230 - When liquidity risk becomes a macro-prudential issue: Empirical evidence of bank behaviour

DNB Working Papers
Date 4 December 2009

This paper provides empirical evidence of behavioural responses by banks and their contribution to system-wide liquidity stress. Using firm-specific balance sheet data, we construct aggregate indicators of macro-prudential risk. Measures of size and herding show that balance sheet adjustments have been pro-cyclical in the crisis, while responses became increasingly dependent across banks and concentrated on certain market segments. Banks’ reactions were shaped by decreased risk tolerance and limited flexibility in risk management. Regression analysis confirms that their behaviour contributed to financial sector stress. The behavioural measures are useful tools for monetary and macro prudential analyses and can improve the micro foundations of financial stability models.

Keywords: banking, financial stability, stress-tests, liquidity risk.

JEL Classification: C15, E44, G21, G32.