In response to the recent severe financial crisis and the worst recession since the Great Depression, the U.S. Congress enacted and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) in July 2010. An important objective of DFA is to mitigate the threat to financial stability posed by systemically important financial institutions, or SIFIs. Should any of these institutions fail, the entire financial industry would be adversely affected and most likely the broader economy as well. The Financial Stability Oversight Council (FSOC) was established by DFA to identify any and all SIFIs, which are then subjected to enhanced prudential supervision by the Federal Reserve Board. Section 165 of DFA, however, requires that bank holding companies (BHCs) with $50 billion or more in consolidated assets must be designated as SIFIs.
{"title":"Designating Bank SIFIs: An Arbitrary Threshold for Risk","authors":"James R. Barth, Moutusi Sau","doi":"10.2139/SSRN.2688680","DOIUrl":"https://doi.org/10.2139/SSRN.2688680","url":null,"abstract":"In response to the recent severe financial crisis and the worst recession since the Great Depression, the U.S. Congress enacted and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) in July 2010. An important objective of DFA is to mitigate the threat to financial stability posed by systemically important financial institutions, or SIFIs. Should any of these institutions fail, the entire financial industry would be adversely affected and most likely the broader economy as well. The Financial Stability Oversight Council (FSOC) was established by DFA to identify any and all SIFIs, which are then subjected to enhanced prudential supervision by the Federal Reserve Board. Section 165 of DFA, however, requires that bank holding companies (BHCs) with $50 billion or more in consolidated assets must be designated as SIFIs.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"86 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-11-09","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"123812641","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We investigate long-run stock–bond correlation using a model that combines the dynamic conditional correlation model with the mixed-data sampling approach and allows long-run correlation to be affected by macro-finance factors (historical and forecasts). We use macro-finance factors related to inflation and interest rates, illiquidity, state of the economy, and market uncertainty. Macro-finance factors, particularly their forecasts, are good at forecasting long-run stock–bond correlation. Supporting the flight-to-quality phenomenon, long-run correlation tends to be small and negative when the economy is weak.
{"title":"Macro-Finance Determinants of the Long-Run Stock-Bond Correlation: The DCC-MIDAS Specification","authors":"Hossein Asgharian, C. Christiansen, A. Hou","doi":"10.2139/ssrn.2423361","DOIUrl":"https://doi.org/10.2139/ssrn.2423361","url":null,"abstract":"We investigate long-run stock–bond correlation using a model that combines the dynamic conditional correlation model with the mixed-data sampling approach and allows long-run correlation to be affected by macro-finance factors (historical and forecasts). We use macro-finance factors related to inflation and interest rates, illiquidity, state of the economy, and market uncertainty. Macro-finance factors, particularly their forecasts, are good at forecasting long-run stock–bond correlation. Supporting the flight-to-quality phenomenon, long-run correlation tends to be small and negative when the economy is weak.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"11 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-11-04","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"133880899","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
The aftermath of the 2008-09 U.S. financial crisis has been characterized by regulatory intervention of unprecedented scale. Although the necessity of a realignment of incentives and constraints of financial markets participants became a shared posterior after the near collapse of the U.S. financial system, considerable doubts have been subsequently raised on the welfare consequences of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and its various subcomponents, such as the Volcker Rule. The possibility of permanently inhibiting the market making capacity of large banks, with dire consequences in terms of under-provision of market liquidity, has been repeatedly raised. This paper presents systematic evidence from four different estimation strategies of the absence of breakpoints in market liquidity for fixed-income asset classes and across multiple liquidity measures, with special attention given to the corporate bond market. The analysis is performed without imposing restrictions on the exact dating of breaks (i.e. allowing for anticipatory response or lagging reactions to regulation) and focusing both on levels and dynamic latent factors. We report both single breakpoint and multiple breakpoint tests and analyze the liquidity of corporate bonds matched to their main underwriters making markets on those assets. Post-crisis U.S. regulatory intervention does not appear to have produced structural deteriorations in market liquidity.
