To Basel or not to Basel? Banking crises and contagion

Author:Aristeidis Samitas, Stathis Polyzos
Position:Department of Business Administration, University of the Aegean, Chios, Greece; Department of Business Administration, University of the Aegean, Chios, Greece
Pages:298-318
SUMMARY

Purpose - The purpose of this paper is to propose an object-oriented model of financial simulations which aims to test the applicability and suitability of the proposed measures of Basel III with respect to the prevention of banking crises. Design/methodology/approach - The authors introduce an object-oriented model of financial... (see full summary)

 
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To Basel or not to Basel?
Banking crises and contagion
Aristeidis Samitas and Stathis Polyzos
Department of Business Administration, University of the Aegean,
Chios, Greece
Abstract
Purpose – The purpose of this paper is to propose an object-oriented model of nancial simulations
which aims to test the applicability and suitability of the proposed measures of Basel III with respect to
the prevention of banking crises.
Design/methodology/approach The authors introduce an object-oriented model of nancial
simulations in the banking sector, namely, virtual banking (VBanking). The system is based on
behavioural simulation of economic agents and allows for transactions between them, using various
forms of nancial assets. VBanking has been implemented as an automated stand-alone model,
allowing for repetitive simulations under the same parameter sets, producing an efcient series of
statistical data.
Findings Interpretation of the resulting data suggests that some of the criticism against the
proposed measures is justied, as neither economic crises nor contagion are diminished under Basel III.
At the same time, the authors’ ndings support that the stability goal is met, at least in part.
Research limitations/implications The model encompasses a relatively small part of the
banking sector, while the authors choose not to deal with the production part of the economy. However,
these limitations do not hinder the validity and importance of the authors’ ndings.
Originality/value – The originality of this article lies in the use of an object-oriented behavioural
model and in the resulting model application that is based on it. This enables the authors to run a series
of simulations with different parameters, the results of which the authors can then compare. The
authors’ ndings can contribute to the authorities’ efforts to ameliorate the policies of Basel III.
Keywords Basel III, Banking crises, Contagion, VBanking
Paper type Research paper
1. Introduction
The economic systems worldwide are still dealing with the repercussions of the 2008
nancial crisis. This crisis brought forth the weaknesses of the global banking system
and was not limited to only one economy. Additionally, the crisis has shaken the faith of
both governments and investors in the banking system, and this faith has yet to be
restored. The regulatory response to this crisis was the introduction of a stricter
framework for capital requirements and of new procedures to dynamically monitor the
nancial institutions. These were included in a series of measures termed Basel III,
which is a new set of rules under which nancial institutions must operate and full
their role in the economic system. The immediate criticism of the new measures
suggested that they did little to deal with the problems of their predecessor, Basel II, and
in particular, those that were regarded as root causes of the crisis (Quignon, 2011;Allen
et al., 2012).
In this paper, we present an empirical study of the effects on the banking system of
enforcing the measures of Basel III, as compared to other alternatives. We propose an
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFRC
23,3
298
Journalof Financial Regulation
andCompliance
Vol.23 No. 3, 2015
pp.298-318
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-11-2014-0045
object-oriented model for economic simulations that allows for behavioural modelling of
economic agents. We will show how this type of model is better suited for the purposes
of this study. The model employs features from the relevant literature and permits us to
perform simulations of the economic system and gather statistics on key economic
gures. Our work has resulted in a new software application, VBanking, which
incorporates all these features and allows its user to execute parameterised simulations
and collect statistics.
The literature relating to banking crises and stress testing deals with these issues
from many different perspectives. The concept of the VBanking model and its
object-oriented nature can be attributed to the work of Tsomocos (2003a,2003b). His
work proposes a mathematical model, which incorporates object-oriented
characteristics, and can be used to predict the behaviour of economic agents based on a
series of randomised initial endowments. In effect, VBanking expands this
mathematical model to a multi-period frame (as opposed to a two-period model allowed
in Tsomocos’ work) and allows for unlimited repetitions that produce statistical data for
further analysis. Tsomocos also introduces the role of the Economic Agents and the
Regulator, which is similar the role implemented in VBanking, as well as the risk of the
securities issued by bank. However, in the mathematical model of Tsomocos, the risk is
treated as exogenous and random, while VBanking links that risk to the credibility of
the issuing bank. Goodhart and Tsomocos (2007) also suggest that dealing with default
and bankruptcy should be a key issue in nancial analyses.
In terms of banking-crisis prediction, Wong et al. (2007,2011) propose a probit model
which includes variables that may be used to identify banks which are experiencing
nancial troubles. Their approach on banking crises, as well as that of Demirgüc-Kunt
and Detragiache (1998), is used on VBanking to characterise a time period as a crisis
period. For the same purpose, VBanking also employs signalling, as proposed by
Kaminsky and Reinhart (1999). Another approach is proposed by Pezzuto (2008), who
pinpoints a banking crisis in the reduction of inter-bank debt, a reasonable assumption
given the recent bank defaults. Davis and Karim (2008) and Laeven and Valencia (2008)
provide a thorough survey of the various Early Warning Systems which are used to
predict banking crises. The discussion in both of these papers was taken under
advisement during the development of VBanking.
In a more theoretical context, Chang (2011) suggests some macroeconomic variables
that were taken into consideration during the development of VBanking. Chang also
provides implications in terms of the regulatory framework imposed, where he also
discusses Basel III. Gorton (2009,2010) also provides us with a thorough analysis of the
effects on the economy of the banking crises and the ensuing panic. Gorton also
considers the real estate market, which is indisputably an important part of the banking
business. Additionally, Gorton characterises the current crisis a “wholesale” crisis,
suggesting that the problems of the banking sector cannot be attributed (at least to a
signicant extent) to retail customers. Hence, he proposes further study of the interbank
market, an argument also put forth by Pezzuto (2008),Boissay et al. (2013) and
Drehmann and Tarashev (2013). The dangers arising from the exposure of nancial
institutions to each other is demonstrated effectively in the VBanking environment.
Boissay et al. also consider issues of moral hazard of nancial institutions, during
interbank nancial asset trading. Memmel and Sachs (2013) examine contagion in the
interbank market and analyse the factors that inuence the way nancial crises spread
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Basel or not to
Basel

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