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Liquidity Risk The Interbank Market and Game Theory

Interbank markets may fail to allocate liquidity efficiently due to: asymmetric information about the quality of banks’ assets, banks’ free-riding on each other’s liquidity or on central bank liquidity; or as a consequence of predatory behaviour forcing ineffiient liquidation of bank assets. These are the (reasonably) well understood features of the "Game Theory" of the global interbank market.

It is becoming generally understood (particulalry in banking software development) that the framework of analysis provided by Game-Theoretic techniques is the only manner of approach to pragmatically understanding global interbank markets from both the perspective of the Supervisors and of the participants from a Risk Management and possibly more importantly from a Supervisory (Risk Capital) perspective.

Let's face it; all other approaches are 'old hat', 'borrow the watch and tell the time'!! Implementation of any form of Game Theoretic analytic framework is however not something you want to "try at home"; you don't want to re-invent that wheel yourself so the Open Source approach, particularly that available on CRAN-R is probably the optimal starting point to getting this challenge properly sorted! Getting that stuff done!

Recently on my corporate blog I referenced a new paper on the theoretics of Liquidity Risk as it must be grasped by a project team engaged in a software engineering project to compute liquidity risk in a financial institution. This is from the holisitic perspective to economic risk capital in banking, my reference is here;-

http://www.asymptotix.eu/content/liquidity-risk-definitive-methodological-paper-drehman

Another new [important] paper has arrived in this space. It is about "market power" in the interbank market (Acharya, Gromb and Yorulmazer 2008); the authors show that when the outside options of needy banks are limited, surplus banks may strategically under-provide lending, thereby inducing inefficient sales of bank-specific assets. A central bank can ameliorate this inefficiency by standing ready to lend to needy banks, provided it has greater information about banks (e.g., through supervision) compared to outside markets, or is prepared to extend loss-making loans.(This is one portrayal of the current position of course).

This paper has been much heralded with public expositions in discussions by its authors from conference proceedings. Examples are below;-

http://siteresources.worldbank.org/INTFR/Resources/AcharyaPresentat...

http://www3.imperial.ac.uk/pls/portallive/docs/1/44163698.PDF

The final publication is here;-

http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6984.asp

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