Friday, March 6, 3:00 p.m.
Center for Social Complexity Suite
Research Hall, Third Floor

Regulatory Requirements and their Implications for Bank Solvency, Liquidity and Interconnectedness Risks: Insights from Agent-Based Simulations

Jorge Chan-Lau
Senior Economist, International Monetary Fund
Krasnow Nondegree Student
George Mason University

ABSTRACT: Assessing how banks respond to changes in regulatory requirements requires the use of a modeling framework able to account for heterogeneity in the banking system and the adaptive behavior of banks. This paper proposes an agent-based model to analyze the interaction between regulatory requirements and bank solvency, liquidity, profitability, and interconnectedness. The model features endogenous bank networks arising through interbank loans, and dynamic bank balance sheet adjustment through risk-weight optimization, dividend payments, and loan book expansion. Numerical simulations uncover complex patterns linking solvency, liquidity and interconnectedness risk to regulatory requirements. Higher reserve requirements may lead to a larger number of bank failures when capital ratio requirements are low vis-à-vis the credit risk underlying banks’ loan portfolios. Higher minimum capital ratios help to reduce solvency problems in banks but raise interconnectedness risk, as measured by the increase in the number of degrees in the interbank network.

The latest version of the paper is available at the link below in SSRN: