Regulation of Banks’ Liquidity: Why and How?

1. Regulation of Banks’ Liquidity: Why and How? Discussion Erlend Nier, Bank of England

2. Summary of main messages • Why? Liquidity regulation justified by externalities and bank opaqueness. • How? It depends: • Externalities arising from individual bank failure could be addressed by simple regulatory liquidity ratios (such as SSLR) • Externalities arising from exposure to macro shocks may need to be addressed by liquidity ratios that are tied to a banks’ ex ante exposures to macro-shocks.

3. Questions addressed (Comments) • Why do we regulate banks? • What is the specific role of liquidity requirements? (How different from solvency regulation? from deposit insurance? Could expand on this.) • What is the relationship between ex ante and ex post intervention? • What are the costs and benefits of liquidity regulation? (open question) • How should liquidity requirements be designed? (comments and alternative suggestions)

4. Why Regulate Banks? • Banks are opaque, creating inefficiencies in monitoring. • Bank failure (weakness) can have micro-systemic externalities • on borrowers • on other banks, arising through • informational contagion • financial contagion • common shocks • Bank failure (weakness) can have macro-systemic externalities • on the functioning of the macro-economy as a whole • Bank-loan supply decisions may amplify economic fluctuations • Banks may over-invest in upturns. This creates vulnerabilities that when crystallised lead to tightening of credit supply in downturns, Borio and Lowe, 2002), Dell Arricia et al (2005).

5. What is specific role of liquidity req.? Micro-systemic externalities • Banks are opaque and can suffer withdrawal of (wholesale) funding as a result of uncertainty on bank’s solvency. This may result in liquidation of illiquid assets and can lead to insolvency (liquidity risk). • Banks self-insure against liquidity risk from (wholesale funding) by holding liquidity buffers. • Externalities mean that private choice of liquidity buffers (capital buffers, credit risk management) do not reflect social cost of failure. • Liquidity buffers (capital buffers, levels of credit and market risk management) are lower than would be optimal from social point of view.

6. What is the specific role of liquidity requirements.? • Deposit insurance removes liquidity risk from depositor runs, but does not affect liquidity risk from wholesale funding. • Solvency standards cannot remove liquidity risk as long as banking assets are opaque. • Additional intervention on liquidity required because of opacity of banks (asymmetric information) and resulting inefficiencies in monitoring. Macro-systemic externalities • Additional intervention on liquidity because of macro-systemic externalities? • Liquidity is flipside of lending. Liquidity requirements could be used to address over-lending. • But could use other tools, eg increase capital requirements during upturns? Not where we are going with Basel II!

7. Ex post and ex ante intervention • Ex post government intervention LOLR (monetary policy) partly deals with micro- and macro-systemic externalities. • Do we need ex ante requirements in addition? • Yes, if banks free-ride on ex post support • Micro: banks may free-ride on ex post LOLR support and reduce private holdings of liquidity, making it harder for CB to assess the situation ex post and increasing frequency of ex post intervention, Repullo (2003). • Macro: banks may free-ride on ex post monetary easing by over-investing ex ante, making it harder for CB to reduce economic fluctuations (Rochet, 2004, Borio and Lowe, 2002)

8. What are the costs and benefits of requirements? • Liquidity requirements may create inefficiencies related to a reduction in the overall amount of intermediation. Is this a strong concern? Open question. • Useful first step: what determines private choices of liquidity buffers? And how do they relate to • Wholesale funding • Ex post support • Macro-conditions • Investigated this for large cross-country panel of banks (Lee and Nier, 2005).

10. Cost and benefits: results and implications • Banks private choices appear to respond to threat of wholesale liquidity runs. • But support expectations reduce private choices of liquidity. • Strengthening the micro-systemic case for ex ante intervention. • Liquidity buffers tend to be low in upturns and high in downturns. • Could in part be due to banks over-investing in booms and hoarding liquidity in recessions (macro-systemic externalities). • Strengthening the macro-systemic case for ex ante intervention.

11. How should liquidity requirements be designed? • Micro-systemic perspective: • Simple ratio enough? Yes, but perhaps one can do better? • If ex post support leads to lower liquidity, could tie requirement to support? Tricky. • May want to tie size of requirement to degree of opaqueness (eg an index of transparency), degree of complexity? • Gives incentives for banks to become more transparent, reducing liquidity risks.

12. How should liquidity requirements be designed? Macro-systemic perspective • Simple ratio enough? • Yes. Because a simple ratio would bind in booms and be slack in recessions, addressing concerns about over-lending. • Of course this will do little to counter loan supply contractions in recessions. Can monetary policy do this job?

13. How should liquidity requirements be designed? Macro-systemic perspective (cont.) • Need to tie liquidity requirements to ex ante exposure to macro-shocks? • Potentially, but could equally tie solvency requirements to ex ante exposure to macro shocks? • In both cases need to be sure not to exacerbate macro-systemic externalities (procyclicality) • Beta higher in crisis times. Liquidity (solvency) requirements tied to beta may exacerbate credit crunch during crisis.

14. Why can liquidity risk not be resolved by private sector? • Eg by private liquidity pools? Puzzle. • Banks are competitors and may be reluctant to help in rescue operations both (ex ante and ex post). • Systemic externalities of bank failure mean that there are insufficient private incentives to create such private liquidity pools. • It may be difficult to specify conditions ex ante as to when liquidity will be granted (cannot write a complete contract). But this is also true of official arrangements. • May need official intervention on liquidity both ex post (LOLR) and ex ante (requirements).