Collaborative Research: Financial Network Reactions to Regulations and Interventions

University Of Pennsylvania, Philadelphia PA

Investigators

Abstract

Abstract The role of government interventions and regulations in the operation of the financial sector has important implications for the economy. This project explores how banking regulations and government interventions affect the interaction of banks. The project uses historical and modern data sources to analyze the changes in interbank relations in changing regulatory policy environments. The project considers that a banking network adjusts to the anticipation of government support in ways that makes the banking system more reliant on government support and more prone to less likely catastrophic events. Second, the project looks at the effects of opacity versus transparency by considering that banks operating with opacity support each other at times of distress without disturbing the broader economy and creating panics. Finally, the research looks at the implications of central clearing counterparties. Central clearing counterparties (CCP) are institutions that take counterparty risk to transactions and provide clearing and settlement services for them. This research explores how central clearing of derivatives enhances coordination among banks and prevents crises which can arise as coordination failures on clearing obligations. This project explores several research questions on the banking system and central clearing policies. First question explores how public liquidity provision affects the way banks relate to each other. The project constructs a theory on the effects of the public liquidity provisions by the Federal Reserve System (FED) and test the predictions of this theory utilizing historical data on the establishment of the FED in 1913. This research indicates that public liquidity provision by the FED indirectly creates the first shadow banking sector in the U.S., so that an unexpected contraction in public liquidity can induce systemic risk. Second research question explores recent regulations that mandate central clearing of derivatives and how these regulations affect the exposure and interconnections of different banks. This research constructs a theoretical model of derivatives which highlights a tradeoff. On the one hand, CCPs have the benefit of enhancing coordination across banks. On the other hand, CCPs operate partly as an exchange that improves market transparency, reducing bank insurance. Using detailed data that includes exposures of all banks in the U.S. to all other financial and non-financial institutions, this research explores how these tradeoffs interact in different layers of the banking network. This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.