Impact of Interbank Connections on Liquidity Risk and the Role of Lender of Last Resort

here is some case study material to read as the basis for your answers.  In addition, you should draw on other reading included in the lecture and seminar programme.  The module guide contains references for further reading.  You may also do your own research.

Answers are to be between 2,500 and 3,000 words, and each question should be answered separately.  You do not need to include an introduction or overall conclusion.

·Inclusion of the relevant details.
·Application and analysis using the appropriate concepts and theories.
·Critical evaluation of ideas and data.
·Logic and coherence of the argument.
·Clarity of the explanations and presentation.

Read Article 1 before answering all four questions below.

1.Drawing on the details in the article, explain how interbank connections can affect the exposure of individual banks and the banking system to liquidity risk.

2.Use economic theory and the evidence in the article to assess the effects on the banking system of a central banker that acts as the lender of the last resort.

3.Discuss whether regulations in addition to a lender of the last resort are needed for the efficient operation of the financial system.

We also examine how the founding of the Fed might have affected banks’ management of network liquidity risks.

We identify two separable aspects of network relationships that affected liquidity risk in the pre-Fed era, consistent with the fact that network relationships could be either a source of liquidity risk or a means of mitigating liquidity risk. One aspect (the amount of deposits due to correspondents) created liquidity risk, and the other (the total number of network relationships, which we interpret as a measure of the bank’s reputation and credit worthiness within the network, and thus its ability to access resources) mitigated liquidity risk. After controlling for the amount of deposits due to correspondents, which would tend to increase risk, the size of a bank’s correspondent network – i.e. the number of correspondents the bank had – should ordinarily mitigate liquidity risk.

We find that before the Fed was established, both aspects affected how banks managed their portfolio risk and leverage. Greater exposure to interbank deposits encouraged banks to increase their capital ratios, while more network relationships (holding constant the amount of interbank deposits) led them to hold lower cash and capital ratios. By contrast, after the Fed was established, correspondent banks appear less sensitive to network liquidity risk.

We find that both aspects of network connections had much less impact on banks’ risk management decisions in the years after the Fed’s founding, suggesting that expected access to liquidity from the Fed reduced differences in perceived liquidity risk for correspondent banks, which likely heightened contagion risk through the interbank network. In essence, the founding of the Fed provided a perception of liquidity risk insurance against the sorts of shocks associated with banking panics in the National Banking era, and in so doing weakened the incentives for correspondent banks to guard against interbank liquidity risks by holding more capital or liquid assets.