TOPIC: Bank Liquidity Crises
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Q1.How interbank connections can affect the exposure of individual banks and the banking system to liquidity risk
Interbank connection involves many banks coming together and operating together where the interbank network is used by the financial institutions to trade currencies among them. The liquidity risk involves a financial risk for a certain period when financial assets and commodities cannot be sold quickly enough in the market without impacting the market price (Calomiris and Carlson, 2017). These interbank connections affect the exposure of individual banks, and banking systems where these extend of interconnection leads to the collapse of some banks in case their correspondents are affected. This extends of interconnection makes the correspondents’ banks less prudent in managing liquidity risk, and this exposes the individual banks to liquidity risk.
The interbank connection affects the individual banks to liquidity risk by sudden withdrawals of the interbank deposits. This makes the correspondent banks in illiquid positions, and this exposes the own banks to liquidity risk (Vodova, 2011). This is facilitated by interbank, which alters banks’ incentive to manage their exposure to liquidity risk. These withdrawals of deposits by the interbank connection make the individual banks be in an unstable position of dealing with the financial crisis, and this makes the own banks be exposed to liquidity risk, and this, in turn, affects the banking system.
Lack of comprehensive interbank information makes the individual banks lack access to relevant information. This makes the banks not aware of the measures taken by the interbank networks. This exposes their banks to liquidity risk, and this affects the banking system (Bonfim and Kim, 2012). This is facilitated where the interbank information is not comprehensive, and this makes the individual banks lack details on how to handle shocks from the interbank, and this promoted by the structure used by the interbank, and this exposes the individual banks into liquidity risks.
Contagion, through direct contractual obligations between individual banks, which is facilitated by interbank, makes the individual correspondent banks get exposed to liquidity risk and also influences the banking system (Bessis, 2011). This is achieved when the interbank connections transmit shocks where balance sheets show the probability of banks’ failure where this probability spreads even to other banks that have a lower chance of closing, and this exposes individual banks to liquidity risk and impacts the banking system.
These interbank connections offer greater exposure to interbank deposits among its banks. This encourages banks to increase their capital ratios, making the interbank deposits lower the risk management decisions made to reduce liquidity risk (Upper and Worms, 2004). These interbank deposits affect the liquidity risk, and this has increased banking panic among the individual banks since they have reduced buffers. This weakened the banks’ incentive to safeguard against interbank liquidity risk, and this exposes the individual banks to the liquidity risk, affecting the banking systems.
The interbank connection affects individual banks by amplifying the shocks where this is enhanced by the size and concentration of network members involved in the interbank connection and network (Georg, 2013). Through the amplification of shocks makes the individual banks get affected as a result of the other correspondent banks since the magnitude of shocks hitting the system is magnified and thus affecting individual banks and thus affecting the banking system, exposing them to liquidity risk. The interbank connection affects individual banks where the collapse of the interbank lending market makes individual banks scramble to hoard reserves as a means of self- insurance and this exposes individual banks to liquidity risk since they are not insured against any kind of shock, and this makes the individual banks get exposed to liquidity risk, and this interferes with the banking systems.
The interbank connection affects the individual banks where the presumable closure of correspondent banks interferes with the network ties. This affects the interbank network, and this affects the other individual banks bound by the same interbank system (Carlson, 2005). Since these banks are correspondent in a way that impacts a particular bank, the impact travels all around and affects the other banks. That’s why the presumable closure of a correspondent bank in the interbank connection affects the individual banks. This exposes the individual banks to liquidity risk, and this affects the banking system.
Interbank connection affects the individual banks by their relationship to the corresponding banks. This lousy relationship makes the individual banks receive inadequate and inadequate information from the interbank network, and this makes the individual banks get exposed to liquidity risk since these banks do not have adequate information that will help them handle shocks that result from liquidity crisis (Calomiris, Jeremski and Wheelock, 2019). This affects the banking systems and thus exposing individual banks to liquidity risk. The functional relationship between the interbank and the correspondent banks helps these individual banks absorb shocks that result from the financial crisis, which makes them handle liquidity crises, but the lousy relationship predicts otherwise.
Q2. The effects on the banking system of a central banker that acts as a lender of the last resort
During the financial crisis, the central banks act as lenders of the last resort, where they lend money to the individual banks to sustain the country’s economic status and prevent inflation. The banking system was reformed as an impact of the financial crisis, where the central bank became the solution to the financial crisis. The central banks in which the effect of the banking system helps lower long-term interest rates and this encourages investment (Epstein, 2001). Through the lowered rates, many people will be in a position of acquiring loans, and these help them invest the money in businesses. These businesses, in turn, result in the country’s economic growth even in times of financial crisis. The central bank also encourages banks to give out more loans to its citizens since the bank’s reserves are already swollen. Through the investments, the country’s economy remains healthy and more a bit stable. This bank also regulates banks and also provides financial services and also stabilizes the nation’s currency. This bank also acts as the clearinghouse of the interbank transactions, thus acting as the lender of the last resort. This banking system has been influenced by how the central bank implements monetary policy and makes proper adjustments between the demand for and supply for money.
