How Banks’ Capital Ratio and Size Affect the Stability of the Banking System: A Simulation-Based Study

34 Pages Posted: 15 Jun 2016

See all articles by Mitja Steinbacher

Mitja Steinbacher

Fakulteta za poslovne vede

Matjaz Steinbacher

Kiel Institute for the World Economy; University of Donja Gorica

Date Written: March 20, 2015

Abstract

In this paper, we construct a structural model of credit risk in order to examine how different magnitudes of exogenous shocks to bank loans propagate across the network. We also examine how bank capital, size and the network structure affect the stability of the banking system. We demonstrate that balance sheet diversification reduces the probability of bank failure much more than diversification across the interbank market, which only works for weak shocks. Larger and well-capitalized banks are expected to default not only less frequently than other banks, but also at later dates. These banks are also expected to need less additional capital to avoid bankruptcy when hit by a shock. Larger systemic shocks are highly detrimental in all network topologies, and even for moderate shocks connectivity works contagiously. Our model is capable of generating cascading defaults. Importantly, the system's microstructure affects shock consequences. In a stable banking system, if possible, banks would primarily diversify their exposure across different systemic events, not just across the interbank market, and maintain adequate levels of capital. The stability of the system can be enhanced if a sufficient number of banks that would have otherwise defaulted is rescued. Further, we find the minimum capital ratio for each bank that is required to prevent defaults within the banking system. Finally, we demonstrate that counterparty risk leads to an extreme nonlinear characteristic in the shock effects.

Keywords: bank capital; diversification, credit risk, financial stability, structural models, network models

Suggested Citation

Steinbacher, Mitja and Steinbacher, Matjaz, How Banks’ Capital Ratio and Size Affect the Stability of the Banking System: A Simulation-Based Study (March 20, 2015). Journal of Credit Risk, Vol. 11, No. 1, 2015. Available at SSRN: https://ssrn.com/abstract=2795515

Mitja Steinbacher

Fakulteta za poslovne vede ( email )

Ciril Metodov Trg 9
Ljubljana, 1000
Slovenia
38631703057 (Phone)

HOME PAGE: http://www.katoliski-institut.si

Matjaz Steinbacher (Contact Author)

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, D-24100
Germany

University of Donja Gorica ( email )

Podgorica, 81000
Montenegro

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