Reducing the Chance of Pulling the Plug on Liquidity
IMF Blog, April 6, 2011
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- Authors: Jeanne Gobat
- Published: April 6, 2011
Problem statement: systemic liquidity shortfalls
- The near collapse of the financial system that set off the global crisis was due in part to financial institutions suddenly lacking access to funding markets, and liquidity drying-up across securities markets.
- Many financial institutions were unable to roll over or obtain short term funding without sustaining significant losses, threatening to sink them.
- Financial institutions underestimated their contribution to systemic liquidity risk in good times and did not bear the cost of their actions on others in bad times.
- "It only takes a few institutions to pull the plug on a liquidity-filled bathtub before it runs dry," creating a need for central banks to provide systemic liquidity backstops.
Measurement and macroprudential approach
- The key is to make sure that firms have less incentive to pull the plug by establishing the right incentives in the good times.
- The Global Financial Stability Report proposes a way to measure how much an individual financial institution contributes to system-wide liquidity risk to support macroprudential policy.
- Proposed mechanism: require all financial firms that contribute to systemic liquidity risk to buy insurance proportionate to the expected contingent liquidity support they might need from central banks in times of systemic liquidity stress.
Three proposed approaches to measuring systemic liquidity risk
- a systemic liquidity risk index that captures breakdowns of various financial arbitrage relationships across securities and can be used to signal a tightening of market liquidity and funding liquidity conditions.
- a systemic risk-adjusted liquidity model that can be used to calculate a time-varying, forward looking market-based measure of systemic liquidity risk, and an institution’s contribution to that risk.
- a macro stress-testing model which gauges the effects of an adverse macroeconomic or financial environment on the solvency of institutions and in turn the impact failures may have on liquidity shortfalls of others.
Key research findings on interconnectedness
- Taking interactions among financial institutions into account shows that the probability that all institutions would have troubles meeting their cash flow needs was far higher during times of extreme market disruptions compared to simply adding up individual institutions’ chances of liquidity problems.
- "Our research underscores that the whole is greater than the sum of its parts." Connections between asset and funding markets, and relationships among financial institutions, contribute materially to systemic liquidity risk.
Scope and implementation considerations
- Next step: test the models to assess performance and whether a capital surcharge or an insurance premium more cost effectively captures an institution’s contribution to systemic liquidity risk.
- Ideally, the framework should be expanded to include all non-bank financial institutions that contribute to systemic liquidity risk, including special investment vehicles, money market mutual funds, hedge funds, finance companies and others; implementation will depend on the structure of a financial system and vary from country to country.
- A multipronged regulatory approach is emphasized:
- Impose add-on capital surcharges to control systemic solvency risk among global systemically important financial institutions (as being considered under the G-20 reform agenda), which may also help lower systemic liquidity risk.
- If capital surcharges lessen the need for systemic liquidity risk mitigation, that is preferable; but residual contributions to systemic liquidity risk should be charged to the institution.
- Strengthen funding market infrastructure (for instance, by having collateral behind repurchase agreements registered with central counterparties) to help lower systemic liquidity risk.
Relationship to existing reforms
- New quantitative liquidity standards under Basel III for commercial banks should help enhance banking sector stability and indirectly mitigate systemic liquidity risk.
- However, Basel III reforms are microprudential and firm specific; they do not account for interconnections between institutions or pro-cyclical tendencies that contribute to buildups of systemic liquidity risk.
Source: Reducing the Chance of Pulling the Plug on Liquidity, Jeanne Gobat, April 6, 2011.
Content in this bundle
- CHAPTER 2 hoW to aDDreSS the SySteMIc Part oF lIQuIDIty rISK