Abstract
The paper presents a comprehensive model of a banking system that integrates network effects, bankruptcy costs, fire sales, and cross-holdings. For the integrated financial market we prove the existence of a price-payment equilibrium and design an algorithm for the computation of the greatest and the least equilibrium. The number of defaults corresponding to the greatest price-payment equilibrium is analyzed in several comparative case studies. These illustrate the individual and joint impact of interbank liabilities, bankruptcy costs, fire sales and cross-holdings on systemic risk. We study policy implications and regulatory instruments, including central bank guarantees and quantitative easing, the significance of last wills of financial institutions, and capital requirements.
Highlights
The paper presents a comprehensive model of a banking system that integrates network effects, bankruptcy costs, fire sales, and cross-holdings
We investigate the joint impact of network effects, bankruptcy costs, fire sales, and cross-holdings in our integrated model and study the robustness of the results of the previous section
We focus on the following three questions: (i) Is quantitative easing in the joint model an appropriate policy for limiting systemic risk? How is this affected by other model drivers? (ii) Are the results modified by the change of the order of liquidation? (iii) Do cross-holdings have a beneficial effect on the stability of the financial system if bankruptcy costs and fire sales are included in the model? Which regulatory policies are appropriate?
Summary
The paper presents a comprehensive model of a banking system that integrates network effects, bankruptcy costs, fire sales, and cross-holdings. For the integrated financial market we prove the existence of a price-payment equilibrium and design an algorithm for the computation of the greatest and the least equilibrium. The number of defaults corresponding to the greatest price-payment equilibrium is analyzed in several comparative case studies. These illustrate the individual and joint impact of interbank liabilities, bankruptcy costs, fire sales and cross-holdings on systemic risk. The aim of the current paper consists in constructing and analyzing a comprehensive model that integrates all effects mentioned above This multi-factor setting allows to assess regulatory policies in a robust manner. The equilibrium is characterized by the vector of clearing payments and the price of the commonly held illiquid asset that is exposed to price effects
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