Ebook Measuring Systemic Funding Liquidity Risk in the Interbank Foreign Currency Lending Market
Emerging markets suffered from massive capital outflows during the 2008 global financial crisis. The spillover of the global financial crisis to emerging markets has varied according to the degree of their openness to the international capital markets and the structure of the financial system. Indeed, emerging countries with large exposure to international banks and capital markets faced challenges in rolling over their foreign currency debt. Among the emerging markets, in particular, the Korean financial markets were suffered much more damaged from captial outflows associated with financial deleveraging by international banks and foreign investors. Especially after the failure of Lehman Brothers, the rising concern about counterparty risk in addition to funding liquidity risk led to further dislocations in the Korean financial market.
Why has the Korean financial system been so vulnerable to the rollover risk of foreign currency debt? An immediate answer to this question is the high proportion of short-term foreign debt. For the past decade, the proportion of short-term foreign debt had sharply increased. The recent rise of short-term debt was mainly attributable to branches of foreign banks, but domestic banks faced the most severe shortages in the foreign currency liquidity. Thus, the high proportion of short-term foreign debt cannot fully account for Korea’s exceptionally vulnerable situation during the recent global financial crisis. Another possible answer may be the increasing interconectedness between banks which causes difficulties in rolling over liabilities spill over to the financial system as a whole. In order to detect the systemic linkages through which financial spillovers occur, it is necessary to look into the interbank foreign currency lending market in detail.
There has been a substantial body of work that examines interbank exposures as a possible source of financial spillover, see Allaen and Babus(2009) for a detailed survey. Allen and Gale (2000) model financial contagion via interbank exposures and investigate how the banking system responds to liquidity preference shocks when banks are connected under different interbank market structures. They show that better connected networks are more robust since the proportion of the losses in one bank’s portfolio is spread to more banks. Freixas et al. (2000) and Dasgupta (2004) also explore how linkages between banks, represented by interbank credit lines or crossholding of deposits, can lead to contagious effects. Minguez-Afonso and Shin (2007) use lattice theoretic methods to study liquidity and systemic risk in high-value payment systems and interbank payment systems. Gai and Kapadia (2007) applies statistical techniques from network theory to develop a general model of contagion in complex financial systems. Much of this literature finds that greater connectivity reduces the likelihood of widespread default as with Allen and Gale (2000).
Another strand of the literature focuses on the impact of indirect linkages on financial spillover. Lagunoff and Schreft (2001) construct a dynamic, stochastic game-theoretic model where agents hold diversified portfolios that link their financial positions to those of other agents. De Vries (2005) shows that there is dependency between banks’ portfolios, given the fat tail property of the underlying assets, and this carries the potential for systemic breakdown. Cifuentes et al. (2005) incorporate two channels of contagion direct balance sheet interconnections among financial institutions and contagion via changes in asset prices which may interact with externally imposed solvency requirements to generate amplified endogenous responses. These studies share the same finding that financial systems are inherently fragile.
Besides the theoretical studies, there is a growing empirical literature which analyzes contagion risk through interbank connections for particular countries. Most of these papers use balance sheet information to model the interbank linkages in the form of an interbank lendig matrix. The contagion effect arising from interbank lending is assessed by simulating the breakdown of a single bank. Recent examples are Sheldon and Maurer (1998) for Switzerland, Furfine (2003) for the United States, Wells (2002) for the United Kingdom, Boss et al. (2004) for Austria, Upper and Worms (2004) for Germany, Degryse and Nguyen (2007) for Belgium, Mistrulli (2007) for Italia, Iyer and Peydro-Alcalde (2007) for India, and Cocco et al. (2009) for Portugal. These papers find that the banking systems demonstrate high resilience, even to large shocks. Most of them, however, focus on the credit or solvency risk of a bank failure and usually do not consider the funding liquidity risk, such as the drying up of credit lines.
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