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Timetable (SYRW03)

Regulating Systemic Risk: insights from mathematical modeling

Monday 15th December 2014 to Friday 19th December 2014

Monday 15th December 2014
09:00 to 09:20 Registration
09:20 to 09:30 Welcome from Christie Marr (INI Deputy Director) INI 1
09:30 to 10:15 T Adrian (Federal Reserve Bank of New York)
Intermediary Leverage Cycles and Financial Stability
Co-author: Nina BOYARCHENKO (Federal Reserve Bank of New York )

We develop a theory of financial intermediary leverage cycles in the context of a dynamic model of the macroeconomy. The interaction between a production sector, a financial intermediation sector, and a household sector gives rise to amplification of fundamental shocks that affect real economic activity. The model features two state variables that represent the dynamics of the economy: the net worth and the leverage of financial intermediaries. The leverage of the intermediaries is procyclical owing to risk-sensitive funding constraints. Relative to an economy with constant leverage, financial intermediaries generate higher output and consumption growth and lower consumption volatility in normal times, but at the cost of systemic solvency and liquidity risks. We show that tightening intermediaries’ risk constraints affects the systemic risk-return trade-off, by lowering the likelihood of systemic crises at the cost of higher pricing of risk. Our model thus represents a conceptual framework for cyclical macroprudential policies within a dynamic stochastic general equilibrium model.

INI 1
10:15 to 10:30 Discussion INI 1
10:30 to 11:00 Morning Coffee
11:00 to 11:45 M Summer ([Oesterreichische Nationalbank])
Endogenous Leverage and Asset Pricing in Double Auctions
Co-authors: Thomas Breuer (University of Applied Sciences, Vorarlberg), Hans-Joachim Vollbrecht (University of Applied Sciences, Vorarlberg), Martin Jandacka (University of Applied Sciences, Vorarlberg)

We study the exchange and pricing of leveraged assets in an agent based model of a continuous double auction. In this framework we validate recent results in general equilibrium theory about endogenous leverage and its consequences for asset pricing. We find that the institutional details of exchange are critical for a good match between the predictions of the theory and the outcome of the double auction. The outcome of the double auction is in particular sensitive with respect to the details of how markets for debt and collateral are coordinated and how collateral is cleared. These results delineate the scope of markets and financial instruments for which the equilibrium theory provides an appropriate perspective.

INI 1
11:45 to 12:00 Discussion INI 1
12:30 to 13:30 Lunch at Wolfson Court
13:30 to 14:15 M Marsili (Abdus Salam International Centre for Theoretical Physics)
A Systemic Indicator for the Size of Shadow Banking
Co-authors: Davide Fiaschi (University of Pisa - Department of Economics), Imre Kondor (Parmenides Foundation), Valerio Volpati (Scuola Internazionale Superiore di Studi Avanzati (SISSA))

Using public data (Forbes Global 2000) we show that the asset sizes for the largest global firms follow a Pareto distribution in an intermediate range, that is "interrupted" by a sharp cut-off in its upper tail, where it is totally dominated by financial firms. Pareto distributions are generally traced back to a mechanism of proportional random growth, based on a regime of constant returns to scale. This makes our findings of an "interrupted" Pareto distribution all the more puzzling, because we provide evidence that financial firms in our sample should operate in such a regime. We claim that the missing mass from the upper tail of the asset size distribution is a consequence of shadow banking activity and that it provides an (upper) estimate of the size of the shadow banking system. This estimate -- which we propose as a shadow banking index -- compares well with estimates of the Financial Stability Board until 2009, but it shows a sharper rise in shadow banking activity after 2010. Finally, we propose a proportional random growth model that reproduces the observed distribution, thereby providing a quantitative estimate of the intensity of shadow banking activity.

