Risk Sensitivity of Banks, Interbank Markets and the Effects of Liquidity Regulation
46 Pages Posted: 18 Feb 2012
Date Written: January 3, 2012
Abstract
The industrial organization approach to banking is extended to analyze the effects of interbank market activity and regulatory liquidity requirements on bank behavior. A multi-stage decision situation allows for considering the interaction between credit risk and liquidity risk of banks. This interaction is found to make a risk neutral bank behave as if it were risk averse in an environment where there is no interbank market and liquidity regulation. Introducing a buoyant interbank money market destroys endogenous risk aversion and allows banks to manage credit risk and liquidity risk independently. The paper shows that a liquidity regulation just like the one proposed in BCBS (2010) is not generally able to offset the separating effect of interbank money markets and recreate endogenous risk aversion of banks.
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