The banking system of the central bank was reformed during the financial crisis, where the deposit insurance mechanism was instituted. This effect is aimed at eliminating collective movements of panic that occur to banks, especially during a financial crisis. This deposit insurance gives banks confidence that they are secured even during the economic crisis since they have been insured. These banking systems were also reformed in such a way to prevent the banks from taking many risks, and this was enhanced through the Glass-Steagall Act, which separated commercial banking from investment banking (Goodhart, 1988). This made the banking system effective since the commercial banks would not take too many risks since they are separated from investing. This makes the banking system less fragile and thus preventing a massive scale banking crisis in the country. The banks’ failure to take more risks makes the commercial banks offer more loans to individuals since the central banks are continuously offering loans to the banks. This banking system applies the moral hazard idea where the insured banks or agents will not take more risks, and they will avoid the threats against which they have been insured. This banking system reform affects the central bank since the central bank can deal with the country’s financial crisis.
The banking system of the central bank is situated in such a way that it can absorb all kinds of shock resulting from the country’s financial crisis. This is because the central bank, which is the last resort’s lender, should be in a position to deal with any business problem encountering the country (Schinasi, 2004). This banking system helps the central bank stabilize the country’s economy and regulates money flow through the well- established and implemented monetary policy. The central bank acts as the last resort in lending money through the banking system, especially in a financial crisis where all the other lending institutions like commercial banks are not in a position of offering loans to the individuals. And so the central bank act as the last option and that’s why every country has its central bank playing similar roles like all other central banks in the world since this becomes the only option for the state to sustain its economic status and also improve the economic growth of the country.
The banking system of the central bank, in a liquidity crisis, responds to the banks by lending money to the banks that are illiquid but more solvent. This is lending is usually done against good collateral where the banks which are given the cash refunds it when their banks are in a sustainable position and their activities back into normal after the crisis ceases. This helps provide financial services needed in the country during the crisis period (Diamond and Rajan, 2012). Through this banking system which the central bank oversees, this helps the central bank control the money supply in the country, and this helps create a balance between the demand for and the amount of money thus preventing inflation in the country, and this makes more people invest more, and this makes them open more business. This helps reduce the country’s unemployment rate since the newly opened businesses can accommodate the more unemployed individuals, thus reducing the unemployment rate. This is facilitated by the banking system of the central bank. This banking system has brought along so many effects on the central bank where this bank can curb the shocks that result from a liquidity crisis in the country or even globally by managing the exchange rates.
Q3. Discuss whether regulations, in addition to a lender of last resort, are needed for the efficient operation of the financial system.
Regulations are crucial in the central bank since they are needed for the efficient operation of the financial system. These regulations ensure efficient service of the financial system by reducing the risk to which the creditors can be exposed. This helps reduce the risk of disruption that arises from adverse trading conditions that are caused by the banks by causing multiple bank failure (Hentschel and Smith, 1997) This is achieved through the regulations done by the central bank, and this makes the operation of the financial system more efficient since the rules will have helped reduce risks which may occur. These regulations also support the commercial banks, who are the central bank’s dependants in minimizing the dangers they may encounter by separating them from investment banking. This helps them avoid more risks.
The regulations in the central bank are significant and are needed for the efficient operation of the financial system since these regulations help reduce competition in the banking system. This is ensured since when this competition is left to increase, it affects the less efficient firms since the costs are higher, and they are not in a position of being in the range (Bergman, 2003). Through increased competition, these less efficient firms are highly punished where they experience reduced profits and also market shares, unlike the suitable stocks. This regulation ensures that levels of competition are so low that their impact cannot be felt, and this makes them less efficient firms be in a position of maximizing their profits and maintaining the market shares. Through this regulation and its importance in reducing competition, the operation of the financial system becomes more active.
The regulations in the central bank are necessary since they help the bank maintain stability through the monetary policy implemented. This helps achieve price stability, which leads to inflation, which is low and stable. This stability helps the central bank, which is the lender of the last resort to manage economic fluctuations, ensuring security in the economy (Padoa, 2003). This monetary policy is conducted by the central bank, where it adjusts the supply of money, which is done through open market operations. This stability, created through the regulations in the central bank, helps the financial system of the bank become more productive. Thus it’s able to perform its roles efficiently and effectively.
The regulations in the central bank are very crucial in the efficient operation of the financial system since they help prevent taxpayers from moral hazards that are caused by individual decisions. These moral hazards are prevented where the central bank does proper allocation of losses, which allows reducing moral hazards, which, in turn, helps protect the taxpayers (Hoening, 1996). These are facilitated by bail-outs done by the central banks since these prevent the taxpayers’ money from being misused by the organizations that feel are too big to fail. Through these regulations, central banks ensure that the taxpayer is prevented from moral hazards, which makes operation of the financial system more efficient. These moral hazards are known to encourage indebtedness. So this prevention makes economic policies more effective, thus being in an excellent position in offering their services efficiently and effectively.
These regulations in the central bank are beneficial since they help prevent financial crime where the customers are protected from financial fraud, which may include unethical mortgages or even other financial products. These regulations help reduce the banks’ use for criminal purposes, such as laundering the proceeds of crime, to protect the confidentiality of the bank (Johnston and Nedelescu, 2006). This is achieved where the central banks put regulations to deal with money crimes. These regulations help protect the customers from fraud and also establishes fair treatment among all the customers, and this is achieved through CSR. This prevention of financial crime ensures effectiveness in the financial systems, thus performing their responsibilities with ease and efficacy. Regulations in the central bank ensure market efficiency, and this is promoted by regulated interest rates that are put when one is acquiring a loan. This makes the market efficient since the bank has an appropriate interest rate put in place, which prevents inflation in the market (Levine, 1996). This prevents the banks from increasing interest rates anyhow and thus making the market efficient. Through the regulation, the financial system becomes more efficient and effective since a specific pattern of interest rate is adhered to.
References
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