Regulatory Requirements and Their Implications for Bank Solvency, Liquidity and Interconnectedness Risks: Insights from Agent-Based Model Simulations
40 Pages Posted: 13 Dec 2014 Last revised: 5 Mar 2015
Date Written: December 11, 2014
Abstract
Assessing how banks respond to changes in regulatory requirements requires the use of a modeling framework able to account for heterogeneity in the banking system and the adaptive behavior of banks. This paper proposes an agent-based model to analyze the interaction between regulatory requirements and bank solvency, liquidity, profitability, and interconnectedness. The model features endogenous bank networks arising through interbank loans, and dynamic bank balance sheet adjustment through risk-weight optimization, dividend payments, and loan book expansion. Numerical simulations uncover complex patterns linking solvency, liquidity and interconnectedness risk to regulatory requirements. Higher reserve requirements may lead to a larger number of bank failures when capital ratio requirements are low vis-à-vis the credit risk underlying banks’ loan portfolios. Higher minimum capital ratios help to reduce solvency problems in banks but raise interconnectedness risk, as measured by the increase in the number of degrees in the interbank network.
Keywords: agent-based model, banks, regulation, financial stability, solvency, liquidity, interconnectedness
JEL Classification: G21, G28, G32
Suggested Citation: Suggested Citation