{"title":"Regulation and Market Liquidity","authors":"Francesco Trebbi, Kairong Xiao","doi":"10.2139/ssrn.2687465","DOIUrl":"https://doi.org/10.2139/ssrn.2687465","url":null,"abstract":"The aftermath of the 2008-09 U.S. financial crisis has been characterized by regulatory intervention of unprecedented scale. Although the necessity of a realignment of incentives and constraints of financial markets participants became a shared posterior after the near collapse of the U.S. financial system, considerable doubts have been subsequently raised on the welfare consequences of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and its various subcomponents, such as the Volcker Rule. The possibility of permanently inhibiting the market making capacity of large banks, with dire consequences in terms of under-provision of market liquidity, has been repeatedly raised. This paper presents systematic evidence from four different estimation strategies of the absence of breakpoints in market liquidity for fixed-income asset classes and across multiple liquidity measures, with special attention given to the corporate bond market. The analysis is performed without imposing restrictions on the exact dating of breaks (i.e. allowing for anticipatory response or lagging reactions to regulation) and focusing both on levels and dynamic latent factors. We report both single breakpoint and multiple breakpoint tests and analyze the liquidity of corporate bonds matched to their main underwriters making markets on those assets. Post-crisis U.S. regulatory intervention does not appear to have produced structural deteriorations in market liquidity.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-11-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"129635784","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Non-U.S. banks with relatively low capital ratios appear to temporarily remove an average of $170 billion from the U.S. market for tri-party repurchase agreements (repo) before each quarter-end in order to appear safer and less levered. This amount is more than double the $76 billion market-wide drop in tri-party repo during the turmoil of the 2008 financial crisis and represents about 10% of the entire tri-party repo market. Such window dressing-induced deleveraging spills over into agency bond markets and money market funds and affects market liquidity each quarter.
{"title":"Regulatory Arbitrage in Repo Markets","authors":"Benjamin Munyan","doi":"10.2139/ssrn.2685592","DOIUrl":"https://doi.org/10.2139/ssrn.2685592","url":null,"abstract":"Non-U.S. banks with relatively low capital ratios appear to temporarily remove an average of $170 billion from the U.S. market for tri-party repurchase agreements (repo) before each quarter-end in order to appear safer and less levered. This amount is more than double the $76 billion market-wide drop in tri-party repo during the turmoil of the 2008 financial crisis and represents about 10% of the entire tri-party repo market. Such window dressing-induced deleveraging spills over into agency bond markets and money market funds and affects market liquidity each quarter.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"51 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-10-29","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"117206867","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
ABSTRACT: This study examines the effects of the mandatory adoption of International Financial Reporting Standards (IFRS) on the contract terms of bank loans in a global setting. Using a difference-in-differences design based on 26,474 bank loans in 31 countries during the 2000–2011 period, we find that borrowers who mandatorily adopt IFRS experience an increase in interest rates, a reduction in the use of accounting-based financial covenants, an increase in the likelihood that a loan is collateralized, a reduction in loan maturity, and an increase in the fraction of a loan retained by lead arrangers. These findings are robust to the removal of the 2008 financial crisis from our analysis, as well as to the matching of IFRS and non-IFRS borrowers on various country- and firm-level characteristics. Furthermore, we find that these changes are more pronounced for borrowers with greater financial reporting changes, as well as those with poorer accounting quality after IFRS adoption. JEL Classifications: G15; ...
