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Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements LSE Conference presentation Jan. 24, 2011 Clas Wihlborg Chapman University.

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Presentation on theme: "Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements LSE Conference presentation Jan. 24, 2011 Clas Wihlborg Chapman University."— Presentation transcript:

1 Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements LSE Conference presentation Jan. 24, 2011 Clas Wihlborg Chapman University

2 Long ago before the crisis During the 90s EU was leaning towards abolishing liquid asset (reserve) requirements for banks Reserve Requirements became primarily a monetary policy tool in countries with undeveloped financial markets Financial Institution (FI) regulation focusing on safety net including –LOLR to support liquidity when agents cannot distinguish between solvent and insolvent FIs –Deposit insurance to prevent runs –Capital Adequacy with focus on solvency of individual banks (micro-prudential)

3 Liquidity at the Center of Crisis –Liquidity has become a somewhat obscure concept as a result of increased role of securities on both sides of FIs balance sheets (reduced reliance on traditional commercial banking taking deposits to offer conventional loans) Liquidity on assets side as speed and predictability of asset liquidation (asset values insensitive to liquidity in markets) Liquidity on liability side as stability and predictability of funding (funding costs insensitive to liquidity in markets) Liquidity requires that buyers exist when FI sells assets, issues securities (V. Smith)

4 Basel III and Liquidity Expanding the risk-weight and minimum ratio approach: Higher capital ratio and increase its buffer role –Capital conservation buffer –Countercyclical capital proposal Change in definition of Tier 1 (equity) Add leverage ratio requirement Extend Basel II to cover Counterparty credit risk and derivatives Liguidity ratios –LCR; Liquidity Coverage Ratio –NSFR; Net Stable Funding Ratio –Monitoring tools

5 Liquidity on the asset side: LCR (Stock of high-quality liquid assets/total net cash outflows over the next 30 days under stress scenario)>1 Level 1 assets –(cash, CB reserves, marketable securities with 0 risk weight Level 2 securities; max 40% after 15% haircut –(marketable securities assigned 20% risk weight) Total net cash outflows= outflows under stress - Min(inflows, 75% of outflows) –Funding sources (inflows) are assigned =run-off factors) Reducing the need for fire sale of risky assets subject to liquidity premium (lack of buyers) in stress situation An expanded reserve requirement with monetary policy implications.

6 NSFR (Available amount of stable funding/Required amount of stable funding)>1 Funding sources assigned ASF (Available Stable Funding)-factors between 0 and 100% Assets assigned RSF (Required Stable Funding)-factors between 0 and 100% –>One year maturity of liability (100% ASF) –<One year maturity of asset (<100% RSF adjusted for risk) Addressing mismatch problem by reducing the need to refinance long maturity assets in short term market, and by increasing availability of short term assets in case fire sales needed. DO we need both LCR and NSFR?

7 Monitoring tools Contractual maturity mismatch metric Concentration of funding metric Available unencumbered assets metric LCR by significant currency Market related monitoring tools (equity prices, long and short debt yields, derivatives, CDS spreads, sub-debt yields, etc.)

8 Starting point for discussion 1: Critique of Basel II Complexity and regulatory burden Supervisory burden given info disadvantage Reduced Cap. Req. in non-obvious ways (possibly increasing systemic risk) Gaming, manipulation and risk arbitrage Focus on institution (micro prudential) Pro-cyclicality Insufficient attention to market discipline What are the costs of hitting required ratio? –Buffers or binding requirements? –Refusal to consider Structured Early Intervention and Insolvency procedures

9 Has Basel given up on market discipline? Experience from crisis: Bail-outs with respect to both solvency and liquidity –If the expected bail-out incentive structure is accepted; – Government steps in when minimum ratios are hit – Strong detail regulation and enforcement is needed as a result of strong conflict of interest between FI and government with respect to both solvency and liquidity risk Stronger market discipline reducing conflict of interest requires: –Predictability of costs when min. ratios are hit; costs determine incentives to keep buffers –Loss sharing by creditors to strengthen incentives to monitoring –Focus regulatory structure on externalities/market failures

10 Starting point for discussion 2: Theory of liquidity and contagion Expanding literature on contagion, liquidity and systemic risk in market oriented financial system as theoretical foundation for regulation. For example: Allen and Gale (2007) Diamond and Rajan (2001, 2010) Adrian and Shin (2008,2010) Brunnermeier and Pedersen (2009) Acharya and Thakor (2010) Acharya, Pedersen, Philippon and Richardson and (2010) Bebchuk and Goldstein (2010) Segoviano and Goodhart (2009) New view summarized nicely in Brunnermeier, Crocket, Goodhart, Hellwig, Persaud and Shin (2009) and Kashyap, Rajan and Stein (2009)

11 Summary of New View of Systemic Risk Sufficiently large loss in asset value and capital in financial system with highly leveraged FIs and mark- to market valuation induces fire sales that create additional losses in the system when most FIs struggle to restore capital and buy side of market dries up. Factors contributing to magnitude of externality (Asset price declines below fundamental values and contraction of credit supply) –Strength of creditor guarantees –Lack of capital buffer –Interconnectedness –Margin requirements –Liquidity spirals (self-fulfilling illiquidity/lack of buyers) –Opaqueness about solvency of FIs –Incentives to hoard liquid assets (lack of buyers), for example. as a result of expected forbearance.

