of the two effects depend on the market structure, the heterogeneity of the population and the actual distance between lending technologies. If the individuallending market is competitive, then the only possible effect is the increase of the interest rate charged by moneylenders, which will happen as soon as the pool of borrowers of the two types of lenders are overlapping. If traditional moneylenders have market power, then the two effects are at work. Even then, whenever a group-lending institution is present in the market, a monopolistic moneylender has to give up supplying credit to relatively safe borrowers, which can allow it to raise its interest rate (though making a lower profit). This arguably less intuitive impact of microfinance, which has been overlooked until now, is important given the nearly-universal coexistence of MFIs and traditional lenders in developing countries. Moreover, it is not only theoretically likely, but seems to match some empirical evidence presented in the paper. Our paper is thus a contribution in the understanding of the redistributive impact of the microfinance revolution that has been occurring in the last years.
    Keywords: Microfinance, Rural credit market, Adverse selection, Group lending, Competition.
    JEL: D82 G21 L1 O12 O16
    Date: 2010–03
  18. By: A.Ananth, -; R.Ramesh, -; Dr.B.Prabaharan, -
    Abstract: The present study evaluates the customer perceptions of service quality in selected private sector banks. Data was collected from 200 customers of ICICI and CUB using structured questionnaire. Gap analysis and Multi regression were used fro analysis of data. The result shows that the dimension of service quality such as Empathy and Accessibility has more gap, as the customer expectations are high to their perceived service. The result also indicates that Empathy-Reliability-Assurance positively influences the service quality. The study implies that bank should reduce the service gap to deliver superior quality of service to retain existing customers as well as to attract new customers.
    Keywords: Service quality; Service Gap; Multi Regression
    JEL: G2 G21
    Date: 2010–12–06
  19. By: Nikola Tarashev; Mathias Drehmann
    Abstract: We develop a measure of systemic importance that accounts for the extent to which a bank propagates shocks across the banking system and is vulnerable to propagated shocks. Based on Shapley values, this measure gauges the contribution of interconnected banks to systemic risk, in contrast to other measures proposed in the literature. An empirical implementation of our measure reveals that systemic importance depends materially on the bank's role in the interbank network, both as a borrower and as a lender. We also find substantial differences between alternative measures, which implies that prudential authorities should be careful in choosing the underlying approach.
    Keywords: Systemic risk, Shapley values, Interbank positions
    Date: 2011–03
  20. By: Fang, Yiwei (Lally School of Management and Technology, Rensselaer Polytechnic Institute); Francis , Bill (Lally School of Management and Technology, Rensselaer Polytechnic Institute); Hasan , Iftekhar (Lally School of Management and Technology, Rensselaer Polytechnic Institute and Bank of Finland Research); Wang, Haizhi (Stuart School of Business. Illinois Institute of Technology)
    Abstract: This paper examines the effects of strategic alliances on non-financial firms’ bank loan financing. We construct several measures to capture firms’ alliance activities using the frequency of alliance activities, the prominence of the alliance partner and the relative networking position in the overall alliance network. We find that firms with active alliance involvement experience a lower cost of debt from banks. We also document that allying with a prestigious partner (ie S&P 500 firms) can provide an endorsement effect and benefit the borrowers by reducing the price of bank loans. Moreover, a borrowing firm positioned at the centre of an alliance network enjoys a lower cost of bank loans. Finally, we find that borrowing firms with alliance experience are less likely to use collateral and covenants in their loan contracts.
    Keywords: cost of bank loans; strategic alliances; product market relationships
    JEL: D82 D85 G21 G30
    Date: 2011–03–15
  21. By: Panetti, Ettore
    Abstract: In the present paper, I analyze how unobservable savings affect risk sharing and bankruptcy decisions in the financial system. I extend the Diamond and Dybvig (1983) model of financial intermediation to an environment with heterogeneous intermediaries, aggregate uncertainty and agents' hidden borrowing and lending. I demonstrate three results. First, unobservability imposes a burden on financial intermediaries, that in equilibrium are not able to offer a banking contract that balances insurance and incentive motivations. Second, unobservable markets do induce default, but only as long as insurance markets are incomplete. Therefore, their presence is not a rationale for government intervention on bankruptcy via "resolution regimes". Third, even in case of complete markets the competitive equilibrium is inefficient, and a simple tier-1 capital ratio similar to the one proposed in the Basel III Accord implements the efficient allocation.
    Keywords: financial intermediation; hidden savings; bankruptcy; insurance; optimal regulation
    JEL: E44 G28 G21
    Date: 2011–02–10
  22. By: José Pedro Fique (Faculdade de Economia da Universidade do Porto and LIAAD, INESC-Porto)
    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.
    Keywords: Financial Network, Regulation, Counterparty Risk, Liquidity Coinsurance
    JEL: D85 G18 G21
    Date: 2011–03
  23. By: Panetti, Ettore
    Abstract: How do market-based channels for the provision of liquidity affect financial liberalization and contagion? In order to answer this question, I extend the Diamond and Dybvig (1983) model of financial intermediation to a two-country environment with unobservable markets for borrowing and lending and comparative advantages in the investment technologies. I demonstrate that the role of hidden markets crucially depends on the level of financial integration of the economy. Despite always imposing a burden on intermediaries, unobservable markets allow agents to partially enjoy gains from financial integration when interbank markets are autarkic. In fully liberalized systems such effect instead disappears. Similarly, in autarky the distortion created by hidden markets improve the resilience of the system to unexpected liquidity shocks. With fully integrated interbank markets, such effect again disappears, as unexpected liquidity shocks always lead to bankruptcy and contagion.
    Keywords: financial intermediation; financial liberalization; financial contagion; unobservable savings
    JEL: E44 G28 G21
    Date: 2011–03–01

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