INI 1
14:15 to 14:30 Discussion INI 1
14:30 to 15:15 N Klimenko (Universität Zürich)
Tail Risk, Capital Requirements and the Internal Agency Problem in Banks
In this paper I show how to design capital requirements that would prevent the bank from manufacturing tail risk. In the model, the senior bank manager may have incentives to engage in tail risk. Bank shareholders can prevent the manager from taking on tail risk via the optimal incentive compensation contract. To induce shareholders to implement this contract, capital requirements should internalize its costs. Moreover, bank shareholders must be given incentives to comply with minimum capital requirements by raising new equity and expanding bank assets. Making bank shareholders bear the costs of compliance with capital regulation turns out to be crucial for motivating them to care about risk-management quality in their bank.
INI 1
15:15 to 15:30 Discussion
15:30 to 16:00 Afternoon Tea
16:00 to 16:45 E Faia (Goethe-Universität Frankfurt)
Bank Networks: Contagion, Systemic Risk and Prudential Policy
Co-authors: Inaki Aldasoro (Goethe University Frankfurt), Domenico Delli Gatti (Catholic University Milan)

We present a network model of the interbank market in which optimizing risk averse banks lend to each other and invest in non-liquid assets. Clearing takes place through a price tâtonnement mechanism, while traded quantities ate obtained through three alternative matching algorithms: Maximum Entropy, Closest matching and Random matching. Contagion occurs through liquidity hoarding, interbank interconnections and fire sale externalities. The resulting network configurations exhibits core-periphery structure, dis-assortative behavior and low clustering coefficient. We measure systemic importance with network centrality and input-output metrics and systemic risk with Shapley values. Given the realm of our network we analyze the effects of prudential policies on the stability/efficiency trade-off. Liquidity requirements unequivocally decrease systemic risk but at the cost of lower efficiency (measured by aggregate investment in non-liquid assets); equity requirements tend to reduce risk (hence increase stability) without reducing significantly overall investment.

INI 1
16:45 to 17:00 Discussion INI 1
17:00 to 18:00 Welcome Wine Reception
Tuesday 16th December 2014
09:00 to 09:45 A Kashyap (University of Chicago)
How does macroprudential regulation change bank credit supply?
Co-authors: Alexandros Vardoulakis (Federal Reserve Board), Dimitrios Tsomocos (Oxford University)

We analyze a variant of the Diamond-Dybvig (1983) model of banking in which savers can use a bank to invest in a risky project operated by an entrepreneur. The savers can buy equity in the bank and save via deposits. The bank chooses to invest in a safe asset or to fund the entrepreneur. The bank and the entrepreneur face limited liability and there is a probability of a run which is governed by the bank’s leverage and its mix of safe and risky assets. The possibility of the run reduces the incentive to lend and take risk, while limited liability pushes for excessive lending and risk-taking. We explore how capital regulation, liquidity regulation,deposit insurance, loan to value limits, and dividend taxes interact to offset these frictions. We compare agents welfare in the decentralized equilibrium absent regulation with welfare in equilibria that prevail with various regulations that are optimally chosen. In general, regulation can lead to Pareto improvements but fully correcting both distortions requires more than one regulation.

INI 1
09:45 to 10:00 Discussion INI 1
10:00 to 10:45 F Malherbe (London Business School)
Opitmal Capital requirements over the Business and Financial Cycles
I propose a simple theory of intertwined business and financial cycles, where financial regulation both optimally responds to and influences the cycles. In this model, financial frictions lead to excessive aggregate lending by the financial sector. In response, the regulator sets capital requirements to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy and, because of a general equilibrium effect, its stringency increases with aggregate banking capital. A regulation that fails to take this effect into account would exacerbate economic fluctuations and result in excessive aggregate lending during a boom. It would also allow for an excessive build up of risk in the financial sector, which implies that, at the peak of a boom, even a small adverse shock could trigger a banking sector collapse, followed by an excessively severe credit crunch.
INI 1
10:45 to 11:00 Discussion INI 1
11:00 to 11:30 Morning Coffee
11:30 to 12:15 E Schaanning (Imperial College London)
Fire sales, endogenous risk and price-mediated contagion: modeling, monitoring and prudential policy
Co-author: Rama CONT (Imperial College London)

Large-scale deleveraging of assets by distressed financial institutions have been recognized as an important channel for the contagion of losses during the recent financial crisis. We propose a model for analyzing the impact of fire sales on system-wide losses in a system with multiple financial institutions subject to a macroeconomic stress scenario affecting asset values. Our model emphasizes the nonlinear threshold nature of deleveraging, as a result of which the volume of deleveraging is a convex function of initial asset losses, and enables to quantify the magnitude of spillover effects due to price-mediated contagion in terms of liquidity-weighted overlaps of institutional asset holdings. We illustrate these observations on a dataset of European banks.

