How to avoid a liquidity shock

Severe disruption to funding and a liquidity crunch are central features of almost all systemic banking crises. A major fire can break out when a small spark lands on combustible material – so long as there is oxygen available. Likewise, a financial crisis often starts with some relatively minor disturbance to an already-vulnerable system, which is propagated and amplified by liquidity strains. The initial shock that triggered the global financial crisis starting in 2007 – namely, direct losses due to household defaults on U.S. subprime mortgages totaling around US$500 billion – was not overwhelming compared to the aggregate loss absorbing capacity of the U.S., let alone the global financial system; but it was amplified enormously through liquidity effects. Once Lehman Brothers had to start scrambling to meet demands for immediate payment, additional losses were incurred that pushed it deeper into insolvency. And when the commercial banks came under strong funding pressures, national authorities (specifically central banks) felt obliged to inject emergency liquidity, often deviating from the pursuit of traditional monetary policy objectives, and taking on credit risk in the process.

Given these facts, how to address systemic liquidity risk should be central to the regulatory and supervisory reform efforts that followed the crisis – in particular to the development of macroprudential policy. Yet the issue has received only sporadic attention.

This article seeks to provoke more thinking and debate on how to reduce the probability of a systemic liquidity crisis, and to limit the consequences should such a crisis occur.

Chronic exposure to liquidity risk is intrinsic to the banking business. The prototypical commercial bank is highly leveraged, and the major services that it provides normally include maturity transformation and the offer of interest-bearing deposits or bonds with a guarantee of principal. It is unavoidable that the bank exposes itself to the possibility that those supplying funding will not sustain financing as soon as doubts arise as to whether the bank’s investments will succeed as anticipated. Therefore, the possibility of a ‘run’ by retail or wholesale funders, a spike in financing costs, and the need to conduct a ‘fire sale’ of assets is an ever-present risk.

This risk is systemic – one agent’s liquid asset is another agent’s liquid liability. Funding arrangements link banks with other banks, other financial institutions, and the nonfinancial sector. The failure of one institution to meet its obligations in full and on time will potentially cause others to be short of liquidity, thus leading to a cascade of illiquidity. Similarly, a ‘fire sale’ by one institution will depress prices for all and provoke margin calls and demands for additional collateral, affecting others. Furthermore, the liquidity properties of an asset or an institution depend on market conditions and the interaction among market participants, and not just on the face-value characteristics of that asset or institution. An asset is considered to be liquid if it can be sold relatively quickly without a major price mark-down – that is, whether others stand ready to buy it. Likewise, an institution is considered to be liquid if it can meet its obligations in full and on time and without recourse to the sale of illiquid assets or obtaining exceptionally expensive funding from others. In all cases, liquidity varies with the state of the system.

Analysis of financial crises have emphasised the crucial role of liquidity risk. Persaud (2003), Krishnamurthy (2009), and Brunnermeier (2008), for example, have explained various mechanisms whereby ‘liquidity spirals’ or ‘liquidity black holes’ can amplify shocks and spread them across the financial system. One implication of these analyses is that markets that are liquid in normal times may rapidly freeze up as conditions deteriorate, and what seem like stable sources of funding can abruptly become unavailable. Any policy related to protecting against liquidity risk needs to be as robust as possible against such ‘sudden stops’.

Tools to mitigate the problem

The policy response to the global crisis has included numerous prominent measures to strengthen bank capitalisation. Main initiatives for banks include higher Tier 1 capital requirements, a capital conservation buffer, a revived solvency ratio, an add-on for systemically important institutions, a counter-cyclical buffer, revised risk weights, stress testing and asset quality reviews for credit risk, and targets for total loss absorbing capacity.

Less attention has been paid to strengthening liquidity buffers and management. There is indeed broad agreement to impose on banks a Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These are not purely micro-prudential instruments; the LCR in particular is based on a kind of stress test of whether or not a bank can meet its obligations over 30 days while the liquidity of asset and funding markets is impaired. The European Systemic Risk Board has floated the idea of a time-varying LCR or NSFR (ESRB 2014), and there have been other proposals (Perotti and Suarez 2009, Milne 2010). Also, countries have taken ad hoc action to relieve systemic liquidity pressures during crises; for example, by relaxing reserve requirements. The alternative would often have been the proactive injection of central bank money and the use of foreign currency reserves.

Yet, given the importance of liquidity risk, an enlivened debate on the merits and demerits of various options is urgently needed.

The existing proposals generally rely on strong, granular assumptions – for example, about which funding sources are more stable than others over various time horizons and situations – and extensive modeling. Therefore susceptibility to model risk or circumvention may be high. Also, requirements of most of these proposals depend on the characteristics of the individual banks, rather than system-wide conditions.

Proposal

We suggest, rather, that a robust liquidity policy instrument be developed, designed expressly for macroprudential purposes. Specifically, we propose the mandating of a ‘Macroprudential Liquidity Buffer’ (MPLB) that each bank – or any highly leveraged financial institution – would be required to hold in the form of systemically-liquid assets (assets that are liquid even in a severe crisis, such as central bank money). The buffer would be in proportion to the bank’s liabilities less regulatory capital (i.e., its non-equity funding). The factor of proportionality would vary positively with growth in system-wide funding needs. Banks would have to build up extra liquidity buffers when aggregate non-equity funding is expanding rapidly, but could use them without stigma should the need arise.1 How the requirement might vary over the financial cycle is illustrated below.

