International Monetary and Regulatory Transmission with Bank Heterogeneity and Default Risk

Abstract

This paper proposes a numerically evaluated open-economy multiperiod general equilibrium model for macro-prudential analysis of monetary and regulatory policies, where optimal decisions by internationally linked financial intermediaries are key determinants of international financial flows and wider economic outcomes. Financial intermediaries are different in terms of balance sheet endowments, liquidity and risk preferences, and take decisions on borrowing, lending and partial default rationally and competitively impacting the wider economy. Default risk is an endogenous result of individual decisions of private agents (banks, companies and households), as well as a systemic outcome of market interaction. The capabilities of the model are demonstrated in the study of pertinent policy scenarios and contingencies, such as effects of changes in the ECB’s interest rate on refinancing operations, changes in ECB’s penalty interest rate on the deposit facility, systemic consequences of Basel III, changes in banks’ liquidity requirements and a liquidity crunch of a major financial institution.

Keywords: Banking, Monetary Policy, Non-Standard Instruments of Monetary Policy, Endogenous Default Risk, Macro-Prudential Regulation, Liquidity, Financial Stability

JEL Classification: E52, E44, G28