A key concept which emerges from the model is the notion of indirect exposure of a financial institution to an asset class: we show that, when the impact of of fire sales is taken into account, the effective exposure of an institution to an asset class may be found to be much larger than the apparent exposure as revealed by the portfolio holdings alone. We show that regulatory risk weights of asset classes may be used as a macroprudential tool for a a decentralized regulation of fire sales risk, by providing incentives to financial institutions to reduce their exposure to this contagion channel without revealing confidential information on institutional portfolio holdings.

INI 1
12:15 to 12:30 Discussion INI 1
12:30 to 13:30 Lunch at Wolfson Court
14:00 to 15:00 T Adrian & P Dybvig & M Hellwig & D Tsomocos ([Panel Discussion])
Macroprudential regulation
Tobias Adrian (New York Fed)

Philip Dybvig (Washington University)

Martin Hellwig (Max Planck Institute)

Dimitrios Tsomocos (University of Oxford)

INI 1
15:00 to 15:30 Afternoon Tea
15:30 to 16:15 G Iori (City University, London)
Financial regulations and bank credit to the real economy
Co-authors: Saqib Jafarey (City University London), James Porter (City University London), Giampaolo Gabbi (Sda Bocconi Milano)

We present an agent-based model focusing on the linkage between the interbank market and the real economy with a stylised central bank acting as lender of last resort. Using this model we address the tradeoff between stability and economic performance for different structures of the interbank market. We also explore the efficacy of recent regulatory reforms using our rich model. Our results suggest that the effects of regulatory leverage ratios on the banking sector?s performance can vary in a complex and non-monotonic way with the state of the economy, the degree of connectivity of the interbank market and the amount of information available to market participants on bank risks.

INI 1
16:15 to 17:00 S Luck ([Universität Bonn/Max-Planck-Institut für Gemeinschaftsgüter])
Bank, Shadow Banking, and Fragility
Co-author: Paul Schempp (University of Bonn and Max Planck Insitute for Research on Collective Goods)

This paper studies a banking model of maturity transformation in which regulatory arbitrage induces the existence of shadow banking next to regulated commercial banks. We derive three main results: First, the relative size of the shadow banking sector determines the stability of the financial system. If the shadow banking sector is small relative to the capacity of secondary markets for shadow banks' assets, shadow banking is stable. In turn, if the sector grows too large, it becomes fragile: an additional equilibrium emerges that is characterized by a panic-based run in the shadow banking sector. Second, if regulated commercial banks themselves operate shadow banks, the parameter space in which a run on shadow banks may occur is reduced. However, once the threat of a crisis reappears, a crisis in the shadow banking sector spreads to the commercial banking sector. Third, in the presence of regulatory arbitrage, a safety net for banks may fail to prevent a banking crisis. Moreover, the safety net may be tested and may eventually become costly for the regulator.

INI 1
17:00 to 17:15 Discussion INI 1
Wednesday 17th December 2014
09:00 to 09:45 L Clerc (Banque de France)
Capital Regulation in a Macroeconomic Model with Three Layers of Default
Co-authors: Alexis Derviz (Czech National Bank), Caterina Mendicino (Banco de Portugal), Stephane Moyen (Deutsche Bundesbank), Kalin Nikolov (ECB), Livio Stracca (ECB), Javier Suarez (CEPR), Alexandros Vardoulakis (Federal Reserve Board of Governors,), ()

We develop a model which aims at providing a framework for the positive and normative analysis of macroprudential policies. The basic model incorporates optimizing fi…nancial intermediaries (“bankers”) who allocate their scarce wealth (“inside equity”) together with funds raised from saving households across two lending activities, mort- gage lending and corporate lending. External …financing for all borrowers (including banks) takes the form of external debt which is subject to default risk. The model shows the interplay of three interconnected net worth channels as well as distortions due to deposit insurance, and can be extended to analyse the implications of securitization and liquidity risk. The setup allows an explicit welfare analysis of macroprudential policies.

