Understanding Systemic Risk: The Trade-Offs Between Capital, Short-Term Funding And Liquid Asset Holdings
Source: Bank of Canada
The authors offer a multi-period systemic risk assessment framework with which to assess recent liquidity and capital regulatory requirement proposals in a holistic way. Following Morris and Shin (2009), the authors introduce funding liquidity risk as an endogenous outcome of the interaction between market liquidity risk, solvency risk, and the funding structure of banks. To assess the overall impact of different mix of capital and liquidity, the authors simulate the framework under a severe but plausible macro scenario for different balance-sheet structures. Of particular interest, the authors find that capital has a decreasing marginal effect on systemic risk; increasing capital alone is much less effective in reducing liquidity risk than solvency risk.