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FIIT-2: Designing bank regulation and supervision
Illiquidity, Closure Policies and the Role of LOLR
1European Central Bank, Germany; 2Columbia University
We develop a dynamic model of a bank which chooses its optimal liquidity buffers, equity issuance policies, and asset portfolio size when facing frictions in equity issuance, asset liquidations, and closure policies. The bank has a fixed level of debt that it can roll over in the interbank market and has access to central bank liquidity facilities. The central bank policies generally lead to a greater investment in new loans, lower asset liquidations and a lower expected cost of closure. On the other hand, the central bank's provision of liquidity causes the bank to hold lower cash buffers than the bank would have held in the absence of a central bank. It also reduces the incentives of the bank to issue equity or cut dividends. We show that the collateral framework inherently produces these tradeoffs. Using novel data sets we estimate that the average borrowing capacity of banks at the ECB is about 50% of the assets held by the banks. The data also shows that the banks with higher borrowing capacity tend to originate more new loans. These stylized facts are broadly consistent with the model's implications. The credit spreads in the interbank market widens in periods of illiquidity. We run some policy experiments within the modeling framework, wherein we explore the effects of changes in ex-ante margins, penalty rates, and bank closure boundaries on the lending channel, equity issuance and liquidity buffers.
Stress Testing and Bank Lending
1University of Oxford; 2Frankfurt School of Finance and Management
Bank stress tests are a major form of regulatory oversight implemented in the wake of the financial crisis. Banks respond to the strictness of the tests by changing their lending behavior. As regulators care about bank lending, this affects the design of the tests and creates a feedback loop. We analyze a reputational model of this feedback effect where the regulator trades off the costs of reduced credit to the real economy versus the benefits of preventing default. Stress tests may be (1) lenient, in order to encourage lending in the future, (2) tough, in order to reduce the risk of costly bank defaults, or (3) perfectly informative, and there may be multiple equilibria. We find that in some situations, surplus would be higher without stress testing and regulators may strategically delay stress tests.
Sovereign risk and bank fragility
We develop an equilibrium model of bank risk-taking in the presence of strategic sovereign default risk. Domestic banks can either invest in real projects or purchase government bonds. While an increase in purchases of government bonds crowds out profitable investment, it nevertheless improves the government's incentives to repay and reduces the bond price. However, since banks are price-takers in bond markets, this gives rise to a pecuniary externality. We analyze the welfare consequences of the externality and relate our findings to the debate on the efficacy of recent policy proposals for regulating banks' sovereign debt exposures.
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Conference: EFA 2019
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