Illiquidity, Insolvency, and Banking Regulation
Coordinator: Prof. Dr. Gerhard Illing
Participants: Sascha Bützer, Thomas Siemsen
In this project, we plan to analyze the feedback between monetary policy and risk taking of financial intermediaries and contribute to the design of a new framework for macro-prudential regulation. Provision of central bank liquidity as lender of last resort is seen to have contributed to incentives for excessive risk taking in the financial industry. Abundant availability of public liquidity has been a main driving force in the heavy reliance on short term finance and leverage. In the project, we model the impact of liquidity provision by central banks on incentives of financial intermediaries to invest in activities creating systemic risk. Perceived wisdom is that central banks should act as lender of last resort in the case of illiquidity, but not insolvency. In reality, this distinction, however, is blurred in modern financial markets. We plan to introduce joint uncertainty on illiquidity and insolvency risks for central bank intervention and analyze its impact on banks’ behaviour and asset prices. Using this framework, we plan to evaluate recent proposals for changes in the Basel III framework to address both liquidity and solvency risk and analyse optimal regulatory policies. We will also address the trade-off in macro-prudential regulation between benefits from financial stability and potential costs in terms of reduced economic growth.
- Illing, G. and T. Siemsen (2014): Forward Guidance in a Simple Model with a Zero Lower Bound
- Grimme, C. and T. Siemsen (2014): Interbank Uncertainty in a DSGE Model (work in progress)
- Corbae, D., P. D'Erasmo, S. Galaasen, A. Irarrazabal, and T. Siemsen (2014): Stress Testing in a Structural Model of the Banking Industry (work in progress)