12 Insights and questions raised by New View Solvency and transparency of solvency is a key issue for liquidity (existence of buyers of bargains relative to fundamental values Role of self-fulfilling expectations of illiquidity (lack of buyers)? Role of expectations of government bail- outs? The theory of contagion through asset prices and liquidity is one and the same as theory for pro-cyclicality

13 Proposals based on New View –Kashyap, Rajan and Stein: Capital insurance contingent on systemic losses –Brunnermeier et al: Capital req. linked to mismatch of maturities, credit expansion and other macro-prudential indicators to reduce procyclicality Mark to funding rule for some assets (non-systemic?) Prompt and laddered response when ratios violated –Acharya et al: Tax based on FIs contribution to Systemic Expected Shortfall of Capital (SES, the expected shortfall related to contagion through interconnectedness, lack of liquidity, etc); SES is a close relative of CoVaR (Adran and Brunnermeier, 2009) –Hart and Zingales (2010) and Duffie(2010) CDS spread on junior debt contingent haircuts and equity issue (focus on TBTF issue).

14 The proposed liquidity ratios in perspective All proposals above focus on capital regulation and solvency to reduce systemic risk; in one case expansion of req capital to compensate for mismatch. Is there an economically valid role of LCR and NSFR to complement (counter-cyclical) capital requirements? In the above framework NSFR in particular reduces the scope for externalities by constraing interconnectedness and mismatching But at an efficiency COST: Short term funding as commitment and disciplinary device.

15 Pulling the strings together: Setting priorities Choose regulatory philosophy –Greater market discipline vs detail regulation Preference for the first based on –Regulatory burden on financial system –Excess burden on supervisors –In combination creating incentives for gaming, manipulation, evasion, non-transparency. –Binding requirements vs buffers; determines what requirements accomplish Before establishing new ratios; –SET RULES FOR WHAT WILL HAPPEN WHEN RATIOS ARE HIT. KEY TO INCENTVE EFFECTS –CONDUCT DYNAMIC Q.I STUDIES IN CASE OF EVENT. Not just fairly static QIS and stress tests.

16 Principles for new regulation 1 Focus regulatory structure on –1. Strengthening incentives for risk and liquidity management –2. Reducing likelihood of and scope for externalities/market failures –1. Achieving 1 enhances 2. Analyze consequence of any reform in combination with rule for intervention in event. –Requires explicit crisis management procedures/structured early intervention/insolvency procedures Analyze costs and benefits –Regulatory burden, supervisory burden and efficiency losses vs reduced likelihood of crisis

17 Principles for new regulation 2 Is it appropriate to try to achieve multitude of objectives through capital requirement (solvency buffer, risk- pricing, countercyclicality, liquidity, TBTF)? Pro: Complex regulation can be made relatively homogeneous across countries using weights and ratios (level playing field). FIs like it too.

18 Principles for new regulation 3 But there are costs to reliance on complex capital requirements: Con 1. Cost of equity relatively high; High ratios increase incentives for arbitrage and evasion (even in good times) Con 2: Equal regulatory burden across countries require substantial national discretion (the level playing field argument lacks economic validity); There are potential benefits from regulatory competition in some dimensions. To avoid race to the bottom in system with strong national discretion we need to think of incentive contract for supervisors (deferred pay-out conditional on system performance)

19 Priority among proposals Focus on incentives, simplicity and transparency 1. Rules for predictability of costs and allocation of losses at trigger ratios 2. Contingent capital linked to aggregate system losses (Capital insurance contingent on systemic problem; Kashyap et al) 3. Individual FI differentation and recapitalization restricted to TBTF; Use for example, expected systemic shortfall 4. Dealing with mismatch of maturities in a simpler way than NSFR –Monitoring metrics of interconnectedness, mismatch, living will information and market indicators. Large changes in indicators trigger (national) supervisory response, possibly required capital adjustment.

20 Cross-border considerations Systemic risk through price and liquidity channels puts emphasis on integrated financial system; usually geographically defined by country. Capital buffer of an FI needs to be associated with financial system wherein contagion occurs Indicates that branch banking across financial systems (countries) is inappropriate Host country subsidiaries should have well defined capital supporting well-defined risk and liquidity characteristics; consider New Zealand type requirement for operational separability of subsidiaries.

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