Motivated by the credit crisis 2007-08, this paper presents a theory of "capital market banks"; banks that use derivative programs to exploit inefficiencies in the capital markets. I model banks' use of asset backed commercial paper (ABCP) programs as a local game, and analyse how these programs affect financial stability. In a financial market where banks are subject to costly capital requirements and investors are heterogeneous, the ABCP program arises endogenously in response to inefficient risk sharing. The sustainability of the ABCP program depends crucially on the sponsoring bank's capital. Small shocks to the bank's capital can lead to a failure of the ABCP program. This amplifies the shock and pushes the the bank into bankruptcy. I link the dynamics of the ABCP market to the interbank market, and argue that an unravelling of the ABCP market can cause a seizure of the interbank market. The model indicates, that traditional monetary policy is unable to alleviate seizures of the interbank market, but that targeted liquidity measures, such as the "Term Securities Lending Facility", the "Term Auction Facility", the "Troubled Asset Relief Program", the "Money Market ABCP Program" and the launch of a "super fund", could end the unravelling of the ABCP market and ease the pressures in the interbank market.
Publication Date
Financial Markets Group Discussion Papers DP 625
