Incentives through the cycle: microfounded macroprudential regulation

Following a decline in the fundamental risk of assets, the ability of banks to expand the balance sheet under a Value-at-Risk constraint in- creases (as in Adrian and Shin (2010)), boosting the bank’s incentives to provide costly monitoring effort that prevents asset deterioration. On the other hand, high asset demand and prices, eventually, raise the bank’s pay- off in the event of liquidation associated to asset deterioration, jeopardiz- ing incentives. This paper shows that a microprudential regulatory regime that disregards the equilibrium effect of macro variables (asset prices) on micro behavior (effort), performs poorly as low fundamental (exogenous) risk reduces bank’s effort and induces high (endogenous) deterioration risk. This analysis calls for a macroprudential regulatory regime in which the equilibrium feedback effect is fully taken into account by the author- ity in designing incentive compatible capital requirements, providing a theoretical foundation to the countercyclical buffer of Basel III.Macroprudential regulation, financial stability, capital requirement.

Interbank markets and multiplex networks: centrality measures and statistical null models

The interbank market is considered one of the most important channels of contagion. Its network representation, where banks and claims/obligations are represented by nodes and links (respectively), has received a lot of attention in the recent theoretical and empirical literature, for assessing systemic risk and identifying systematically important financial institutions. Different types of links, for example in terms of maturity and collateralization of the claim/obligation, can be established between financial institutions. Therefore a natural representation of the interbank structure which takes into account more features of the market, is a multiplex, where each layer is associated with a type of link. In this paper we review the empirical structure of the multiplex and the theoretical consequences of this representation. We also investigate the betweenness and eigenvector centrality of a bank in the network, comparing its centrality properties across different layers and with Maximum Entropy null models.Comment: To appear in the book "Interconnected Networks", A. Garas e F. Schweitzer (eds.), Springer Complexity Serie

The multiplex structure of interbank networks

The interbank market has a natural multiplex network representation. We employ a unique database of supervisory reports of Italian banks to the Banca d'Italia that includes all bilateral exposures broken down by maturity and by the secured and unsecured nature of the contract. We find that layers have different topological properties and persistence over time. The presence of a link in a layer is not a good predictor of the presence of the same link in other layers. Maximum entropy models reveal different unexpected substructures, such as network motifs, in different layers. Using the total interbank network or focusing on a specific layer as representative of the other layers provides a poor representation of interlinkages in the interbank market and could lead to biased estimation of systemic risk.Comment: 41 pages, 8 figures, 10 table

Incentives through the cycle: microfounded macroprudential regulation

We use an incentive model in which improvements to fundamentals boost the ability of leveraged financial firms (banks) to expand the balance sheet (as in Adrian and Shin 2010). The rise in asset prices due to the amplified response of procyclical systems distorts bankers' incentives in providing (costly and non observable) monitoring effort. On the one hand, the fundamental value of assets positively affects the optimal effort of the banker, thus allowing supervisory authorities to relax incentive-compatible capital requirements and boosting asset demand and prices. On the other hand, in a macro perspective, high prices positively affect the banker's payoff in the bad state of asset liquidation (via asset prices), jeopardizing incentives. This type of externality follows from a purely “macro” phenomenon à la Borio (2003) and should be taken into account by the regulatory authority in designing capital requirements. In procyclical and advanced (low agency costs and highly liquid) financial systems, incentive compatibility requires a higher capital requirement in the face of an improvement to fundamentals. Our results provide a theoretical foundation to the countercyclical buffer provided for by the Basel Committee

Incentives through the cycle: microfounded macroprudential regulation

We use an incentive model in which improvements to fundamentals boost the ability of leveraged financial firms (banks) to expand the balance sheet (as in Adrian and Shin 2010). The rise in asset prices due to the amplified response of procyclical systems distorts bankers' incentives in providing (costly and non observable) monitoring effort. On the one hand, the fundamental value of assets positively affects the optimal effort of the banker, thus allowing supervisory authorities to relax incentive-compatible capital requirements and boosting asset demand and prices. On the other hand, in a macro perspective, high prices positively affect the banker's payoff in the bad state of asset liquidation (via asset prices), jeopardizing incentives. This type of externality follows from a purely “macro” phenomenon à la Borio (2003) and should be taken into account by the regulatory authority in designing capital requirements. In procyclical and advanced (low agency costs and highly liquid) financial systems, incentive compatibility requires a higher capital requirement in the face of an improvement to fundamentals. Our results provide a theoretical foundation to the countercyclical buffer provided for by the Basel Committee.Macroprudential regulation, financial stability, capital requirement.

