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Title :Bank liquidity risk and official sector safety nets: economic rationale and policy response to the crisis
Creator :Stathousis, Konstantinos
Contributor :Pagratis, Spyros (Επιβλέπων καθηγητής)
Athens University of Economics and Business, Department of Economics (Degree granting institution)
Type :Text
Extent :117p.
Language :en
Abstract :Banking institutions constitute a central pillar of the financial system. Hence, it comes as no surprise a large volume of theoretical and empirical work in financial economics concerns these institutions and their function. As a result of their operations in financial markets, banking institutions are susceptible to a wide range of financial risks. A broad taxonomy of such risks, closely followed in “building block”approaches to banking regulation and by market participants and academics, is credit risk, market risk, operational risk and liquidity risk. The first, relates to the possibility of bank losses due to deterioration in the credit quality of loan portfolios and other credit exposures. Market risk associates to potential losses that banks could face as a result of fluctuations in rates and asset prices. Operational risk relates to potential failures in the day-to-day business contact for reasons such as fraud, system failure and regulatory compliance. Such risks may feed into and interact with the latter form of risk embedded in bank operations, namely liquidity risk.Liquidity risk relates to the ability of a bank to fund its assets and meet its obligations on a timely basis. It arises from the maturity transformation role that banking institutions perform by transforming short term funding (deposits) into long termliabilities (loans). As a result of this, banks risk a possible failure if too many short term liabilities are claimed and not enough assets are available to make these claims good. It is further aggravated by the opaqueness and asymmetric information of banking assets, giving room for speculation that could potentially cause panic, taking the form of a run on the bank by depositors and other claim holders.Advances in economic theory over the past decades provide some strong predictions on how liquidity risk could crystallize, guiding the design of prudential regulation and other official-sector safety nets aimed at mitigating liquidity-risk vulnerabilities of banking institutions. This dissertation discusses policy implications for banking and financial stability in view of three important contributions by Diamond & Dybvig(1983), Rochet & Vives (2004) and Goldstein & Pauzner (2005).Diamond & Dybvig were the first to establish that maturity transformation makes banks susceptible to bank runs and provide the theoretical foundations of Deposit Insurance and a rationale for Suspension of Convertibility as stabilization devices. Rochet & Vives provide the theoretical foundations of the Lender of Last Resort as stabilization device in cases where banks are susceptible to runs by depositors. They highlight the complementarity of bail-ins (through the interbank markets) and bailouts(through a Lender of Last Resort) and support “constructive ambiguity” of Central Banks’ announcements. Goldstein & Pauzner provide a major technical breakthrough in the formal treatment of bank-run dynamics by proving theuniqueness of equilibrium under a state of one-sided strategic complementarities and noisy signals. They offered a new perspective for the design of policies aimed at mitigating bank liquidity risk by endogenizing the probability of a bank run and relating it to the parameters of the banking contract.From that perspective, we attempt a critical appraisal of official sector safety nets such as Deposit Insurance, Lender of Last Resort facility and prudential Capital and Liquidity Requirements presenting the potential benefits of each one, along with the possible underlying risks, as well as the complementarity of these safety nets. In light of the recent financial crisis, we examine the liquidity providing mechanisms of the European Central Bank and the extent to which it acts as a Lender of Last Resort.In particular, we present the measures taken by the ECB in order to help Eurozone banks cope with the severe banking crisis that started in 2007 and further exacerbated by the sovereign debt crisis in 2009 up to date, as well as present the criticism these measures have undergone. We discuss both “standard” and “nonstandard”measures. “Standard” measures such as Open Market Operations and Standing Facilities, along with “non-standard”, part of an enhanced credit support toolkit, such as Emergency Liquidity Assistance, Long-term Refinancing Operations,Securities Market Programme and Outright Monetary Transactions. We close ECB’s Liquidity Provision mechanism discussion presenting the controversial issue whether banks are weaning on ECB liquidity and are becoming too dependent on it, possibly hindering the functioning of markets by substituting or interfering with them, or not.Concluding this dissertation, we present the latest Prudential Liquidity Requirements implemented, Liquidity Coverage Ratio and Net Stable Funding Ratio, the standards set by the Basel III Accord. Both aim at requiring banks to withstand severe liquidity shocks in order to reduce the need for massive public liquidity support in such[3]events. Liquidity Coverage Ratio seeks to promote resilience against a liquidity crisis similar to the Lehmann Crisis on a thirty-day horizon. Net Stable Funding Ratio aims to limit over-reliance of banks on short-term wholesale funding (especially in good times) and encourage better assessment of liquidity risk both for on- and off-balance sheet items. We present some of the main lines of criticism these standards have faced, such as leading banks to overexposure in sovereign debt. Finally, based on recent empirical advances in the literature, we come up with proposals for improving these standards in order to enable liquidity risk diversification and differentiation of liquidity requirements based on bank size.
Subject :Liquidity risk
Banking stability
Official sector safety nets
European Central Bank
Basel III Accord
Date :11-10-2012
Licence :

File: Stathousis_2012.pdf

Type: application/pdf