INI 1
09:45 to 10:00 Discussion INI 1
10:00 to 10:45 Y Sannikov (Princeton University)
Financial intermediaries in the theory of money
Co-author: Markus BRUNNERMEIER (Princeton)

A theory of money needs a proper place for financial intermediaries. Intermediaries create inside money and their ability to take risks determines the money multiplier. In downturns, intermediaries shrink their lending activity and re-sell their assets. Moreover, they create less inside money. As the money multiplier shrinks, the value of money rises. This leads to a Fisher disinflation that hurts intermediaries and all other borrowers. The initial shock is amplified, volatility spikes up and risk premia rise. An accommodative monetary policy in downturns, focused on the assets held by constrained agents, recapitalizes intermediaries and hence mitigates these destabilizing adverse feedback effects. A monetary policy rule that accommodates negative shocks and tightens after positive shocks, provides an ex-ante insurance, mitigates financial frictions, reduces endogenous risk and risk premia but it also creates moral hazard.

INI 1
10:45 to 11:00 Discussion INI 1
11:00 to 11:30 Morning Coffee
11:30 to 12:15 M Hellwig (Max-Planck-Institut für Gemeinschaftsgüter)
Systemic Risk and Macroprudential regulation
INI 1
12:15 to 12:30 Discussion INI 1
12:30 to 13:30 Lunch at Wolfson Court
14:00 to 14:45 S Kapadia (Bank of England)
Taking uncertainty seriously: simplicity versus complexity in financial regulation
Co-authors: David Aikman (Bank of England), Mirta Galesic (Max Planck Institute for Human Development, Berlin), Gerd Gigerenzer (Max Planck Institute for Human Development, Berlin), Konstantinos Katsikopoulos (Max Planck Institute for Human Development, Berlin), Amit Kothiyal (Max Planck Institute for Human Development, Berlin), Emma Murphy (Bank of England), Tobias Neumann (Bank of England)

Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; and (iii) when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.
INI 1
14:45 to 15:00 Discussion INI 1
15:00 to 15:30 Afternoon Tea
15:30 to 17:00 R Cont & L Clerc & J Vickers & S Kapadia ([Panel Discussion])
Regulating the financial network: the agenda for structural reform
Rama Cont (Imperial College London)

Laurent Clerc (Banque de France)

John Vickers (University of Oxford)

Sujit Kapadia (Bank of England)

INI 1
19:30 to 22:00 Conference Dinner at Trinity College
Thursday 18th December 2014
09:00 to 09:45 S Morris (Princeton University)
Illiquidty Component of Credit Risk
Co-author: Hyun Song Shin (Bank of International Settlements)

We describe and contrast three different measures of an institution's credit risk. "Insolvency risk" is the conditional probability of default due to deterioration of asset quality if there is no run by short term creditors. "Total credit risk" is the unconditional probability of default, either because of a (short term) creditor run or (long run) asset insolvency. "Illiquidity risk" is the difference between the two, i.e., the probability of a default due to a run when the institution would otherwise have been solvent. We discuss how the three kinds of risk vary with balance sheet composition. We provide a formula for illiquidity risk and show that it is (i) decreasing in the "liquidity ratio" -- the ratio of realizable cash on the balance sheet to short term liabilities; (ii) increasing in the "outside option ratio" -- a measure of the opportunity cost of the funds used to roll over short term liabilities; and (iii) increasing in the "fundamental risk ratio" -- a measure of ex post variance of the asset portfolio.

INI 1
09:45 to 10:00 Discussion INI 1
10:00 to 10:45 D Skeie (Texas A&M University)
Information Management in Banking Crises
Co-author: Joel Shapiro (University of Oxford)

A regulator resolving a bank faces two audiences: depositors, who may run if they believe the regulator will not provide capital, and banks, which may take excess risk if they believe the regulator will provide capital. When the regulator's cost of injecting capital is private information, it manages expectations by using costly signals: (i) A regulator with a low cost of injecting capital may forbear on bad banks to signal toughness and reduce risk taking, and (ii) A regulator with a high cost of injecting capital may bail out bad banks to increase confidence and prevent runs.

