Capital Provision to Reduce Liquidity Defaults and the Role of Central Banks

Jinyun Tong, Bart De Keijzer, Carmine Ventre

Keywords: Financial Networks, Liquidity Default, Systemic Risk, Empirical Game-Theoretic Analysis

Abstract: We study to what extent the interbank market and central bank intervention can reduce funding liquidity defaults in banking networks. We build a multi-period agent-based model to simulate the banking network and interbank market for the long term. Based on this model, we define a strategic game in which each systemically important bank faces a decision of whether to lend and to which type of distressed bank to lend. Our theoretical analysis shows that when all demand banks in the market are solvent, central bank lending can transform the induced game into a potential game with pure Nash equilibria and incentivise the interbank market to reach the equilibria. Moreover, we conduct an empirical analysis based on datasets published by the European Banking Authority. We compute the equilibria of the induced game using Empirical Game-Theoretic Analysis with different equilibrium solvers and analyse bank behaviour at different equilibria. The experimental results show that in the non-cooperative scenario, if all demand banks are solvent, central bank lending can significantly reduce liquidity defaults. Our results also suggest that the central bank can indirectly intervene in the interbank market by coordinating banks through recommendations, thus increasing interbank lending and reducing liquidity defaults, even without central bank lending.

Area: Modelling and Simluation of Societies (SIM)

Generative A I: I acknowledge that I have read and will follow this policy.

Submission Number: 1125