{"title":"The Effects of Financial Reporting on Bank Loan Contracting in Global Markets: Evidence from Mandatory IFRS Adoption","authors":"Tai-Yuan Chen, C. Chin, Shiheng Wang, Chun Yao","doi":"10.2308/JIAR-51031","DOIUrl":"https://doi.org/10.2308/JIAR-51031","url":null,"abstract":"ABSTRACT: This study examines the effects of the mandatory adoption of International Financial Reporting Standards (IFRS) on the contract terms of bank loans in a global setting. Using a difference-in-differences design based on 26,474 bank loans in 31 countries during the 2000–2011 period, we find that borrowers who mandatorily adopt IFRS experience an increase in interest rates, a reduction in the use of accounting-based financial covenants, an increase in the likelihood that a loan is collateralized, a reduction in loan maturity, and an increase in the fraction of a loan retained by lead arrangers. These findings are robust to the removal of the 2008 financial crisis from our analysis, as well as to the matching of IFRS and non-IFRS borrowers on various country- and firm-level characteristics. Furthermore, we find that these changes are more pronounced for borrowers with greater financial reporting changes, as well as those with poorer accounting quality after IFRS adoption. JEL Classifications: G15; ...","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"226 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-10-19","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"116156161","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
The failure of Lehman Brothers uncovered a shocking fact that after six decades of automation there are no global standards for the identity of financial market participants nor their financial products. Bankruptcy attorneys and forensic accountants tried to understand Lehman’s exposure to others and others’ exposure to Lehman. There was no consistency in identifying Lehman as a counterparty; no understanding of what relationships Lehman had with others; no mechanism to associate all of Lehman’s products and businesses into a total view of the exposure others had to Lehman should it fail. In effect, no one… not regulators nor creditors nor counterparties could see into Lehman’s exposure to risk. This paper illuminates a fundamental component of the financial system that goes largely unrecognized as a key pillar of finance, non-standardized financial transaction data. Financial transactions lack unique, universal and unambiguous identifying codes for the supply chain of financial market participants and the products they manufacture, issue, own, process, and trade. Imagine if every supermarket had a different barcode for the same product on its shelves or a different code for the producer or supplier of the product. Walmart, FedEx and Amazon could not exist. This failure has exasperated researchers, analysts, financial institutions and regulators who are forced to map and scrub this data before aggregating financial transactions for performance, risk and regulatory reporting. Considerable risks, costs and delays in receiving payment are inherent in this reconciliation process. This paper explores the history, current status, issues, work yet to be done, and recommendation by the author to create financial industry identity standards. The Barcodes of Finance will enable an automated means to aggregate risk data so firms can reduce risk and costs, and regulators can oversee the largest systemically important global financial firms.
{"title":"Risk, Data and the Barcodes of Finance","authors":"Allan D. Grody, Peter J. Hughes","doi":"10.2139/SSRN.2544356","DOIUrl":"https://doi.org/10.2139/SSRN.2544356","url":null,"abstract":"The failure of Lehman Brothers uncovered a shocking fact that after six decades of automation there are no global standards for the identity of financial market participants nor their financial products. Bankruptcy attorneys and forensic accountants tried to understand Lehman’s exposure to others and others’ exposure to Lehman. There was no consistency in identifying Lehman as a counterparty; no understanding of what relationships Lehman had with others; no mechanism to associate all of Lehman’s products and businesses into a total view of the exposure others had to Lehman should it fail. In effect, no one… not regulators nor creditors nor counterparties could see into Lehman’s exposure to risk. This paper illuminates a fundamental component of the financial system that goes largely unrecognized as a key pillar of finance, non-standardized financial transaction data. Financial transactions lack unique, universal and unambiguous identifying codes for the supply chain of financial market participants and the products they manufacture, issue, own, process, and trade. Imagine if every supermarket had a different barcode for the same product on its shelves or a different code for the producer or supplier of the product. Walmart, FedEx and Amazon could not exist. This failure has exasperated researchers, analysts, financial institutions and regulators who are forced to map and scrub this data before aggregating financial transactions for performance, risk and regulatory reporting. Considerable risks, costs and delays in receiving payment are inherent in this reconciliation process. This paper explores the history, current status, issues, work yet to be done, and recommendation by the author to create financial industry identity standards. The Barcodes of Finance will enable an automated means to aggregate risk data so firms can reduce risk and costs, and regulators can oversee the largest systemically important global financial firms.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"144 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-09-28","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"116883564","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We study the impact of shadow banking on optimal liquidity regulations in a Diamond-Dybvig maturity mismatch environment. A pecuniary externality arising out of the banks' access to private retrade renders competitive equilibrium inefficient. Shadow banking provides an outside option for banks, which adds a new constraint in the mechanism design problem that determines the optimal allocation. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy in this economy. During expansions, i.e., when the return on illiquid assets is high, the threat of investors flocking out to shadow banking pins down optimal policy rates. These rates do not respond to business cycle fluctuations as long as the economy stays out of recession. In recessions, when the return on illiquid assets is low, optimal liquidity regulation policy becomes sensitive to the business cycle: both policy rates are reduced, with deeper discounts given in deeper recessions. In addition, when high aggregate demand for liquidity is anticipated, the IOR rate is reduced and, unless the shadow banking constraint binds, the tax rate on illiquid assets is increased.
