Liquidity Regulation And The Macroeconomy

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Liquidity Regulation and the MacroeconomyNina BoyarchenkoThe views presented here are the authors’ and are not representative of the views ofthe Federal Reserve Bank of New York or of the Federal Reserve SystemJune 8, 2013

Overview Liquidity shortages and mismanagement one of the keycharacteristics of the financial crisis Stress factors to liquidity included Short-term whole sale funding of non-traditional, illiquidassets Mismanagement of contingent liquidity risk Uncertainty about counterparties/collateral disruptingsecured funding markets Basel III regulation promotes resilience to liquidity shocks byaddressing two objectives: Enhance resilience to short-term funding shocks byrequiring FIs to hold a minimum pool of liquid assets (LCR) Improve longer term liquidity management by requiringactivity funded with “core” or stable funding (NSFR)Bank regulation develops empirically theory tries to catch up2

Liquidity Regulation Liquidity Coverage Ratio (LCR): High-quality unencumbered liquid assets sufficient to covernet cash outflows over a 30 day under a stress scenario Stressed net cash outflows capture potential risksassociated with contractual and behavioral responses forboth on- and off-balance sheet positions Stress scenarios include firm-specific shocks Net Stable Funding Ratio (NSFR): Matches one-year stable funding requirement with liquidityrisk profile of assets/activities Assumes extended period of stress Compares available to required stable funding Forward-looking: closer to stress tests than to traditional capitalregulation3


My Remarks1. Review (some) recent literature on liquidity regulation2. Outline issues faced by “policymakers” in this context5

Common Features Two-period models How do intertemporal concerns affect decisions of financialinstitutions and thus the impact of regulation? Endowment economies How does regulation alter the optimal lending mix betweenhousehold, small business and interbank loans? Is banking regulation that is socially optimal in anendowment economy still optimal in a production economy? Could large corporations (GE? Apple? Microsoft?) becomeliquidity producers for the financial system?6

“Financial Regulation in General Equilibrium” byGoodhart, Kashyap, Tsomocos and Vardoulakis General equilibrium model with Two types of intermediaries: banks and shadow banks Two types of real assets: non-durable (“potatoes”) anddurable (“houses”) Three types of households: rich and poor first periodhouseholds and first-time home buyers in the second period Poor households must borrow from banks to finance housepurchases in first period Can choose to optimally default in second period Shadow banks less risk-averse than banks so banks cansecuritize loans and sell to the shadow banking system Shadow banks financed by repos by banks Household default triggers forced selling by shadow bankingsystem, releasing bad assets back into the banking system7

“Financial Regulation in General Equilibrium” byGoodhart, Kashyap, Tsomocos and VardoulakisConsider five policy options: Limits on LTV ratios Capital requirements for banks Liquidity coverage ratios for banks Dynamic loss provisioning for banks Margin requirements on reposConclusions:1. Different tools affect different parts of the financial system;thus, altering allocations during the bust is easier than duringthe boom2. Use of capital requirements creates regulatory arbitrage3. The degree to which regulations act ascomplements/substitutes depend on the channel throughwhich they operate8

“A Pigovian Approach to Liquidity Regulation”by Perotti and Suarez Partial equilibrium with heterogeneous banks facing an NPVcurve associated with short-term funding Expected NPV losses in a systematic liquidity crisis differchange with Type of bank Funding decision Other banks’ funding decisions Flat rate Pigovian tax on short-term funding implements thesocially efficient allocation Quantity-based approach (e. g. NSFR) reduce total amount ofliquidity risk but reallocate it inefficiently, constraining bankswith better investment opportunities and encouraging lowerquality banks to expand9

“A Pigovian Approach to Liquidity Regulation”by Perotti and Suarez Allowing for variation in risk-shifting incentives overturns theranking of regulation options A quantity-based approach limits the scale of lending, reducingrisk-shifting incentives Can be either a liquidity requirement or a capitalrequirement Taxes do little to limit credit expansion since high-riskinstitutions are more willing to pay the tax and expand risktaking10

