Macroprudential Regulation and Systemic Capital Requirements

In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank's contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. Overall risk is estimated using a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks' risk exposures as well as detailed information on interbank linkages including OTC derivatives. We find that systemic capital allocations can differ by as much as 50% from 2008Q2 capital levels and are not related in a simple way to bank size or individual bank default probability. Systemic capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation.Financial stability

Emergency liquidity facilities, signalling and funding Costs

In the months preceding the failure of Lehman Brothers in September 2008, banks were willing to pay a premium over the Federal Reserve's discount window (DW) rate to participate in the much less flexible Term Auction Facility (TAF). We empirically test the predictions of a new signalling model that offers a rationale for offering two different liquidity facilities. In our model, illiquid yet solvent banks need to pay a high cost to access the TAF as a way to signal their quality, in exchange for more favourable funding in the future. Less solvent banks access the less costly and more flexible DW in case they experience an unexpected run, paying a higher future funding cost. The existence of two facilities with different characteristics allowed banks to signal their level of solvency, which helped to decrease asymmetric information during the crisis. Using recently disclosed data on access to these facilities, we provide evidence consistent with these results. Banks that accessed TAF in 2008 paid approximately 31 basis points less in the interbank lending market in 2010 and were perceived as less risky than banks that accessed the DW. Our results can contribute to a better design of liquidity facilities during a financial crisis

Systemic risk and bank size

In this paper we analyse firm level systemic risk for US and European banks from 2004 to 2012. We observe that common systemic risk indicators are primarily driven by firm size which implies an overriding concern for “too-big-to-fail” institutions. However, smaller banks may still pose considerable systemic threats, as exemplified by the Northern Rock debacle in 2007. By introducing a simple standardisation, we obtain new risk measures that often prove to be superior predictors of financial distress during the 2007-2009 subprime crisis. We conclude that the new measures could be a valuable addition to the existing indicators employed in Basel III to identify systemically important banks

Are Market-Based Measures of Global Systemic Importance of Financial Institutions Useful to Regulators and Supervisors?

We analyze whether four market-based measures of the global systemic importance of financial institutions offer early warning signals during three financial crises. The tests based on the 2007–2008 crisis show that only one measure (∆CoVaR) consistently adds predictive power to conventional early warning models. However, the additional predictive power remains small and it is not normally confirmed for the Asian and the 1998 crises. We conclude that it is problematic to identify a market-based measure of systemic importance that remains valid across crises with different features. The same criticism also applies to several conventional proxies of systemic importance, of which size is the most consistent performer

Complex financial networks and systemic risk: a review

In this paper we review recent advances in financial economics in relation to the measurement of systemic risk. We start by reviewing studies that apply traditional measures of risk to financial institutions. However, the main focus of the review is on studies that use network analysis paying special attention to those that apply complex analysis techniques. Applications of these techniques for the analysis and pricing of systemic risk has already provided significant benefits at least at the conceptual level but it also looks very promising from a practical point of view

Macroprudential regulation and systemic capital requirements

In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank's contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. Overall risk is estimated using a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks' risk exposures as well as detailed information on interbank linkages including OTC derivatives. We find that systemic capital allocations can differ by as much as 50% from 2008Q2 capital levels and are not related in a simple way to bank size or individual bank default probability. Systemic capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation

Macroprudential capital requirements and systemic risk

In the aftermath of the financial crisis, there is interest in reforming bank regulation such that capital requirements are more closely linked to a bank’s contribution to the overall risk of the financial system. In our paper we compare alternative mechanisms for allocating the overall risk of a banking system to its member banks. Overall risk is estimated using a model that explicitly incorporates contagion externalities present in the financial system. We have access to a unique data set of the Canadian banking system, which includes individual banks’ risk exposures as well as detailed information on interbank linkages including OTC derivatives. We find that macroprudential capital allocations can differ by as much as 50% from observed capital levels and are not trivially related to bank size or individual bank default probability. Macroprudential capital allocation mechanisms reduce default probabilities of individual banks as well as the probability of a systemic crisis by about 25%. Our results suggest that financial stability can be enhanced substantially by implementing a systemic perspective on bank regulation.N