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Rollover Risk and Endogenous Network Dynamics

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Titel Rollover Risk and Endogenous Network Dynamics
Serientitel Latsis Symposium 2012
Autor Page, Frank
Fique, Jose Pedro
Lizenz CC-Namensnennung - keine kommerzielle Nutzung - keine Bearbeitung 2.5 Schweiz:
Sie dürfen das Werk bzw. den Inhalt in unveränderter Form zu jedem legalen und nicht-kommerziellen Zweck nutzen, vervielfältigen, verbreiten und öffentlich zugänglich machen, sofern Sie den Namen des Autors/Rechteinhabers in der von ihm festgelegten Weise nennen.
DOI 10.5446/35580
Herausgeber Eidgenössische Technische Hochschule (ETH) Zürich
Erscheinungsjahr 2012
Sprache Englisch

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Fachgebiet Wirtschafts- und Sozialwissenschaft
Abstract One of the most striking phenomena of the 2007-2009 financial crises was the rapidity with which liquidity in the interbank markets dried up, especially in long term maturities. In network literature terminology, the once dense interbank network that allowed highly liquid banks to channel liquidity to those banks with investment opportunities, transited to a sparse architecture. The sudden failure of the once well-functioning interbank loan network during the recent financial crisis has given momentum to the movement toward major, worldwide regulatory reform to minimize the possibility of another interbank network failure and to make the financial network more robust. The shortcomings of the regulatory framework exposed by the crisis lead to the design and implementation of new instruments aimed at the insuring the stability of the financial system. One of these instruments, now in use in several European countries, is a special banking levy/tax. The levy/tax aims not only to raise funds to reduce the cost to taxpayers incurred with past (or future) rescues of the financial infrastructure but also to provide banks with the correct incentives for risk taking. The purpose of this paper is twofold: (i) to analyze within a dynamic network formation game how macroeconomic conditions, such as investors' risk appetite, affect rollover decisions and (ii) to determine the effects that a levy has on the endogenous dynamics of network formation. We find that because the existence of linkages between market participants generates an informational externality, the newly formed network is strongly conditioned by past network architectures. Simulations show that this inertia is strongly dependent on macroeconomic conditions, such as investors' risk appetite. The numerical exercises reveal that for intermediate values of the risk appetite parameter, the inability to maintain a threshold number of linkages may push the market into a gridlock. Moreover, this tipping point property implies that the recovery from a market freeze situation requires good conditions of a magnitude considerably greater than the magnitude of the bad conditions precipitated the crisis in the first place – leading to a network induced inertia. Finally, since we model the special banking levy as a cost to the activation of interbank connections, we find that a substantial decline in the tax burden is required in order to re-start lending activity when the market experiences severe stress situations. Thus while we find that banking levy instruments play an important role in aligning private and social incentives for risk taking - and therefore, constitute an important part of the regulatory landscape - if the activation of each interbank connection has an externality that is particularly onerous during periods of financial stress, the weight of this instrument (i.e., banking levies) should be counter-cyclical, as are the recent capital requirement proposals supported both by academia and regulatory bodies.

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