TAILIEUCHUNG - SFB 649 Discussion Paper 2012-065 Covered bonds, core markets, and financial stability

The Indian financial system is changing fast, marked by strong economic growth, more robust markets, and considerably greater efficiency. But to add to its world-class equity markets, and growing banking sector, the country needs to improve its bond markets. While the government and corporate bond markets have grown in size, they remain illiquid. The corporate market, in addition, restricts participants and is largely arbitrage-driven. To meet the needs of its firms and investors, the bond market must therefore evolve. This will mean creating new market sectors such as exchange traded interest rate and foreign exchange derivatives contracts. It will. | SFB 649 Discussion Paper 2012-065 Covered bonds core markets and financial stability Kartik Anand James Chapman Prasanna Gai Technische Universitat Berlin Germany Bank of Canada University of Auckland This research was supported by the Deutsche Forschungsgemeinschaft through the SFB 649 Economic Risk . http ISSN 1860-5664 SFB 649 Humboldt-Universitat zu Berlin Spandauer StraBe 1 D-10178 Berlin SFB 6 4 9 E C O N O M I C R I S K B E R L I N Covered bonds core markets and financial stability Kartik Ananda James Chapmanb Prasanna Gai c aTechnische Universitat Berlin bBank of Canada c University of Auckland Abstract We examine the financial stability implications of covered bonds. Banks issue covered bonds by encumbering assets on their balance sheet and placing them within a dynamic ring fence. As more assets are encumbered jittery unsecured creditors may run leading to a banking crisis. We provide conditions for such a crisis to occur. We examine how different over-the-counter market network structures influence the liquidity of secured funding markets and crisis dynamics. We draw on the framework to consider several policy measures aimed at mitigating systemic risk including caps on asset encumbrance global legal entity identifiers and swaps of good for bad collateral by central banks. Key words covered bonds over-the-counter markets systemic risk asset encumbrance legal entity identifiers velocity of collateral JEL classification codes G01 G18 G21 Paper prepared for the Bank of Canada Annual Research Conference Financial Intermediation and Vulnerabilities Ottawa 2-3 October 2012. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. The views expressed herein are those of the authors and do not represent those of the Bank of Canada. KA and PG acknowledge financial support from the University of Auckland Faculty Research Development Fund FRDF-3700875 . KA also .

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