Bank regulation and financial stability

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Financial stability is one of the main objectives of bank regulations globally. Over the past decades, several rules and policy measures have been implemented to mitigate the propagation of risks in the financial system. However, these regulations can have a multitude of effects at the bank and system-wide levels. The aim of this thesis is to enhance our understanding of bank regulations and their implications on the financial system. The thesis makes substantial contributions to the literature by providing new findings on the desirable and undesirable effects of recent regulations in Australia and the US in three separate studies. Using a simulation technique, the first study quantifies the size of capital buffers required to reduce system-wide losses of Australian banks. The results suggest that a moderate increase in bank capital buffers is sufficient to maintain financial system resilience, even after taking economic downturns into consideration. Furthermore, while banks benefit from paying a lower cost of debt when they have a higher capital buffer, lending volumes are lower indicating that credit supply may be hampered if bank capital levels are too high within a financial system. The second study presents a comprehensive assessment of the impacts of the Federal Reserve crisis liquidity programs using US bank holding company data. The main finding is that the liquidity programs were ex-ante efficient as they targeted illiquid banks with low core stable funding sources, and participants experienced an increase in liquidity creation and loan growth. However, there was a pervasive shift in bank risk taking that increased their stock return synchronicity following liquidity support. Most importantly, while there is strong evidence of an increase in loan supply by banks that accessed the programs that supported short-term funding, these banks are subject to greater stigma effect, and thus pose higher crash risk relative to other banks. The third study examines the effect of banning proprietary trading by banks (the Volcker Rule) on financial stability. There are three channels through which the Volcker Rule impacts bank-level and systemic risks: revenue diversification, bank similarity, and proprietary trading activity. While the reduction in proprietary trading lowers the directly targeted banks’ systemic risk, an unintended consequence is that greater similarity between banks increases the risk that they default at the same time and thus raises the probability of a systemic default. Banks that were not engaged in proprietary trading are also affected by the Volcker Rule through this similarity channel.
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