{"title":"Optimal Liquidity Regulation with Shadow Banking","authors":"Borys Grochulski, Yuzhe Zhang","doi":"10.2139/SSRN.2673540","DOIUrl":"https://doi.org/10.2139/SSRN.2673540","url":null,"abstract":"We study the impact of shadow banking on optimal liquidity regulations in a Diamond-Dybvig maturity mismatch environment. A pecuniary externality arising out of the banks' access to private retrade renders competitive equilibrium inefficient. Shadow banking provides an outside option for banks, which adds a new constraint in the mechanism design problem that determines the optimal allocation. A tax on illiquid assets and a subsidy to the liquid asset similar to the payment of interest on reserves (IOR) constitute an optimal liquidity regulation policy in this economy. During expansions, i.e., when the return on illiquid assets is high, the threat of investors flocking out to shadow banking pins down optimal policy rates. These rates do not respond to business cycle fluctuations as long as the economy stays out of recession. In recessions, when the return on illiquid assets is low, optimal liquidity regulation policy becomes sensitive to the business cycle: both policy rates are reduced, with deeper discounts given in deeper recessions. In addition, when high aggregate demand for liquidity is anticipated, the IOR rate is reduced and, unless the shadow banking constraint binds, the tax rate on illiquid assets is increased.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"42 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-09-28","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"129984160","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
The optimal reinsurance contract is investigated from the perspective of an insurer who would like to minimise its risk exposure under Solvency II. Under this regulatory framework, the insurer is exposed to the retained risk, reinsurance premium and change in the risk margin requirement as a result of reinsurance. Depending on how the risk margin corresponding to the reserve risk is calculated, two optimal reinsurance problems are formulated. We show that the optimal reinsurance policy can be in the form of two layers. Further, numerical examples illustrate that the optimal two-layer reinsurance contracts are only slightly different under these two methodologies.
{"title":"Optimal Non-Life Reinsurance under Solvency II Regime","authors":"Alexandru V. Asimit, Yichun Chi, Junlei Hu","doi":"10.2139/ssrn.2568316","DOIUrl":"https://doi.org/10.2139/ssrn.2568316","url":null,"abstract":"The optimal reinsurance contract is investigated from the perspective of an insurer who would like to minimise its risk exposure under Solvency II. Under this regulatory framework, the insurer is exposed to the retained risk, reinsurance premium and change in the risk margin requirement as a result of reinsurance. Depending on how the risk margin corresponding to the reserve risk is calculated, two optimal reinsurance problems are formulated. We show that the optimal reinsurance policy can be in the form of two layers. Further, numerical examples illustrate that the optimal two-layer reinsurance contracts are only slightly different under these two methodologies.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"516 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-09-26","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"123086702","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
It is often argued that the popularity of Alternative Investment Market (AIM) in terms of higher number of listings relative to the Main Market (MM) is mainly due to the strict listing requirements in the MM. During the 1995 to 2014 period, 577 out of 1143 AIM listed firms did not qualify for MM listing, but the rest (566) that raised equity in AIM could have joined the MM. This raises the question why firms that meet the heavier regulatory environment of the MM choose the AIM, a lighter regulatory environment. This paper subjects this question to a comprehensive investigation and finds that the market choice is a self-selection decision. The two markets attract companies with different characteristics, and dissimilar post-listing investment and financing priorities. The evidence also shows that smaller and younger companies choose to be listed on the AIM due to lower listing and on-going costs. Heckman Selection models addressing the important question of what would have been the operating performance if AIM companies joined MM indicate that AIM companies would not perform better had they selected to go public in the MM.
