Understanding Systemic Risk in the Banking Sector: A MacroFinancial Risk Assessment Framework

Abstract

The MacroFinancial Risk Assessment Framework (MFRAF) models the interconnections between liquidity and solvency in a financial system, with multiple institutions linked through an interbank network. The MFRAF integrates funding liquidity risk as an endogenous outcome of the interactions between solvency risk and the liquidity profiles of banks, which is a complementary approach to the new Basel III Liquidity Coverage Ratio framework for Canada. The calibration exercise presented in the article highlights the vulnerability of leveraged institutions to the combination of low cash holdings and excessive dependence on short-term debt funding. As well, by quantifying the trade-offs among higher capital ratios for banks, increased liquid assets or fewer short-term liabilities in reducing risks in the banking system, the MFRAF illustrates that a regulatory framework that properly controls for systemic risk should consider these three factors in a comprehensive manner.