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Systemic RiskThe Dynamics of Modern Financial Systems$
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Prasanna Gai

Print publication date: 2013

Print ISBN-13: 9780199544493

Published to Oxford Scholarship Online: May 2013

DOI: 10.1093/acprof:oso/9780199544493.001.0001

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Covered Bonds and Systemic Risk

Covered Bonds and Systemic Risk

Chapter:
(p.62) (p.63) 5 Covered Bonds and Systemic Risk
Source:
Systemic Risk
Author(s):

Prasanna Gai

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780199544493.003.0005

This chapter presents some new results describing how the quest for security by banks, in the form of covered bonds, can generate system-wide instability. It presents a model in which banks finance operations with a mix of unsecured and secured funding, and where runs by unsecured creditors can undermine the banking system. The critical threshold for a run is determined by the extent of ring-fenced assets in the covered bond pool and the take-up of covered bond products in the secondary market for these assets. The secondary market price is modelled explicitly as a network game in which over-the-counter investors learn from their neighbours. The results of the model suggest that (time-varying) limits to the amount of assets that can be encumbered on a bank’s balance sheet via secured issuance may help reduce systemic risk.

Keywords:   covered bonds, systemic risk, local interaction games, diffusion, asset encumbrance, OTC networks

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