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Discussant comments on: Quantifying interlinkages between banks and banking systems

Workshop for Non-Regulatory Central Banks, Bank of England, March 2011, London. Discussant comments on: Quantifying interlinkages between banks and banking systems. 30 March 2011 Harry Leinonen. The views expressed are those of the author and do not necessarily reflect

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Discussant comments on: Quantifying interlinkages between banks and banking systems

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  1. Workshop for Non-Regulatory Central Banks, Bank of England, March 2011, London Discussant comments on:Quantifying interlinkagesbetween banks and banking systems 30 March 2011 Harry Leinonen The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. Harry Leinonen

  2. General findings: Systemic risk has increasedThe risk of contagion has increased The data areavailable in banks’ ICT systems and need to be transferred to authorities’ systems Interbank market and international capital market has grown Capital is more efficiently employed, but risks increase during crises Harry Leinonen

  3. Analyses based on • Available interbank direct credit data • Banks’ risk mitigation solutions are not covered • Collateralisation • Bilateral offsetting • Multilateral netting • Continuous netting streams Banks’ risk mitigation solutions have major impact in reducing large gross exposures to reasonable net exposures (when mitigation solutions are legally enforceable) Harry Leinonen

  4. In a homogeneous market all banks will failindependent of contagion when shock > own capital Shock Bank 3 Identical investment portfolio risks Bank 2 Bank 1 Risks reside in portfolios and are materialized by external shocks Harry Leinonen

  5. In a heterogeneous market with strongly interlinked banks, all banks will faildue to contagion when ∑ shock > ∑ own capital Shock Same total investments but non-identical individual investment portfolio risks Bank 3 Bank 2 Bank 1 Interbank linkages distribute shocks among banks and their portfolios. When risks are realized in an interlinked network, it becomes a game of loss-sharing! Harry Leinonen

  6. Systemic risks and contagioncan be viewed as a shock absorbing loss-sharing mechanismamong banks Harry Leinonen

  7. Somebody has to coverthe losses whenassets shrink in bank’s balance sheet Shock Assets Liabilities Protected (guaranteed ) deposits Market funding (unprotected) Interbank credits Central bank credits Own capital After shareholders, creditors will coverthe rest. What are the rules for loss-sharing? Harry Leinonen

  8. Some creditors can secure their credits Assets Liabilities Protected (deposit guaranteed) deposits ? Market participantcollateral, offsetting and multilateralnetting Market funding (non-guaranteed) Interbank collateral, offsetting and multilateralnetting Interbank credits Central bank credits Central bankcollateral Own capital Applied credit risk mitigation mechanisms increase the share of credit losses of other creditors in crises, especially for those providing deposit guarantees Harry Leinonen

  9. there is an upside and a downsidein interbank credits andthese need to be balanced for optimality. Interbank credits allocate capital efficiently anddistribute the returns among banksbut risks are also shared Harry Leinonen

  10. Cross-border contagion with different investment portfolios and bank risksdue to different public policies Cross-border benefits and risks Cross-border benefits and risks Country A Country B Country N Crises induce protect- ionism? Are cross-border risks priced correctly? Are risk mitigation procedures neutral/symmetric? How open should the global market be? How homogeneous should national policies be? Allocation barriers will affect allocation benefits! Harry Leinonen

  11. Two statuses (mindsets) in the liquidity market Expansive = Reinvesting Contractive = Hoarding Change of status producesa shock Slow recycling Rapid recycling (Compare with consumption in inflationary and deflationary economies) Changing mindset from expansive to hoarding is a very rapid process, while the opposite seems to be very slow Harry Leinonen

  12. Strong banks thrive on weak banksduring liquidity crises • Weak banks with liquidity problems will become dependent on other banks and especially central banks • Excessive liquidity will pile up instrong banks when weak banks’ liquidity is used for bank runs • Strong banks can buy assets at fire sale prices • Strong banks have an interest to see competitors disappear Back to normal, only via sufficient long-term stability in the market Banks need to be perceived again as practically equally strong! Harry Leinonen

  13. Systemic risk = contagion = loss-sharing among banks can be affected via a) limiting banks’ overall risks . b) requiring more own capital . c) changing interbank risk mitigation rules( d) reducing size ofexternal shocks?)What is the desiredloss-sharing model? = What kind of resolution mechanisms are applied? Harry Leinonen

  14. However,banks should be the professionalsforassessing credit risksalso on those related to other banks?So in the end,are the current problems basically due to wrong type of risk-taking incentives? Should risk-taking incentives closer to those of authorities be enforced on banks instead of circumventable rules? Harry Leinonen

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