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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

(p.62) (p.63) 5 Covered Bonds and Systemic Risk
Systemic Risk

Prasanna Gai

Oxford University Press

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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