Lenders on the storm of wholesale funding shocks: saved by the central bank?

We provide empirical evidence on banks’ responses to shocks in the wholesale funding market, using data of 181 euro area banks over the period from August 2007 to June 2013. Responses to funding liquidity shocks for both banks’ lending volumes and loan rates, to households and corporates, are analysed in a panel VAR framework. We thereby distinguish banks by country, extent of Eurosystem borrowing, bank size and capitalization. The results show that shocks in the securities and interbank markets have significant effects on loan rates and credit supply, particularly of banks in stressed countries of the periphery. The results also suggest that central bank liquidity has mitigated this effect on lending volumes. Lending to nonfinancial corporations is more sensitive to wholesale funding shocks than lending to households. Lending volumes of large banks that are typically more dependent on wholesale funding and banks with large exposure to sovereign bonds show stronger responses to wholesale funding shocks.     

Inefficiency of bilateral bargaining in interbank markets

Many countries have interbank markets that are over the counter (OTC) instead of exchange mediated. In OTC systems, bilateral bargaining takes place over the rate of interest on the (interbank) loan. This article characterizes such bilateral bargaining for loans between banks under asymmetric information and shows that bargaining outcomes maybe inefficient. The article suggests two sources of inefficiency. In a one-period model, bargaining between two banks may fail due to incomplete information even if gains to trade exist. Intertemporal issues examined in this article reveal that repeated interaction could create distorting effects through reciprocal contracts. Both cases are shown to require active liquidity management by the regulatory authority to restore the first best allocation.     

Search and endogenous concentration of liquidity in asset markets

We develop a search-based model of asset trading, in which investors of different horizons can invest in two assets with identical payoffs. The asset markets are partially segmented: buyers can search for only one asset, but can decide which one. We show the existence of a “clientele’’ equilibrium where all short-horizon investors search for the same asset. This asset has more buyers and sellers, lower search times, and trades at a higher price relative to its identical-payoff counterpart. The clientele equilibrium dominates the one where all investor types split equally across assets, implying that the concentration of liquidity is socially desirable.     

Liquidity shocks and equilibrium liquidity premia

We study an equilibrium in which agents face surprise liquidity shocks and invest in liquid and illiquid riskless assets. The random holding horizon from liquidity shocks makes the return of the illiquid security risky. The equilibrium premium for such risk depends on the constraint that agents face when borrowing against future income; it is insignificant without borrowing constraint, but can be very high with borrowing constraint. Illiquidity, therefore, can have large effects on asset returns when agents face liquidity shocks and borrowing constraints. This result can help us understand why some securities have high liquidity premia, despite low turnover frequency.     

Determinants of income diversification: evidence from Chinese banks

This article presents an analysis of the determinants of Chinese commercial banks’ income diversification decisions. Using a panel dataset comprising 88 Chinese domestic banks from 2003 to 2010, we find that bank diversification reflects a variety of managerial abilities: insolvency risks, cost, capital position, asset scale and ownership structure. A larger ratio of banking assets to gross domestic product and lower interest spread lead to a higher level of diversification. Moreover, national banks and regional banks have different strategic responses to the macroeconomic, and indeed, regulatory environment. Resisting shocks from the banking sector and the macro economy, and supplementing liquidity shortages from intermediation business seem to be the driving forces of national banks to operate in non-banking sectors.     

Optimal asset taxes in financial markets with aggregate uncertainty

This paper studies Pareto-optimal risk-sharing arrangements in a private information economy with aggregate uncertainty and ex ante heterogeneous agents. I show how to implement Pareto optima as equilibria when agents can trade claims to consumption contingent on aggregate shocks in financial markets. The first result is that if aggregate and idiosyncratic shocks are independent, the implementation of optimal allocations does not require any interventions in financial markets. This result can be extended to dynamic settings in the sense that, in this case, only savings need to be distorted, but not trades in financial markets. Second, I characterize optimal trading distortions in financial markets when aggregate and idiosyncratic shocks are not independent. In this case, optimal asset taxes must be higher for those securities that pay out in aggregate states in which consumption is more volatile. For instance, this can provide an efficiency justification for the frequently observed differential tax treatment of different asset classes, such as debt and equity claims.     

