Liquidity and Solvency Risks Armin Eder a Falko Fecht b Thilo Pausch c a Universität Innsbruck, b European Business School, c Deutsche Bundesbank WebEx-Presentation February 25, 2011 Eder, Fecht, Pausch (2011) (2010) 1 / 15
Motivation Observations made during the recent crisis: Liquidity risk is a primary source of risk to banks and may quickly translate into solvency risk Liquidity risk comprises market liquidity risk and funding liquidity risk Interaction of market liquidity risk and funding liquidity risk appears to be one reason for propagation of shocks among banks But: Why did not banks take precautions? Empirical findings suggest that financial crises appear approximately once in 10 years = Is the probability of a financial crisis too low so that it is not beneficial to prepare for a crisis? Eder, Fecht, Pausch (2011) (2010) 2 / 15
Objective and Research Questions Analysis of the interaction of market liquidity risk and funding liquidity risk in order to understand the propagation of shocks among banks and the translation of liquidity risk into solvency risk Research Questions How does an exogenous crisis probability affect the riskiness of banks portfolio? Does a high crisis probability induce banks to hold larger buffers? Does a low crisis probability lead to systemic risk and financial contagion? Are regulatory liquidity requirements a valuable instrument to enhance financial stability? Eder, Fecht, Pausch (2011) (2010) 3 / 15
Methodology Theoretical Model Endogenous emergence of different financial systems Bank dominated financial system 1 Households invest predominantly in bank deposits 2 Banks main financier of firms 3 Financial market plays minor role In BD system banks might follow two different strategies: 1 Strategy I: not preparing for a financial crisis 2 Strategy II: preparing for a financial crisis by holding an excess liquidity buffer Focus on banks liabilities liquidity risk as the major source of risk no credit risk Eder, Fecht, Pausch (2011) (2010) 4 / 15
Relationship to the Literature I 1. Fragility and financial contagion with spatial monopolistic banks of Diamond/Dybvig-type Interbank market Allen / Gale (2000b, 2001b) Freixas / Martin / Skeie (2010) Freixas / Parigi / Rochet (2000) Contagion through general financial markets Fecht (2004) Allen / Gale (2004) Bolton / Scheinkman / Santos (2010) Eder, Fecht, Pausch (2011) (2010) 5 / 15
Relationship to the Literature II 2. Coexistence of Diamond/Dybvig-banks and general financial markets Diamond / Dybvig (1984) Optimal risk sharing when households face inter-temporal preference shocks Jacklin (1987) No efficient risk sharing by banks, if financial markets coexist Risk sharing: an ex-post redistribution from patient to impatient depositors Financial markets provide patient depositors with an exit option Liquidity insurance for patient households with market access not incentive compatible Diamond (1994) Only a fraction of patient households gets access to the financial markets Fecht (2004) No strict participation restriction, but transaction costs Eder, Fecht, Pausch (2011) (2010) 6 / 15
Assumptions I Unobservable individual preference shocks and linear utility functions { x1 c U(c 1, c 2 ) = 1 with probability π c 2 with probability (1 π) Time line x 1 > R Eder, Fecht, Pausch (2011) (2010) 7 / 15
Assumptions II Two types of households No participation constraint but transaction costs t = 0 t = 1 t = 2 sophisticated HH -1 0 R naive HH -1 0 γr Households know their type already in t = 0 Two spatial monopolistic banks Eder, Fecht, Pausch (2011) (2010) 8 / 15
Bank Dominated Financial System I Banks offer a deposit contract which provides access to the long-run technology provides liquidity insurance Both consumer types deposit their funds with the bank in t = 0 Impatient consumers withdraw their funds in t = 1 Patient, sophisticated households may withdraw funds and invest directly at secondary market. Implies cross-subsidies from naive to sophisticated households Contagion channel Eder, Fecht, Pausch (2011) (2010) 9 / 15
Bank Dominated Financial System II Strategy 1: No precautions Evolves if the fraction of naive households is intermediate and if the ex-ante probability of a financial crisis is low Patient, sophisticated consumers withdraw their funds and invest in t = 1 Households trade exclusively in the secondary market Banks sell assets in the secondary market to raise liquidity in equilibrium Contagion occurs in this financial system and the asset market serves as a propagation mechanism 1 Run on one bank (self-fulfilling equilibrium) forces bank to fire sale 2 Fires sales lead to asset price deterioration 3 Due to asset price deterioration other bank(s) receive less liquidity than expected for asset sales 4 Other bank(s) also end up in liquidity crisis Eder, Fecht, Pausch (2011) (2010) 10 / 15
Bank Dominated Financial System III 2.4 2.2 (1) Utility of Naive Households 0.7 0.6 (2) Liquidity Level and Expected Asset Sale l k 2 0.5 Utility 1.8 1.6 l,k 0.4 0.3 1.4 0.2 1.2 0.1 1 0 0.2 0.4 0.6 0.8 1 Proportion of Naive Consumers (i) 0 0 0.2 0.4 0.6 0.8 1 Proportion of Naive Consumers (i) 1.6 (3) Optimal Deposit Contract Repayment 1.4 (4) Market Equilibrium Prices Consumption/Repayment 1.4 1.2 1 0.8 d 1 d 2 d c Price 1.2 1 0.8 0.6 0.4 0.2 p n p c 0 0.2 0.4 0.6 0.8 1 Proportion of Naive Consumers (i) 0 0 0.2 0.4 0.6 0.8 1 Proportion of Naive Consumers (i) Eder, Fecht, Pausch (2011) (2010) 11 / 15
Bank Dominated Financial System IV Strategy 2: Banks hold excess liquidity Evolves if the fraction of naive households is relatively high and the ex-ante probability of a financial crisis is high Since risk of contagion is too large banks will hold a liquidity buffer to avoid contagion p n increases to R Patient, sophisticated consumers withdraw their funds and invest at the secondary market only in the crisis state markets may not exist in normal times Households trade only to a limited extend > banks have a high transaction volume No contagion occurs Eder, Fecht, Pausch (2011) (2010) 12 / 15
Different Financial Systems Eder, Fecht, Pausch (2011) (2010) 13 / 15
Conclusion The proportion of naive households determines the financial system the susceptibility to contagion effects of the financial system Regulation may help to avoid contagion effects Influences the probability of a financial crisis Influences the type of financial system Eder, Fecht, Pausch (2011) (2010) 14 / 15
Further Research Market maker of last resort Lender of last resort Liquidity regulations Eder, Fecht, Pausch (2011) (2010) 15 / 15