Crises in the modern financial ecosystem

We build a moral hazard model to study incentives of financial intermediaries (shortly, bankers) facing a leverage-insurance trade-off in their investment choice. We demonstrate that the choice is affected by two recent transformations of the financial ecosystem bankers inhabit: (i) the rise of institutional savers, such as treasurers of global corporations, which manage huge balances in need for parking space and (ii) the proliferation of balance sheets with asset-liability mismatch, like those of insurance companies and pension funds (ICPFs), which allocate capital to bankers to reach for yield and meet their liabilities offering guaranteed returns. Bankers supply parking space to institutional savers and deliver leverageenhanced returns to ICPFs. When the demand for parking space and the mismatch which ICPFs must bridge are large, the equilibrium allocation is characterized by high leverage and financial crises. We show that post-crisis regulatory reforms, while improving the resiliency of the regulated banking sector, create room for bank disintermediation and do not unambiguously limit systemic risks which can build up in the asset management complex. Both transformations indeed stem from real economy developments (e.g. population ageing, global imbalances, income and wealth inequality, increased sophistication of tax arbitrage). Fiscal and structural reforms that directly address the real economy roots of those secular developments are then essential to complement financial and banking regulations and promote financial stability and balanced growth

Market failures in market-based finance

We build a three-period model to investigate market failures in the market-based financial system. Institutional investors (IIs), such as insurance companies and pension funds, have liabilities offering guaranteed returns and operate under a risk-sensitive solvency constraint. They seek to allocate funds to asset managers (AMs) that provide diversification when investing in risky assets. At the interim date, AMs that run investment funds face investor redemptions and liquidate risky assets and/or deplete cash holdings, if available. Dealer banks can purchase risky assets, thus providing market liquidity. The latter ultimately determines equilibrium allocations. In the competitive equilibrium, AMs suffer from a pecuniary externality and hold inefficiently low amounts of cash. Asset fire sales increase the overall cost of meeting redemptions and depress risk-adjusted returns delivered by AMs to IIs, forcing the latter to de-risk. We show that a macroprudential approach to (i) the liquidity regulation of AMs and (ii) the solvency regulation of IIs can improve upon the competitive equilibrium allocations

Macroprudential regulation of investment funds

The investment fund sector, the largest component of the non-bank financial system, is growing rapidly and the economy is becoming more reliant on investment fund financial intermediation. This paper builds a dynamic stochastic general equilibrium model with banks and investment funds. Banks grant loans and issue liquid deposits, which are valuable to households. Funds invest in corporate bonds and may hold liquidity in the form of bank deposits to meet investor redemption requests. Without regulation, funds hold insufficient deposits and must sell bonds when hit by large redemptions. Bond liquidation is costly and eventually reduces investment funds' intermediation capacity. Even when accounting for side effects due to a reduction of deposits held by households, a macroprudential liquidity requirement improves welfare by reducing bond liquidation and by increasing the economy's resilience to financial shocks akin to March 2020

Capital and contagion in financial networks

We implement a novel method to detect systemically important financial institutions in a network. The method consists in a simple model of distress and losses redistribution derived from the interaction of banks' balance-sheets through bilateral exposures. The algorithm goes beyond the traditional default-cascade mechanism, according to which contagion propagates only through banks that actually default. We argue that even in the absence of other defaults, distressed-but-non-defaulting institutions transmit the contagion through channels other than solvency: weakness in their balance sheet reduces the value of their liabilities, thereby negatively affecting their interbank lenders even before a credit event occurs. In this paper, we apply the methodology to a unique dataset covering bilateral exposures among all Italian banks in the period 2008-2012. We find that the systemic impact of individual banks has decreased over time since 2008. The result can be traced back to decreasing volumes in the interbank market and to an intense recapitalization process. We show that the marginal effect of a bank's capital on its contribution to systemic risk in the network is considerably larger when interconnectedness is high (good times): this finding supports the regulatory work on counter-cyclical (macroprudential) capital buffers