Cross-country differences in monetary policy execution and money market rates’ volatility

Volatility patterns in overnight interest rates display differences across industrial countries that existing models—designed to replicate the features of individual countries’ markets—cannot account for. This paper presents an equilibrium model of the overnight interbank market that matches cross-country differences in patterns in interest volatility by incorporating differences in how central banks manage liquidity in response to shocks. Our model is consistent with central banks’ practice of rationing access to marginal facilities when the objective of stabilizing short-term interest rates conflicts with another high-frequency objective, such as an exchange rate target.     

Central Bank and Commercial Banks' Liquidity Management – What is the Relationship?

The paper explores the relation between individual banks' liquidity management in the euro area and the ECB's management of the aggregate current accounts held by banks with the Eurosystem. It is argued that, in the case of the euro area with its large, remunerated reserve requirements that have to be fulfilled only on average over a one-month period, the banks' demand for working balances to serve as a buffer against market imperfections is always below reserve requirements. It is therefore normally sufficient for the ECB when steering short-term interest rates to control aggregate liquidity in a way that the aggregate banking system is in a position to fulfil adequately its reserve requirements. In particular, the ECB normally does not need to take care of any factors that affect temporarily the demand for working balances, such as the level and uncertainties of interbank payment flows. However, two exceptions are noteworthy and are discussed in the paper: the banks' balance sheet management activities implying a regular end of month peak of the EONIA rate; and the liquidity situation in the case of substantive market tensions as in the days following the terrorist attacks of 11 September 2001. The need of the ECB's liquidity management to address the associated deviations from a model of perfect markets is discussed.     

The Theory of the Second Best and the Competitive Equilibrium Model

We study the international transmission of bank liquidity shocks from multinational, Islamic, bank-holding companies to their subsidiaries. Based on a total sample of 120 Islamic and conventional bank subsidiaries, we test whether foreign bank lending for Islamic and conventional banks is determined by different factors. We estimate a model that includes subsidiary and parent bank characteristics as well as host and home country variables. Our empirical findings show that lending is negatively affected by the fragility of conventional parent banks' subsidiaries. Nevertheless, we show that parent Islamic banks do not significantly affect lending by subsidiaries. Finally, we examine the market discipline regarding the transmission of liquidity shocks. We also find that reduction in foreign Islamic bank lending is stronger for those that are dependent on the interbank market. We establish that the depositors react to a deterioration of bank performance and punish their institutions by withdrawing their money. We show that market discipline has a more important role for Islamic banks, whereas liquidity needs determine the change in conventional banks.     

What Do Data Say About Monetary Policy,Bank Liquidity and Bank Risk Taking?

This paper tests empirically the linkage between banks' investment and interbank lending decisions in response to interest rate changes. We draw conclusions for the monetary policy, which uses the interest rate as its main tool. Across European countries we find that the risk-free (i.e. monetary policy) interest rate negatively affects the liquidity retained by banks and the decision of a bank to be a lender in the interbank market. Instead, the interbank interest rate has a positive impact on these decisions. We also find that banks who lend show less risk-taking behaviour and tend to be smaller than those who are borrowers. Most importantly, the risk-free interest rate is positively correlated with loans investment and bank risk-taking behaviour.     

