Systemic risk in an interconnected banking system with endogenous asset markets

Bluhm, Marcel; Krahnen, Jan Pieter

doi:10.1016/j.jfs.2014.04.002

“…The implication is that, all else equal, an additional dollar of equity capital raises the market 15 A similar approach is used in Bluhm and Krahnen (2014). 16 Note that min{∅} = ∞ by convention, so that τB = ∞ if the bank does not default in t ∈ {1, 2, ..., T }.…”

Section: The Life Insurermentioning

confidence: 99%

Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment Under Solvency Regulation

Niedrig

¹

2014

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Abstract I assess how Basel III, Solvency II and the low interest rate environment will affect the financial connection between the bank and insurance sector by changing the funding patterns of banks as well as the investment strategies of life insurance companies. Especially for life insurance companies, the current low interest rate environment poses a key risk since declining returns on investments jeopardize the guaranteed return on life insurance contracts, a core component of traditional life insurance contracts in several European countries. I consider a contingent claim framework with a direct financial connection between banks and life insurers via bank bonds. The results indicate that life insurers' demand for bank bonds increases over the mid-term but ultimately declines in the long-run. Since life insurers are the largest purchasers of bank bonds in Europe, banks could lose one of their main funding sources. In addition, I show that shareholder value driven life insurers' appetite for risk increases when the gap between asset return and liability growth diminishes. To check the robustness of the findings, I calibrate a prolonged low interest rate scenario. The results show that the insurer's risk appetite is even higher when interest rates remain persistently low. A sensitivity analysis regarding industry-specific regulatory safety levels reveals that contagion between bank and life insurer is driven by the insurers' demand for bank bonds which itself depends on the regulatory safety level of banks. Terms of use: Documents in

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“…is limited (Bluhm et al, 2013;Bluhm and Krahnen, 2014). Aymanns and Georg (2015) additionally argue that the vulnerability of the financial sector to common shocks is stronger if banks pursue similar investment strategies.…”

Section: Introductionmentioning

confidence: 99%

“…As the interconnections between financial institutions are a dominant source of systemic risk (Bluhm and Krahnen, 2014), a lot of attention has recently been paid to the nature and vulnerabilities of interbank networks explicitly. Through the prism of an endogenous network model, Bluhm et al (2013) find that increased financial stability can come at the cost of lower provision of financial services to the real economy as there is a trade-off between limiting the effects of potential sequential cascades and fostering banks to invest in non-liquid assets.…”

Section: Introductionmentioning

confidence: 99%

Interbank loans, collateral and modern monetary policy

Wolski

¹

,

Leur

²

2016

Journal of Economic Dynamics and Control

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte.

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“…9 See Georg (2013), Bluhm and Krahnen (2014), Bluhm, Faia and Krahnen (2014a), Bluhm, Faia and Krahnen (2014b) and Aldasoro, Delli Gatti and Faia (2015) for analyses of the financial system using agent based complex systems analysis.…”

Section: Introductionmentioning

confidence: 99%

“…Related analyses investigating the interbank market and its stability properties, can be found in Bluhm and Krahnen (2014) who investigate macro prudential capital surcharges as a risk management tool, Bluhm, Faia and Krahnen (2014a) who investigate spillover effects between monetary and macroprudential policymakers, as well as Georg (2013) who analyzes optimal policy responses to different sources of systemic risk.…”

Section: Introductionmentioning

confidence: 99%

Interbank Funding as Insurance Mechanism for (Persistent) Liquidity Shocks

Bluhm¹

2015

SSRN Journal

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0

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in Non-Technical SummaryThe financial system serves to allocate funds from savers to investors. In this framework banks assume a crucial function via the provision of credit and liquidity to the real economy. To efficiently fulfill this function, the interbank market allows for the allocation of funds among banks. In particular, banks use the interbank market to hedge idiosyncratic liquidity shocks, that is, in-or outflow of funds. The recent financial crisis however has demonstrated that the interbank market can be prone to freezes and become a source of systemic risk and adverse spill-over effects to the banking system and the wider economy.This paper extends the literature on interbank markets via taking into account persistence of liquidity shocks. In particular, a theory of short and long term interbank funding is developed and embedded in a micro-founded agent based network model. The model combines analytical rigour with a flexible simulation framework in which effects driven by individually motivated heterogeneous agents on financial system and real economy can be assessed. Besides numerous innovations it features interbank funding as an over-the-counter phenomenon and realistically replicates financial system phenomena of network formation, monetary policy transmission and endogenous money creation. After investigating the model's network properties, it is used for analyses to shed light on the purpose of the interbank market and its role for allocation and stability in the financial system. Analyses in the modeling framework provide evidence that the interbank market renders the financial system more efficient relative to a setting without mutual insurance against persistent liquidity shocks. However, given that banks in the model can maximize profit via emitting credit and creating money while only facing limited liability, an unleashed financial system without a policymaker's regulation can well lead to economic outcomes below those resulting from a financial system with less efficient allocation. In a realistically calibrated simulation exercise featuring a policymaker who puts a lid on credit and money creation with a view on real economic activity while keeping financial fragility in check allows for significant output gains. Therefore the model provides evidence that interbank funding indeed plays a crucial role for welfare.Furthermore, and related to those findings, the framework is used to carry out an optimal po...

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Systemic risk in an interconnected banking system with endogenous asset markets

Cited by 94 publications

References 44 publications

Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment Under Solvency Regulation

Optimal Asset Allocation for Interconnected Life Insurers in the Low Interest Rate Environment Under Solvency Regulation

Interbank loans, collateral and modern monetary policy

Interbank Funding as Insurance Mechanism for (Persistent) Liquidity Shocks

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