Vulnerable Banks

Abstract:     
When a bank experiences a negative shock to its equity, one way to return to target leverage is to sell assets. If asset sales occur at depressed prices, then one bank’s sales may impact other banks with common exposures, resulting in contagion. We propose a simple framework that accounts for this effect and adds it up across all related banks. The framework explains how the distribution of leverage and risk exposures across banks contributes to systemic risk. We compute bank exposures to system-wide deleveraging, as well as the spillover of a single bank’s deleveraging onto other banks. We use the model to evaluate a variety of policy proposals, such as caps on size or leverage, mergers of good and bad banks, and equity injections. In our model, “microprudential” interventions, which target the solvency of individual banks, tend to be less effective than “macroprudential” policies which aim to minimize spillovers across firms. We apply the framework to European banks vulnerable to sovereign risk in 2010 and 2011, and US banks between 2001 and and 2010.

Number of Pages in PDF File: 64

Keywords: systemic risk, deleveraging, liquidity

JEL Classification: G21, G38

working papers series