Academic journal article Federal Reserve Bank of New York Economic Policy Review

Stability of Funding Models: An Analytical Framework

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Stability of Funding Models: An Analytical Framework

Article excerpt

* During the recent financial crisis, many institutions and some market-based intermediation arrangements experienced strains owing to declining asset values and a drying-up of funding sources.

* Although these stress events led several institutions to fail and others to require extraordinary public support, a full understanding of their causes still proves elusive.

* This study clarifies that understanding by providing a rigorous, yet easily applicable, framework for analyzing the sources of the stress events and the effect of various funding structure characteristics on financial stability.

* The framework can potentially help policymakers form views on regulatory reform and evaluate the ways that policy options may affect financial stability.

1. INTRODUCTION

The recent financial crisis highlighted the fragility of many financial intermediaries. A large number of commercial banks, investment banks, and money market mutual funds (MMFs) experienced strains created by declining asset values and a loss of funding sources, as did some market-based intermediation arrangements such as asset-backed commercial paper (ABCP). These strains were severe enough to cause several institutions to fail and others to require extraordinary public support. In reviewing these events, one notices that some arrangements appear to have been more stable--that is, better able to withstand shocks to their asset values and/or funding sources--than others. (1) The precise determinants of this stability are not well understood. Gaining a better understanding of these determinants is a critical task for both market participants and policymakers as they try to design more resilient arrangements and improve financial regulation.

In this article, we use a simple analytical framework to illustrate how the characteristics of an arrangement for financial intermediation (a funding model) affect its ability to survive stress events. There is a large and growing literature on this issue; see Yorulmazer (2014b) for a detailed review. Our aim here is to present an approach that is sufficiently general to encompass a wide range of intermediation arrangements, but sufficiently simple to illustrate the economic forces at work in a transparent and intuitive way. Our hope is that this analysis will provide policymakers with a useful starting point for more detailed evaluations of alternative arrangements and for the analysis of regulatory proposals.

Our framework begins with the simplified balance sheet of a representative financial intermediary. The intermediary holds two types of assets: safe and risky. Safe assets are always liquid, but risky assets may be illiquid in the short run. On the liability side of its balance sheet, the intermediary has short-term debt, long-term debt, and equity. This intermediary faces two types of risk: The value of its assets may decline and/or its short-term creditors may decide not to roll over their debt. We measure the stability of the intermediary by looking at what stress events it can survive, that is, what combinations of shocks to the value of its assets and to its funding it can experience while remaining solvent.

An important issue in any such analysis lies in determining the conditions under which short-term creditors will and will not choose to roll over their debt. We do not try to explain creditor behavior in our framework; instead, we treat this behavior as exogenous. This approach greatly simplifies the model and allows us to present an intuitive analysis of the determinants of stability. Again, a way to think of our analysis is that it subjects banks to different types of stress events. In most of our applications, we hold fixed the balance sheet of the bank, and ask whether the bank is stable for different sizes of short-term creditor runs and declines in the value of its assets. The creditor behavior in our framework is used as a parameter that generates a certain size of run on the bank. …

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