The transmission of financial shocks in an estimated DSGE model with housing and banking

We develop a dynamic stochastic general equilibrium (DSGE) model with housing and banking to study the transmission of financial shocks between the financial and real sectors. A deterioration in the bank's balance sheet induced by financial shocks could have amplified and persistent impacts on real activities. The amplification of the shocks are originated from financial frictions tied to households and banks. We find that a disruption in bank net worth initiated by capital quality shocks generates a decline in household loans, house prices and output. Bank liquidity shocks also have negative effects on these variables. Housing preference shocks could generate a positive comovement between house prices and output. All these findings are qualitatively consistent with empirical evidence, suggesting that these financial shocks are critical to the dynamics of house prices and other macroeconomic variables.     

Collateral rehypothecation,safe asset scarcity,and unconventional monetary policy

We build a mark-to-market model where commercial banks can enlarge their balance sheets, repledging the available collateral several times to exchange liquidity through the interbank market. In bad times, the fall of risky asset price disrupts the length of the repledging chain due to the increase of the haircut and the decrease of external assets' value. In such a scenario, the central bank can intervene implementing unconventional monetary policies by purchasing a fraction of the banking system's external assets, both safe treasury bonds, and risky asset-backed securities, to inject liquidity. Our results show that a quantitative easing policy that purchases only safe assets is highly ineffective in restoring the intermediation activity to the pre-crisis level due to its inability to sustain the risky asset price and the repledging chain of collateral. Instead, focusing on risky assets only, the monetary authority can sustain risky asset prices, avoiding the freezing of the money market.     

Oil price shocks and stock market activities: Evidence from oil-importing and oil-exporting countries

While the relationship between oil prices and stock markets is of great interest to economists, previous studies do not differentiate oil-exporting countries from oil-importing countries when they investigate the effects of oil price shocks on stock market returns. In this paper, we address this limitation using a structural VAR analysis. Our main findings can be summarized as follows: First, the magnitude, duration, and even direction of response by stock market in a country to oil price shocks highly depend on whether the country is a net importer or exporter in the world oil market, and whether changes in oil price are driven by supply or aggregate demand. Second, the relative contribution of each type of oil price shocks depends on the level of importance of oil to national economy, as well as the net position in oil market and the driving forces of oil price changes. Third, the effects of aggregate demand uncertainty on stock markets in oil-exporting countries are much stronger and more persistent than in oil-importing countries. Finally, positive aggregate and precautionary demand shocks are shown to result in a higher degree of co-movement among the stock markets in oil-exporting countries, but not among those in oil-importing countries.     

Sovereign risk,interbank freezes,and aggregate fluctuations

This paper shows how spillovers from sovereign risk to banks׳ access to wholesale funding establish a bank-sovereign nexus. In a dynamic stochastic general equilibrium set-up, heterogeneous banks give rise to an interbank market where government bonds are used as collateral. Government borrowing under limited commitment is costly ex ante as bank funding conditions tighten when the quality of collateral drops. These spillovers, by impeding interbank intermediation, lower the penalty from defaulting due to an interbank freeze during a recession and propagate aggregate shocks to the macroeconomy. The model is calibrated using Greek data and is capable of reproducing stylized facts from the European sovereign debt crisis. In an application, we show that the ECB׳s non-standard financing operations mitigate the adverse feedback mechanism.     

Multiple equilibrium overnight rates in a dynamic interbank market game

We analyse a two-period model of the interbank market, i.e. the market where banks trade liquidity. We assume that banks do not take the interbank interest rate as given, but instead negotiate on interest rates and transaction volumes with each other. The solution concept applied is the Shapley value. We show that there are a multiplicity of average equilibrium interest rates of the first period so that the average interest rate in this period does not convey any information on the expected liquidity situation on the interbank market. As the banks control not only the transaction volumes, but also the interest rates, they can leave the interest rates constant and adjust the transaction volumes when, for example, a liquidity deficit becomes more likely.     

Sudden stops, financial frictions, and labor market flows: Evidence from Latin America

While the aggregate effects of sudden stops and international financial crises are well known, the disaggregated channels through which they work are not well explored yet. In this paper, using job flows from a sectoral panel dataset for four Latin American countries, we find that sudden stops are characterized as periods of lower job creation and increased job destruction. Moreover, these effects are heterogeneous across sectors: we find that when a sudden stop occurs, sectors with higher dependence on external financing experience lower job creation. In turn, sectors with higher liquidity needs experience significantly larger job destruction. This evidence is consistent with the idea that dependence on external financing affects mainly the creation margin and that exposure to liquidity conditions affects mainly the destruction margin. Overall, our results provide evidence of financial frictions being an important transmission channel of sudden stops and in the restructuring process in general.     

Estimating the direct impact of bank liquidity shocks on the real economy: Evidence from letter‐of‐credit import transactions in Colombia

This study identifies and provides an estimate of the impact of bank liquidity shocks on real economic activity by exploring letter‐of‐credit import transactions in Colombia during the 2008 to 2009 global financial crisis. The detailed dataset on letter‐of‐credit transactions allows for exploiting within‐importer–exporter variation across issuing banks. The study finds substantial effects of bank liquidity shocks on letter‐of‐credit import transactions: banks that were more vulnerable to adverse liquidity shocks—proxied by the ex ante reliance on wholesale funding or borrowings from foreign banks—reduced letter‐of‐credit issuances more in both intensive and extensive margins. The study also confirms that it had real effects: importer–exporter pairs that relied more on letter‐of‐credit transactions experienced a greater reduction in their total imports in response to adverse bank liquidity shocks.     

An empirical analysis of excess interbank liquidity: a case study of Pakistan

We investigate the drivers of excess interbank liquidity in Pakistan, using the Autoregressive Distributed Lag approach on weekly data for December 2005 to July 2011. We find that the financing of the government budget deficit by the central bank and nonbanks leads to persistence in excess liquidity. Moreover, we identify a structural shift in the interbank market in June 2008. Before June 2008, low credit demand was driving the excess liquidity holdings by banks. After June 2008, banks’ precautionary investments in risk-free securities drive excess liquidity holdings. Monetary policy is less effective if banks hold excess liquidity for precautionary reasons.     

DEGREASING THE WHEELS OF FINANCE

Can there be too much trading in financial markets? We construct a dynamic general equilibrium model, where agents face idiosyncratic liquidity shocks. A financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The optimal policy is to restrict access to this market because portfolio choices exhibit a pecuniary externality: Agents do not take into account that by holding more of the liquid asset, they not only acquire additional insurance against these liquidity shocks, but also marginally increase the value of the liquid asset, which improves insurance for other market participants.     

Recursive equilibrium in endogenous growth models with incomplete markets

This paper analyzes the existence of recursive equilibria in a class of convex growth models with incomplete markets. Households have identical CRRA-preferences, production displays constant returns to scale with respect to physical and human capital, and all markets are competitive. There are aggregate productivity shocks that affect aggregate returns to physical and human capital investment (stock returns and wages), and there are idiosyncratic shocks to human capital (idiosyncratic depreciation shocks) that only affect individual human capital returns. Aggregate and idiosyncratic shocks follow a joint Markov process. Conditional on the aggregate state, idiosyncratic shocks are independently distributed over time and identically distributed across households. Finally, households have the opportunity to trade assets in zero net supply with payoffs that depend on the aggregate shock, but markets are incomplete in the sense that there are no assets with payoffs depending on idiosyncratic shocks. It is shown that there exists a recursive equilibrium for which equilibrium prices (returns) only depend on the exogenous aggregate shock variable (the wealth distribution is not a relevant state variable). Moreover, the allocation associated with this recursive equilibrium is identical to the equilibrium allocation of an economy in which households live in autarky and face both aggregate and idiosyncratic risk.I would like to thank for helpful comments Peter Howitt, Bob Lucas, Michael Magill, Tomo Nakajima, Herakles Polemarchakis, Martine Quinzii, Kevin Reffett, an anonymous referee, and seminar participants at various universities and conferences.