Figure 1.

From the viewpoint of prevention, the MPLB would reduce incentives and scope for debt-funded expansion of banks’ balance sheets during upswings, and therefore reduce the likelihood of excessively rapid growth and a subsequent systemic crisis. Should a crisis occur, individual institutions would be better able to withstand liquidity shocks, and transmission will be dampened. Requiring banks to hold ample systemically-liquid assets would also offer comfort to the central bank, which might otherwise have to provide liquidity with questionable collateral once a severe crisis hits and thereby take on quasi-fiscal credit risk.

The proposed MPLB is meant to be robust, in analogy with the leverage ratio – both are based on relatively simple measures of financial soundness derived from unweighted balance sheet aggregates. Neglect of differences in the maturity structure of banks’ liabilities is the unavoidable cost of a robust and hard-to-circumvent macroprudential requirement. But the MPLB would complement more granular, bank-specific liquidity requirements such as the LCR and NSFR, much as the leverage ratio complements risk-weighted capitalisation ratios.

The cost of the MPLB for banks should not be very large on a net, risk-adjusted basis. The assets held in the liquidity buffer would typically bear little credit or market risk, and have low correlation with the market portfolio compared to that of typical bank assets. Indeed, the MPLB may lower overall costs. Banks would benefit from lower funding costs, lower risk-weighted capital requirement, and – if macroprudential policies are successful – lower contributions to bail-out and deposit guarantee funds. Furthermore, increasing the stability of the system will benefit all, and especially the most prudent market participants, who might otherwise be adversely affected the excessive behavior of others.

In our view the instrument proposed has other desirable features, such as

• Interacting suitably with other macro- and micro-prudential instruments,
• Being shielded from pressures for time inconsistency and favorable treatment of special interests,
• Limiting the scope and incentives for circumvention,
• Allowing for the diversity of banks’ business models, and
• Not creating a major disruption to monetary and other macroeconomic policies.

Many practical issues would have to be resolved in deploying a macroprudential liquidity instrument. For example, a determination is needed on how to treat branches and subsidiaries of foreign banks, and whether to impose separate requirements by currency.

Two considerations seem to constitute substantial – but not insurmountable – challenges to implementing the proposed MPLB. First, some jurisdictions may lack a sufficiently large supply of systemically-liquid assets that can be used to build the buffer, and also be available for other purposes such as acting as collateral in active financial markets. Certain foreign assets such as short-date U.S. treasury bills may supplement the local supply, but a country may be reluctant to see what amounts to a large-scale financing of foreign entities. Second – and this challenge is pervasive in macroprudential policy – the calibration of the optimal average setting of the instrument over the cycle, and its sensitivity to cyclical developments, may be demanding. A country may not have enough relevant evidence from history to judge how to protect itself against rare disturbances, and a mis-calibrated instrument may do harm.

Conclusions

Liquidity is a systemic concept, and a disruption to liquidity availability is a central element in the origination and amplification of systemic financial crises. Hence, macroprudential policy should consider how to address this risk – how to reduce the probability of a liquidity crisis, and how to dampen its effects. The MPLB proposed here is meant to be a well-targeted at these truly system-wide objectives, and is designed to be effective, efficient, and robust.

A next phase of the discussion of the macroprudential approach to liquidity risk would involve a comparison of the various available proposals, including through empirical ‘back testing’ of their possible effects across a range of countries and episodes. Maintaining systemic liquidity is so important for financial sector and macroeconomic stability that the search for a practical instrument to this purpose deserves the active attention of policy-makers.

References

Brunnermeier, M K (2008), “Deciphering the Liquidity and Credit Crunch 2007-08,” NBER Working Paper No. w14612.

ESRB (2014), “The ESRB Handbook on Operationalising Macroprudential Policy in the Banking Sector”.

Hardy, D C and P Hochreiter (2014), “A simple macroprudential liquidity buffer,” IMF Working paper WP/14/235.

Krishnamurthy, A D (2009), “Amplification Mechanisms in Liquidity Crises,” NBER Working Paper No. w15040.

Milne, A (2010), “Using ‘Cap and Trade’ to Contain Systemic Financial Risk,” Social Science Research Network Working Paper.

Perotti, E and J Suarez, (2009), “Liquidity Risk Charges as a Macroprudential Tool”, CEPR Policy Insight 40.

Persaud, Avinash (Ed.) (2003), Liquidity black holes: understanding, quantifying and managing financial liquidity risk, London: Risk.

Footnote

1 Detailed proposals and explanations are contained in the accompanying working paper.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Daniel C Hardy is an Advisor at the International Monetary Fund. Philip Hochreiter is an economist in the Integrated Financial Markets Division at the Austrian Financial Market Authority (FMA).

Image: A man walks past buildings at the central business district of Singapore February 14, 2007. REUTERS/Nicky Loh.