Systemic Loops and Liquidity Regulation

Risk contagion in the banking sector occurs through interconnections on the asset side or through liquidity spirals affecting the liability side. We build a network model of optimizing banks featuring contagion on both sides of banks? balance sheets. To already existing asset side channels (liquidity hoarding, interbank exposures and fire sales of common assets) we add a critical liability side channel of contagion, namely bank runs triggered by information coordination akin to global games. The model is calibrated to the network of large European banks by a simulated method of moments approach and by using the real-world interbank matrix as a prior for the maximum entropy estimation of the model-based interbank matrix. We use the model to study the effects of phase-in increases of liquidity coverage ratios. Interestingly we find that the systemic risk profile of the system is not improved and might even deteriorate. Based on those insights we propose an alternative approach: differential (across banks) increases in coverage ratios based on systemic importance rankings help to mitigate the externalities and deliver a much more stable system.