Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: IMF Says Steps Needed to Avert Systemic Liquidity Shortages

September 29, 2010

  • Wholesale funding raised systemic liquidity risks during global crisis
  • Financial institutions, regulators failed to account for liquidity risks
  • Practices in wholesale funding markets must be improved

The inability of financial institutions, including banks, to obtain short-term funding during the global financial crisis was the result of weaknesses in risk management practices by the institutions themselves, serious and unforeseen issues in how wholesale funding markets work, and regulatory gaps, according to a new IMF report.

IMF Says Steps Needed to Avert Systemic Liquidity Shortages

Financial institutions that rely on short-term wholesale markets for funding should be required to maintain higher liquidity buffers (IMF photo)

GLOBAL FINANCIAL STABILITY REPORT

Financial institutions increasingly relied on short-term wholesale rather than deposit-based funding to finance their activities, which caused systemwide liquidity shortages when wholesale markets dried up, the IMF’s Global Financial Stability Report said. The systemic liquidity shortage—essentially the simultaneous and widespread inability of institutions to find the cash they need to operate—was one of the key factors that threatened the health of the global financial system and triggered massive interventions by authorities to keep banks and other financial institutions afloat.

Financial institutions failed to take into account the sharp declines in collateral valuations that undermined their funding strategy in secured lending markets such as those for repurchase agreements (repos). Nor did they factor in the possibility of a sudden, large-scale disruption to money markets, when investors—uncertain about asset valuations, the ability of counterparties to live up to their obligations, and the availability of liquidity—withdrew and cut back credit lines, the IMF said in the special report released on September 29.

Banks, and nonbanks, raise cash in repo markets by selling securities and promising to buy them back at an agreed price at a future date. If the borrower cannot repay, the securities serve as collateral that the creditor can sell. But during the global crisis the value of much of the collateral was questioned and creditors were reluctant to make loans.

Worldwide dollar shortage

Money market mutual funds, which invest with a goal of keeping their net asset value at $1 a share, essentially ceased buying asset-backed commercial paper that depended on mortgages and certificates of deposit. That also contributed to a worldwide shortage of dollars and affected many internationally active non-U.S. banks that fund their dollar-denominated assets in the U.S. wholesale market. To ease the global shortage, the U.S. Federal Reserve engaged in swaps with other central banks to pump out dollars in the world economy.

The IMF report on systemic liquidity problems is one of two special analyses that accompany the IMF’s Global Financial Stability Report, whose main chapter will be released October 5.

The IMF says that policymakers continue to struggle with how to address the systemic component of liquidity risk. The report says that policies to address systemic liquidity risk must deal both with institutions and the markets within which they interact. For institutions, the chapter recommends that

• All financial institutions (not just banks) that rely on short-term wholesale markets for funding be required to maintain higher liquidity buffers—cash, or assets than can quickly be converted to cash—as cushions against shocks.

• New guidelines be issued on how much maturity transformation—in which short-term funds finance long-term assets—can be taken by financial institutions that have access to central bank or government support.

• Policymakers consider a systemically based fee or surcharge on financial institutions to account for the liquidity risk they pose for others in funding markets.

Higher liquidity buffers

The IMF report welcomes the prudential liquidity rules proposed on September 12 by the Basel Committee on Banking Supervision. The proposals encourage banks to hold higher liquidity buffers and reduce the mismatch between the cash flows from their assets and the payment obligations on their liabilities. Still, the IMF says more analysis must be done to assess the effects the rules might have on how banks fund themselves and on market liquidity.

The IMF also said that regulators should consider applying the guidelines in some form to nonbank financial institutions that contribute to maturity transformation and systemic liquidity risk. This could offset any buildup of liquidity risks outside the banking system.

To mitigate the systemic risks that funding markets dry up again, the IMF report recommends that

• Information available to market participants be improved to allow them to accurately assess counterparty risks.

• Collateral valuation and margin practices in repo markets be strengthened through more frequent valuation adjustments, more realistic assumptions about how long it might take to sell the collateral, and more reliance on models that take a longer-term view of how collateral should be valued to discourage excessive funding when values are high.

• Supervisors periodically validate the initial margins generated by banks’ in-house models.

• Consideration be given to having third parties provide continuous price estimates for collateral used in repo transactions.

• Greater use of central counterparties to help lower operational and counterparty risk in repo transactions.

More active monitoring

The IMF also suggests that money market mutual funds should, over time, have to choose whether to become mutual funds whose net asset value fluctuates, or be overseen and regulated as banks, with their liabilities treated as deposits with the established guarantees. This should lower the risk of liquidity runs on money market mutual funds because investors would be required to more actively monitor the liquidity risks that their funds assume.

The IMF also finds that there is merit in making central bank foreign currency swap facilities readily available in the future. Central banks should assure that the terms of operations will enhance banks’ cross-border liquidity management and that they turn to such facilities only in times of systemic stress. In addition, there should be greater supervision of cross-border maturity transformation.

■ Alexandre Chailloux, Simon Gray, Andy Jobst, Kazuhiro Masaki, Hiroko Oura, and Mark Stone also contributed to this article.