Evaluating Regulation within an Artificial Financial System – A Framework and Its Application to the Liquidity Coverage Ratio Regulation

67 Pages Posted: 11 May 2017

See all articles by Jesper Riedler

Jesper Riedler

ZEW – Leibniz Centre for European Economic Research

Frank Brueckbauer

ZEW – Leibniz Centre for European Economic Research

Date Written: April 7, 2017

Abstract

We develop a general model of the financial system that allows for the evaluation of bank regulation. Our framework comprises the agents and institutions that have proved crucial in the propagation of the subprime mortgage shock in the U.S. into a global financial crisis: Commercial banks and investment banks, which can also be interpreted as shadow banks, interact on wholesale debt markets. Beside a market for short term interbank loans and long term bank bonds, other funding sources include insured customer deposits, uninsured investor deposits and repos. While credit to the real sector is the principal asset of commercial banks, investment banks specialize in trading securities, which may differ according to risk, maturity and liquidity. As a first application of the model we implement the liquidity coverage ratio (LCR) regulation and analyze its impact on bank balance sheets, interest rates, the transmission of monetary policy and the stability of bank lending in the face of shocks. We find that the LCR regulation reduces the supply of loans to the real sector, increases the maturity and interest rate of long term wholesale debt, and strongly diminishes the role of the overnight interbank market as a funding source. Our simulations suggest that the transmission of changes to short term monetary policy rates is severely impaired when the LCR regulation is binding. Furthermore, we find that a strong confidence shock can lead to a protracted credit crunch under the liquidity regulation.

Keywords: financial system, agent-based model, liquidity coverage ratio

Suggested Citation

Riedler, Jesper and Brueckbauer, Frank, Evaluating Regulation within an Artificial Financial System – A Framework and Its Application to the Liquidity Coverage Ratio Regulation (April 7, 2017). ZEW - Centre for European Economic Research Discussion Paper No. 17-022, Available at SSRN: https://ssrn.com/abstract=2966007 or http://dx.doi.org/10.2139/ssrn.2966007

Jesper Riedler (Contact Author)

ZEW – Leibniz Centre for European Economic Research ( email )

P.O. Box 10 34 43
L 7,1
D-68034 Mannheim, 68034
Germany

Frank Brueckbauer

ZEW – Leibniz Centre for European Economic Research ( email )

P.O. Box 10 34 43
L 7,1
D-68034 Mannheim, 68034
Germany

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