“A Theory of Bank Liquidity Requirements”by Calomiris and Heider Argue for using cash-holding instead of capital requirementssince cash1. Has zero liquidation costs2. Is observable and verifiable: no need to evaluate the loanportfolio3. Improves incentives to manage risk of the non-cashassets: riskiness of cash is invariant to bankers’ riskmanagement decision Consider three banking system configurations: autarky,banking coalition and government deposit insurance Assumes that there are no systemic liquidity needs11

“A Theory of Bank Liquidity Requirements”by Calomiris and Heider In autarky, banks use cash to commit to proper riskmanagement and increase cash holdings in response toadverse shocks In a coalition, banks commit to lend to each other in responseto a members’ need to accumulate cash Cash requirements imposed by the coalition to eliminatefree riding Requirements less than the voluntary holdings in autarky With deposit insurance, cash requirements necessary toprevent moral hazard and ensure proper risk management Higher than either in autarkic or coalition equilibria12

Policy Issues and Concerns: Objectives Are the objectives of liquidity regulation theoretically justified? To what extent should institutions/groups of institutions berequired to self-insure ex-ante against “systemic risks”? Can there be an ex-post commitment to no bail-outs? Will regulating maturity/liquidity transformation in the bankingsector just shift the activity elsewhere? Costs of liquidity regulation What is the impact on the funding costs of financialinstitutions? What is the spillover effect on the funding costs of nonfinancial borrowers? Data collection costs for institutions and data processingcosts for regulators13

Policy Issues and Concerns: Implementation What is the definition of liquid assets? Does eligibility for central bank/discount window borrowingmake the asset liquid? Is the set of liquid assets fixed over time or time varying? What is the extent of discretion in classifying assets asliquid? What is the right stress scenario? Is the calibration of the Basel standards consistent withhistorical experience (should it be)? Should stress scenarios recognize traditional/prospectivegovernment support of sectors? As with capital stress tests, what is the right approach toregulatory disclosure?14

Policy Issues and Concerns: Interactions Liquidity only part of the new regulatory toolkit Are liquidity and capital regulations complements? Substitutes? Liquidity regulation is prudential: limits risk taking duringeconomic booms Capital regulation is provisional: limits losses during periodsof stress How does monetary policy impact liquidity? LCR/NSFR require institutions to hold safe assets; willperiods of monetary policy tightening create shortages ofsafe assets? Holding safe assets during periods of low interest rates isespecially costly; does liquidity regulation induce reach foryield? Are required reserves a more or less costly way of insuringliquidity in the short run?15

Appendixfor internal use only

Liquidity Coverage Ratio (LCR) Computes the ratio of high-quality unencumbered liquid assets toprojected net cash outflows over a 30 day scenario under asupervisory specified stress scenario “Liquid” assets are unencumbered, liquid in markets during periods ofstress and central-bank eligible (ideally) Stress scenario includes Partial loss of retail deposits Significant loss of unsecured and secured wholesale funding Contractual outflows associated with a 3-notch rating downgrade Substantial calls on off-balance sheet exposures Haircut on contractual inflows and aggregate cap Firm-specific shock during period of market stress Calibration of scenario run-off rates based on historical experience,banks’ internal stress scenarios and regulatory/supervisory standards17

Net Stable Funding Ratio (NSFR) Matches stable funding requirement over a one year horizon toliquidity risk profile of assets and activities Stable funding defined as those types and amounts of equityand liability financing expected to be reliable sources of fundsover a one-year time horizon under conditions of extendedstress Liabilities assigned “stable funding” factor, ranging from100% to 0% Required amount of funding measured using supervisoryassumptions on the characteristics of the liquidity risk profiles ofassets, off-balance sheet exposures and other activities Value of the assets held and funded by the institutionmultiplied by specific required stable funding (RSF) factorfor each asset type (from 0% to 100%) Same for off-balance-sheet activity18


Use of capital requirements creates regulatory arbitrage 3. The degree to which regulations act as . Assumes that there are no systemic liquidity needs “A Theory of Bank Liquidity Requirements” . Liquidity only part of the new regulatory toolkit Are liquidity and capital regulations complements? Substitutes? Liquidity regulation is .

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