INI 1
10:45 to 11:00 Discussion INI 1
11:00 to 11:30 Morning Coffee
11:30 to 12:15 S Ghamami ([FRB - UC Berkeley])
Static Models of Central Counterparty Risk
Following the 2009 G-20 clearing mandate, international standard setting bodies (SSBs)have outlined a set of principles for central counterparty (CCP) risk management; they have also devised formulaic CCP risk capital requirements on clearing members for their central counterparty exposures. There is still no consensus among CCP regulators and bank regulators on how central counterparty risk should be measured coherently in practice. A conceptually sound and logically consistent definition of the CCP risk capital in the absence of a unifying CCP risk measurement framework is challenging. Incoherent CCP risk capital requirements may create an obscure environment disincentivizing the central clearing of over the counter (OTC) derivatives transactions. Based on novel applications of well-known mathematical models in finance, this paper introduces a risk measurement framework that coherently specifies all layers of the default waterfall resources of typical derivatives CCPs. The proposed framework gives the first risk sensitive definition of the CCP risk capital based on which less risk sensitive non-model-based methods can be evaluated.
INI 1
12:15 to 12:30 Discussion INI 1
12:30 to 13:30 Lunch at Wolfson Court
14:00 to 14:45 V Acharya (New York University)
Financial Sector Health Since 2007: A Comparative Analysis of the United States, Europe and Asia
This essay uses recent methodology for estimating capital shortfalls of financial institutions during aggregate stress to assess the evolution of financial sector health since 2007 in the United States, Europe and Asia. Financial sector capital shortfalls reach a peak in the end of 2008 and early 2009 for United States and Europe; however, they decline thereafter steadily only for the United States, with Europe reaching a similar peak in the Fall of 2011 during the southern periphery sovereign crises. In contrast, the financial sector in Asia had little capital shortfall in 2008-09 but the shortfall has increased steadily since then, notably for China and Japan. These relative patterns can be explained based on adequate regulatory responses in the United States, the lack thereof in Europe, economic stagnation in Japan, and the bank-leverage based fiscal stimulus in China.
INI 1
14:45 to 15:00 Discussion INI 1
15:00 to 15:30 Afternoon Tea
15:30 to 16:15 R Sowers (University of Illinois at Urbana-Champaign)
Geometry of Defaults
Co-author: Henry K. Schenck (University of Illinois at Urbana-Champaign)

We discuss some geometric considerations of defaults in networks of obligations. In particular, we use the clearing policies of Eisenberg and Noe and some ideas from geometry to compare counterparties.

INI 1
16:15 to 16:30 Discussion INI 1
16:30 to 17:15 A Kirilenko (Massachusetts Institute of Technology)
Do U.S. Financial Regulators Listen to the Public? Testing the Regulatory Process with the RegRank algorithm
Co-authors: Shawn Mankad (University of Maryland), George Michailidis (University of Michigan)

We examine the notice-and-comment process and its impact on influencing regulatory decisions by analyzing the text of public rule-making documents of the Commodity Futures Trading Commission (CFTC) and associated comments. For this task, we develop a data mining framework and an algorithm called RegRank, which learns the thematic structure of regulatory rules and public comments and then assigns tone weights to each theme to come up with an aggregate score for each document. Based on these scores we test the hypothesis that the CFTC adjusts the final rule issued in the direction of tone expressed in public comments. Our findings strongly support this hypothesis and further suggest that this mostly occurs in response to comments from the regulated financial industry. We posit that the RegRank algorithm and related text mining methods have the potential to empower the public to test whether it has been given the "due process" and hence keep government agencies in chec k.

