Reforming Liquidity Requirements/Pros and Cons of Separate Liquidity Requirements

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 90’s 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 FI’s 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.