Winter is possibly not coming: Mitigating financial instability in an agent-based model with interbank market

Lilit Popoyan, Mauro Napoletano and Andrea Roventini
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Lilit Popoyan: Institute of Economics (LEM), Scuola Superiore Sant’Anna, Pisa (Italy)

No 2020-14, Documents de Travail de l'OFCE from Observatoire Francais des Conjonctures Economiques (OFCE)

Abstract: We develop a macroeconomic agent-based model to study how financial instability can emerge from the co-evolution of interbank and credit markets and the policy responses to mitigate its impact on the real economy. The model is populated by heterogenous firms, consumers, and banks that locally interact in different markets. In particular, banks provide credit to firms according to a Basel II or III macro-prudential frameworks and manage their liquidity in the interbank market. The Central Bank performs monetary policy according to different types of Taylor rules. We find that the model endogenously generates market freezes in the interbank market which interact with the financial accelerator possibly leading to firm bankruptcies, banking crises and the emergence of deep downturns. This requires the timely intervention of the Central Bank as a liquidity lender of last resort. Moreover, we find that the joint adoption of a three mandate Taylor rule tackling credit growth and the Basel III macro-prudential frame-work is the best policy mix to stabilize financial and real economic dynamics. However, as the Liquidity Coverage Ratio spurs financial instability by increasing the pro-cyclicality of banks’ liquid reserves, a new counter-cyclical liquidity buffer should be added to Basel III to improve its performance further. Finally, we find that the Central Bank can also dampen financial in- stability by employing a new unconventional monetary-policy tool involving active management of the interest-rate corridor in the interbank market.

Keywords: Financial instability; interbank market freezes; monetary policy; macro-prudential policy; Basel III regulation; Tinbergen principle; agent-based models. (search for similar items in EconPapers)
JEL-codes: C63 E52 E6 G01 G21 G28 (search for similar items in EconPapers)
Date: 2020-05
New Economics Papers: this item is included in nep-cmp, nep-hme, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (18)

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Persistent link: https://EconPapers.repec.org/RePEc:fce:doctra:2014

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