On 15 April 2011 a joint IMF-Financial Stability Board workshop gathered senior policymakers and academics in Washington to review the open issue of systemic liquidity risk. Some participating academics agreed to underwrite this common statement, in the belief that this regulatory gap, though intellectually well-recognised, still requires concrete attention.
A consensus view on liquidity riskThere are clear and important lessons to be learned from the crisis of 2007-09. The crisis originated from bad credit, but was intensified by massive runs on financial intermediaries. Fire sales and a jump in perceived counterparty risk propagated losses across markets and economies, causing a systemic crisis.
So far, regulatory reform has targeted bank leverage and started to focus on too-big-to-fail. Yet there is still little public action on another proven source of systemic risk, namely liquidity risk arising from unstable funding and contingent obligations such as derivatives.
The problem is well understood: exposure to liquidity risk creates a negative externality.
Creating exposure to liquidity risk is profitable in good times, but creates vulnerability to massive losses when risk perceptions change. Intermediaries suffering rapid outflows are forced to sell assets at distressed prices, causing losses for other investors. While each intermediary may recognise their individual exposure, they do not internalise losses caused to third parties by the propagation effect. As a result, an unconstrained financial sector naturally creates excess system-wide exposure to liquidity risk.
To understand possible remedies, consider the main sources of liquidity risk.
Financial intermediaries can create credit expansion in excess of deposit growth by increasing reliance on wholesale and short-term funding. While maturity transformation is the essence of banking, an increase in the volume of uninsured short-term funding gives rise to a fire-sale externality. A build-up in unstable funding leads to increased risk when banks suffers large withdrawals, as assets can only be liquidated at large discounts, causing large capital losses. These in turn lead to a jump in risk perceptions, both on asset values and on financial stability of counterparties. Diffused uncertainty over the size and location of potential losses further reinforces a flight to safety, creating more fire sales and adverse feedback loops.
Liquidity risk also builds up via contingent liabilities associated with derivatives and secured financial credit. While these forms of funding and hedging may be longer term, they trigger immediate demands for increased collateral upon distress. The effect of such triggers became dramatically visible around the Lehmann default, when a massive amount of securities were repossessed and immediately resold, while derivative writers suddenly faced huge collateral calls they could not honour.
This experience explains regulatory concerns about a declaration of default in the current Greek crisis, which would cause immediate liquidity demands upon unidentified derivative counterparties. Financial claims such as repos and derivatives enjoyed broader privileges to repossess collateral and resell it immediately upon default since the reform of US and EU bankruptcy rules in 2005. Since then, massive growth in these funding and hedging strategies has increased contingent liquidity risk. At this point, governments and central banks have been rendered hostages in any large potential default, inducing bailouts and forbearance. Ex post intervention in turn only reinforces the return to using such strategies.
Asset illiquidity further contributes to systemic liquidity risk. As more intermediaries with unstable funding and contingent liquidity risk invest in similar long-term assets, asset markets become illiquid during liquidity runs. Systemic liquidity risk depends on liquidity mismatch, constructed from both the asset side and liability side. Moreover, liquidity risk should not be measured purely at a firm-by-firm level, but aggregated across balance-sheets of all financial firms, including the shadow banking system.
The natural conclusion is that the stock of systemic liquidity risk should be carefully measured as a key macroprudential risk measure. Specific instruments should be introduced to contain excessive accumulation of liquidity mismatch that can undermine systemic stability.
The Basel III liquidity proposals (such as the 30-day Liquidity Coverage Ratio and Net Stable Funding Ratio), if not weakened by industry pressure, would help, but are insufficient. They suffer from three weaknesses. First, they focus on individual firm liquidity risk, not on systemic liquidity risk. Second, they are not countercyclical. And third, they do not target liquidity risk in the shadow banking system, in particular in repos and derivatives.
In addition to supporting the Basel III liquidity proposals (with modifications to deal with the three issues mentioned), we recommend action on various fronts.
- Measurement: Exposures to liquidity risk, both on the asset and liability side, should be measured across balance-sheets of all financial firms, including the shadow banking system, and monitored as a key macroprudential risk measure.
- Policy tools: Specific instruments should be introduced to contain excessive accumulation of mismatch. Such instruments may include quantitative limits and risk charges, ideally at countercyclical rates. This will give effective tools and clear responsibilities to macroprudential councils and regulators, such as the FSOC (Financial Stability Oversight Council) in the US and the ESRB (European Systemic Risk Board) in Europe. They would also help separate financial stability from monetary policy, restoring a safe border for central bank autonomy in the monetary policy area.
Concrete proposals which share these principles have been advanced by many academics, including some of us (please see the References section).
Our intervention is meant to signal a broad academic agreement on this critical issue, which calls for a structural solution. In particular, the excessive reliance of intermediaries on destabilising funding and hedging strategies needs to be resolved ahead of central banks’ exit from their support operations.
ReferencesAcharya, Viral V (2011), “A Transparency Standard for Contingent Liabilities such as Derivatives”, mimeo (presentation), New York University Stern School of Business.
Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy (2011), “Risk Topography”, NBER Macroannual 2011.
Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy , Liquidity Mismatch
Perotti, Enrico (2010), “Systemic liquidity risk and bankruptcy exceptions”, VoxEU.org, 13 October.
Perotti, Enrico and Javier Suarez (2011), “The Simple Analytics of Systemic Liquidity Risk Regulation”, VoxEU.org, 16 March.
Perotti, Enrico and Javier Suarez (forthcoming), “A Pigovian Approach to Liquidity Regulation”, International Journal of Central Banking.
Shin, Hyun Song (2010), “Macroprudential Policies Beyond Basel III”, Policy memo.