Essays on Systemic Liquidity Risk

Abstract

This dissertation studies two aspects of the implications of liquidity risk-taking by financial institutions on the economy: first, its effects on macroeconomic volatility and the likelihood of financial distress; second, how the exposure to this source of risk is relevant in determining the failure of financial institutions in times of stress. Optimal regulatory responses are derived in the essays on both the macroprudential and the microprudential front.

The first essay develops a welfare theoretic model to study prudential regulation in an emerging market economy that is facing large short-term capital inflows into the banking system. The prospect of a sudden reversal of those flows exposes the economy to liquidity risk. In the model banks finance investments in short-term and long-term assets by borrowing both locally and externally. Government intervention is rationalized with an externality arising from financial frictions. The potential disruption in external financing constitutes the only source of aggregate risk. The analysis shows that inefficient equilibria exist. In those equilibria banks underinsure against external financing shocks. The underinsurance is the result of excessive external borrowing together with a relative overinvestment in short-term assets. In the proposed setup efficiency is restored by complementing liability-side instruments, such as unremunerated reserve requirements, with asset-side instruments, such as taxes on short-term assets.

The theoretical contribution is twofold: First, the framework rationalizes policy action with instruments that attack distortions in the asset side of banks' balance sheet. Second, the analysis points to the systemic exposure to liquidity risk of banks as being the source of concern and the key vulnerability explaining output collapse after an external financing shock. The latter implication is tested by constructing an index that captures such exposure. Extending a methodology recently introduced by Basel III, the index is developed for a sample of 40 emerging markets and developing countries, covering the financial statements of 1,700 banks. It is shown that the index is a robust explanatory variable for unexpected output declines across emerging markets, after the Lehman's bankruptcy.

The second essay studies the determinants of bank failure during the global financial crisis. It exploits a bank-level dataset that covers about 11,000 banks in the U.S. and Europe from 2001 to 2009 to analyze the evolution of bank funding structures in the run up to the global financial crisis and to study the implications for financial stability. Careful measurement of exposure to liquidity risk is achieved by employing a recently introduced metric, the NSFR, by Basel III. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with bank risk-taking. The main finding of the essay is that, in the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border banks were more susceptible to solvency risk due to excessive leverage. The results point to potentially large gains in moving to international banking regulatory standards that are designed to contemplate the heterogeneity of vulnerabilities across different banks.