{"title":"Why Firms Favour the AIM When They Can List on Main Market?","authors":"John A. Doukas, Hafiz Hoque","doi":"10.2139/ssrn.2656806","DOIUrl":"https://doi.org/10.2139/ssrn.2656806","url":null,"abstract":"It is often argued that the popularity of Alternative Investment Market (AIM) in terms of higher number of listings relative to the Main Market (MM) is mainly due to the strict listing requirements in the MM. During the 1995 to 2014 period, 577 out of 1143 AIM listed firms did not qualify for MM listing, but the rest (566) that raised equity in AIM could have joined the MM. This raises the question why firms that meet the heavier regulatory environment of the MM choose the AIM, a lighter regulatory environment. This paper subjects this question to a comprehensive investigation and finds that the market choice is a self-selection decision. The two markets attract companies with different characteristics, and dissimilar post-listing investment and financing priorities. The evidence also shows that smaller and younger companies choose to be listed on the AIM due to lower listing and on-going costs. Heckman Selection models addressing the important question of what would have been the operating performance if AIM companies joined MM indicate that AIM companies would not perform better had they selected to go public in the MM.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"1 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-08-25","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"124439445","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We analyze the efficiency of the liquidity flows provided to recover stability in a distressed market. Using a theoretical framework, our analysis focuses on the incentives of financial institutions, namely, the incentive for arbitrage profits, the disincentive from liquidity risk, and market manipulation incentives. We show that, depending on market conditions, financial institutions determine their optimal investment strategy based on the three incentives mentioned. This paper explains how the market restabilizes from a distressed state. The main findings are as follows: High deterioration risk and strong trend sensitivity decrease institutions’ investments; when an institution has sufficient risk-bearing capacity, it trades against a market shock, but when it does not, it follows the shock; as more funding is injected into institution, the more it invests capital in risky assets while reducing market exposure; and competition among institutions contributes to market stability stimulating institutions’ investments. Our findings help to explain financial issues such as the flight to quality, liquidity dry-ups, market manipulation, asset fire sales, and shock amplification in a distressed market. In addition, they provide important implications for policymakers endeavoring to recover market stability. We suggest that policymakers lessen the market power of a few financial institutions by spreading private information across the market at lower information costs and by stimulating competition by injecting public funds into as many institutions as possible.
{"title":"Limited Market Power and Institutions’ Incentives in a Distressed Market","authors":"Sangwook Sung, Hoon Cho","doi":"10.2139/ssrn.2628497","DOIUrl":"https://doi.org/10.2139/ssrn.2628497","url":null,"abstract":"We analyze the efficiency of the liquidity flows provided to recover stability in a distressed market. Using a theoretical framework, our analysis focuses on the incentives of financial institutions, namely, the incentive for arbitrage profits, the disincentive from liquidity risk, and market manipulation incentives. We show that, depending on market conditions, financial institutions determine their optimal investment strategy based on the three incentives mentioned. This paper explains how the market restabilizes from a distressed state. The main findings are as follows: High deterioration risk and strong trend sensitivity decrease institutions’ investments; when an institution has sufficient risk-bearing capacity, it trades against a market shock, but when it does not, it follows the shock; as more funding is injected into institution, the more it invests capital in risky assets while reducing market exposure; and competition among institutions contributes to market stability stimulating institutions’ investments. Our findings help to explain financial issues such as the flight to quality, liquidity dry-ups, market manipulation, asset fire sales, and shock amplification in a distressed market. In addition, they provide important implications for policymakers endeavoring to recover market stability. We suggest that policymakers lessen the market power of a few financial institutions by spreading private information across the market at lower information costs and by stimulating competition by injecting public funds into as many institutions as possible.","PeriodicalId":414741,"journal":{"name":"Econometric Modeling: Financial Markets Regulation eJournal","volume":"17 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2015-07-01","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"132290197","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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