Tuesday, April 5, 2011

Capital requirements are not enough (ls)

Great Paper by Shin & Shin.


Financial intermediaries borrow in order to lend. When credit is increasing rapidly, the traditional deposit funding (core liabilities) is supplemented with other funding (non-core liabilities). We explore the hypothesis that monetary aggregates reflect the size of non-core and core liabilities and hence convey information on the stage of the financial cycle. In emerging economies with open capital markets, non-core liabilities of the banking system take the form of short-term foreign exchange liabilities, increasing the vulnerability to the outbreak of “twin crises” where a liquidity crisis is compounded by a currency crisis. 

None of the Basel III measures to be introduced within the next years deals with the procyclical increase of non-core-liabilities such as interbank funding and their implications for systemic risk. Focusing only on assets and equity neglects the importance of fragile (short-term) liability networks and potentially adverse contagion mechanisms.