Bank Liquidity Crises: Interbank Connections and Regulatory Policies

Assessment Criteria

·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. 

You should submit an electronic copy online through the module Blackboard (Turnitin) site.

Topic 1: Bank Liquidity Crises

Read Article 1 before answering all three 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.

Interbank contagion during the Depression and its implications for regulation today

Charles Calomiris, Matthew Jaremski, David Wheelock 12 February 2019

Banks have direct contractual exposures to one another through a variety of channels, and regulators are concerned about the systemic risk that may result from this. This column examines the Great Depression in the US and describes how important contractual contagion occurred during the Depression which significantly worsened the failure risk of banks by increasing liquidity risk. The findings call for regulatory policies that take account of potential contractual contagion, and that require minimum prudential capital and liquidity buffers to take liquidity risks into account.

The financial crisis of 2008-09 heightened interest in how relationships within the financial system can amplify exogenous shocks. Amplification can occur through multiple channels. One channel is counterparty contagion through direct contractual obligations between financial intermediaries. A default by one bank, for example, can impose distress on other firms that hold significant liabilities of the defaulting bank. Furthermore, solvent banks that anticipate withdrawals or an inability to borrow will draw down their interbank balances and thereby reduce aggregate liquidity.

Read Article 2 before answering all three questions below.

1.Use a basic textbook model of money and credit creation and the details in the article to demonstrate how the ECB’s quantitative easing (QE) policy might be expected to increase bank lending and the money supply.

2.What evidence is there in the article to indicate that banks have not responded in the textbook way to the ECB’s QE policy?  Explain how and why banks have responded.

3.Like central banks in some other countries, the ECB supposed to be is independent of political influence.  Discuss the view that an independent central bank is essential for effective monetary policy

The EU’s asset purchase programme saw its central banks’ reserve balances increase to unprecedent levels. This column analyses the response of banks in the euro area to this expansion in system-wide reserves, in particular whether they absorbed the excess liquidity or tried to push it off their balance sheets. The findings suggest that banks dealt with the increased reserves with the purchase of debt securities or paying down funding sources rather than lending to the real economy.