INI 1
Friday 19th December 2014
09:00 to 09:45 A Milne (Loughborough University)
Networks, subnetworks and macroprudential capital requirements
Co-author: Jukka Isohätälä (Loughborouh University and University of Oulu)

This paper explores some of the consequences of network asymmetry for the transmission and containment of systemic financial risk. Before the global financial crisis network linkage was regarded as a source of stability, providing valuable diversification benefits to the most widely connected firms; since the crisis network linkages this view is widely questioned, is connectivity not a source of vulnerability and of potential transmission of systemic events? A related question is whether macroprudential capital requirements, set to protect the financial system against such systemic events, are better framed (for any given level of aggregate required capital) so as EITHER minimize the degree of transmission of shocks across the system i.e. focussed on the most connected firms; OR to maximize the ability of individual firms to withstand systemic disturbances i.e. focussed on the most specialized firms. These questions (connectivity as a source of protection or source of risk? f ocussing capital on connected or exposed firms) are only meaningful once allowance is made for network asymmetry and the presence of sub-networks (local connections and exposures within the financial system). We seek answers to these questions through simulation of a simple model of systemic financial risk, with a network and subnetworks loosely calibrated to UK experience during the financial crisis, with a focus on both exposure to property markets and extent of maturity mismatch.

INI 1
09:45 to 10:00 Discussion INI 1
10:00 to 10:45 B Meller (Deutsche Bundesbank)
BSLoss– a comprehensive measure for interconnectedness
Co-authors: Kilian Fink (Deutsche Bundesbank), Ulrich Krueger (Deutsche Bundesbank), Lui-Hsian Wong (Deutsche Bundesbank)

We propose a measure for interconnectedness: BSLoss, the banking system loss which describes the increase in expected credit losses due to contagion risk. For this purpose, we construct an algorithm to model the transmission of credit risk in the interbank market via a multiple-round-process. Core to the algorithm is the simulation of how a deterioration of credit quality of debtor banks spills over to creditor banks via the interbank credit channel. The transmission of an exogenous shock to one or a group of banks is modeled on the basis of the empirical relationship between the Tier 1 capital ratio and the probability of default of banks. As a consequence of the contagion mechanism a devaluation of banks’ assets and an increase in credit losses can be observed. Compared to other measures for interconnectedness BSLoss comprises several merits: It is easy to interpret in economic terms (ie expressible in monetary units) and reacts sensitively even to small changes in cr edit risk (ie reflects a market value approach). The algorithm may be applied to analyze the effectiveness of systemic capital buffers to curb contagion risk in the banking system.

INI 1
10:45 to 11:00 Discussion INI 1
11:00 to 11:30 Morning Coffee
11:30 to 12:15 Z Feinstein (Washington University in St. Louis)
Systemic Risk Measures for Financial Networks
Co-authors: Birgit Rudloff (Princeton University), Stefan Weber (Leibniz Universitat Hannover)

Systemic risk refers to the risk that the financial system is susceptible to failures due to the characteristics of the system itself. The tremendous cost of this type of risk requires the design and implementation of tools for the efficient macroprudential regulation of financial institutions. The talk proposes a novel approach to measuring systemic risk.

Key to our construction is the philosophy that there is no distinction between risk and capital requirements, as recently described in Artzner, Delbaen & Koch-Medina (2009). Such an approach is ideal for regulatory purposes. The suggested systemic risk measures express systemic risk in terms of capital endowments of the financial firms. These endowments constitute the eligible assets of the procedure. Acceptability is defined in terms of cash flows to the entire society and specified by a standard acceptance set of an arbitrary scalar risk measure. Random cash flows can be derived conditional on the capital endowments of the firms within a large class of models of financial systems. These may include both local and global interaction. The resulting systemic risk measures are set-valued and allow a mathematical analysis on the basis of set-valued convex analysis.

We explain the conceptual framework and the definition of systemic risk measures, provide algorithms for their computation, and illustrate their application in numerical case studies - e.g. in the network models of Eisenberg & Noe (2001), Cifuentes, Shin & Ferrucci (2005), and Amini, Filipovic & Minca (2013).

INI 1
12:15 to 12:30 Discussion INI 1
12:30 to 13:30 Lunch at Wolfson Court
University of Cambridge Research Councils UK
    Clay Mathematics Institute London Mathematical Society NM Rothschild and Sons