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Financial Stability

Paper Session

Saturday, Jan. 8, 2022 10:00 AM - 12:00 PM (EST)

Hosted By: American Finance Association
  • Chair: Dasol Kim, U.S. Office of Financial Research

Interbank Networks in the Shadows of the Federal Reserve Act

Haelim Park Anderson
,
U.S. Federal Deposit Insurance Corporation
Selman Erol
,
Carnegie Mellon University
Guillermo Ordoñez
,
University of Pennsylvania

Abstract

Central banks provide public liquidity to traditional (regulated) banks with the intention of stabilizing the financial system. Shadow banks are not regulated, yet they indirectly access such liquidity through the interbank system. We build a model that shows how public liquidity provision may change the balance sheet and the linkages between traditional and shadow banks, increasing systemic risk through three channels: reducing aggregate liquidity, expanding fragile short-term borrowing, and crowding out of private cross-bank insurance. Using unique historical data on individual payments and funding relationships of Virginia banks, we show that the creation of the Federal Reserve System in 1913 changed the structure and nature of the U.S. interbank network in ways that are consistent with the model and its implications.

Bankruptcy Exemption of Repo Markets: Too Much Today for Too Little Tomorrow?

Viral Acharya
,
New York University, CEPR, and NBER
V. Ravi Anshuman
,
Indian Institute of Management Bangalore
S. Viswanathan
,
Duke University

Abstract

We examine the desirability of granting "safe harbor" provisions to the sale and repurchase (repo) markets, i.e., granting repo contracts exemption from bankruptcy and automatic stay. Such exemption can enable financial firms to raise greater liquidity and operate at higher leverage in normal times. This liquidity creation occurs, however, at the cost of ex-post inefficiency when there are adverse aggregate shocks to the fundamental quality of collateral underlying the contracts. When exempt from bankruptcy, creditors of highly leveraged financial firms respond to such shocks by engaging in collateral liquidations, which lead to re sales. Financial arbitrage by less leveraged financial firms equilibrates returns from acquiring financial assets at re sale prices and those from real-sector lending, inducing a rise in lending rates, a deterioration in endogenous asset quality, a liquidity crunch, and in the extremis, a complete credit crunch in the real sector. Given this inefficiency, an automatic stay on repo contracts in bankruptcy can be not only ex-post optimal, but also ex-ante optimal, especially for illiquid collateral with high exposure to aggregate risk, and for economies with a large real sector.

Bank Balance Sheet Constraints and Bond Liquidity

Johannes Breckenfelder
,
European Central Bank
Victoria Ivashina
,
Harvard University

Abstract

We explore the ties between bonds and individual dealers formed through home advantage and the persistence of previous underwriting relationships. Building on these connections, we show that the introduction of the leverage ratio for the European banks had a large impact on exposed bonds’ liquidity. Moreover, based on these ties, we show that bond mutual fund panic following the 2020 pandemic outbreak affected substantially more mutual funds with the larger exposures to dealer banks’ balance sheet constraints.

Discussant(s)
Shengxing Zhang
,
London School of Economics
Andrew Metrick
,
Yale University
Chester Spatt
,
Carnegie Mellon University
JEL Classifications
  • G1 - Asset Markets and Pricing