Shadow Banking System, Derivatives and Liquidity Risks

MFA Annual Meeting, Chicago, March, 2011

56 Pages Posted: 18 Mar 2010 Last revised: 20 Jan 2011

Jianbo Tian

SUNY at Albany - Department of Economics

Date Written: March 15, 2010

Abstract

This paper introduces a theoretical liquidity risk model to explain how the fire-sale price happens by banks' portfolio composition and the liquidity shocks. The model illustrates that the derivatives can serves as Arrow-Debreu securities for banks to share and eliminate the liquidity risks. The shadow banking system serves as the external funds aids banks to absorb the liquidity shocks, and re-enforce their advantage in borrow-short-and-lend-long. The results are helpful to understanding how bank runs among financial institutions occurred during the subprime crisis, and why the $500B subprime mortgage losses could not be fixed by more than $2T government aids, and crashed the prices and led to a frozen market.

Keywords: liquidity risk, derivatives, origination-and-distribution model, interbank market, bank run, subprime crisis

JEL Classification: D12, G12, G21

Suggested Citation

Tian, Jianbo, Shadow Banking System, Derivatives and Liquidity Risks (March 15, 2010). MFA Annual Meeting, Chicago, March, 2011. Available at SSRN: https://ssrn.com/abstract=1571707

Jianbo Tian (Contact Author)

SUNY at Albany - Department of Economics ( email )

BA125A, 1400 Washington Ave,
Albany, NY 12222
United States

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