The financial crisis that started in 2007 unveiled the fragility of the market for liquidity and how this was underestimated by market participants and regulators alike. Liquidity risk is particularly deceitful because it carries an externality with potentially large systemic implications. From the individual investor’s perspective, while it may be rational to gain exposure to liquidity risk with a large mismatch in asset-liability maturities, many individual investors do not take into account that, when there is a liquidity crunch, the need to unload assets has adverse effects on others and forces them to sell their positions as well, causing a loss spiral of the kind that exacerbated the recent financial crisis (Brunnermeier 2009).
The problem may become even more acute in the future. The extraordinary measures taken by public authorities to prevent the collapse in the markets for liquidity are likely to amplify moral hazard and reduce banks’ incentives to hedge against liquidity risks. There is a clear need for regulation that addresses the externality created by liquidity risk and reduces the need for public intervention.
Current proposals and their shortcomings
The Basel Committee is proposing two concurrent quantity limits (BCBS 2009). The Liquidity Coverage Ratio posits that banks must hold enough high quality liquid assets to cover cash outflows (calculated under heavy stress scenarios) over 30 days. The Net Stable Funding Ratio requires banks to fund their assets, weighted according to their (il)liquidity, with equity, deposits and liabilities with an effective maturity of over one year.
An alternative proposal would impose liquidity risk charges or levies that penalise short-term funding (Perotti and Suarez 2009), i.e. a Pigouvian tax that could be calibrated on banks’ funding structure, size, and interconnectedness. Another price-based suggestion is to apply capital requirement surcharges proportional to the size of the maturity mismatch (Brunnermeier et al. 2009).
These proposals may help reduce aggregate liquidity risk but share three main problems.
- First, they might generate significant deadweight losses by inefficiently curbing the liquidity and maturity transformation function of banks.
Given the uncertainty about marginal costs and benefits of reducing maturity exposures of banks, the choice of a wrong instrument (i.e. a quantity versus a price mechanism) or its inappropriate calibration may imply large welfare costs (Weitzman 1974). While maturity transformation might have been excessive at some point, it remains a vital function of the financial system and its importance is unlikely to diminish in the future given the structural demand for short-term, safe assets from investors and of longer-term funds from firms and households (Caballero 2009).
- Second, the proposed measures do not tackle the systemic dimension of liquidity risk.
The proposed measures are based on individual banks’ asset-liabilities structure. But liquidity risk in the financial system as a whole may be very different from what can be inferred from individual mismatches (Hellwig 2008). They might therefore end up being neither necessary nor sufficient to prevent future crises.
- Third, all the proposals are geared towards reducing the probability of a liquidity crisis, but should a crisis happen they do nothing to dampen it. Indeed, they may even worsen it.
For example, if quantity limits are imposed, a liquidity shock could push many banks below the minimum required; the need to restore the regulatory ratios would trigger sales of assets and/or a rush to “stable” sources of funds that may propagate the panic.
Our proposal: A ROOF for banks
Ideally, since liquidity crises are rare systemic events, policy proposals to limit them should be directed at correcting externalities while minimising the deadweight loss in normal times. Policies should have a systemic perspective, be easy to implement and difficult to circumvent, and possibly provide relief when a crisis occurs.
We suggest that banks should be encouraged, through adequate regulatory relief, to issue a new class of securities (the Roll-Over Option Facilities or ROOFs), with the following characteristics:
- the securities (any standard, plain vanilla bond will do) have a roll-over option attached to them, i.e. the possibility for banks to keep the underlying funds for a pre-specified new maturity;
- the option is activated if, and only if, at expiration there is “sufficient tension” on liquidity markets according to an easily observable indicator, e.g. the Libor-OIS spread is above a pre-determined trigger level;
- the securities are rolled over with a yield that reflects both the credit-worthiness of the bank and the price of liquidity in the market at the moment of roll-over; for example it could be indexed to sector-rating class specific yield indices that are routinely published.
These ROOFs would allow banks to keep liquidity during a crisis, reducing their need to return to panicked markets to get funding or to “fire-sale” assets giving rise to price spirals. Given that the roll-over option would be activated only in the wake of a systemic crisis, in normal times the impact and the distortions in the market for liquidity would be contained (see Nicoletti-Altimari and Salleo 2010 for more detail).
We suggest that the incentive for banks to issue ROOFs is provided by regulatory relief. Within the context of the liquidity standards proposed by the Basel Committee, for example, the funds raised with this instrument could be considered as retail deposits. Issuing a ROOF would reduce the denominator of the issuer’s Liquidity Coverage Ratio and increase the numerator of its Net Stable Funding Ratio, in both cases improving its liquidity position. At the same time, banks would have a disincentive to buy ROOFs as they would increase the denominator of its Net Stable Funding Ratio, worsening their liquidity position. This mechanism would thus provide incentives for banks to shift liquidity risk outside the banking sector, reducing interconnectedness.
Supervisory authorities should set a maximum value for the trigger, i.e. the value of the indicator above which the option could be activated. This is necessary to avoid that the value is set very high by banks and that ROOFs are issued only to circumvent liquidity requirements. Below this maximum the determination of the exact value of the trigger would be left to the contracting parties.
The cost of the embedded option in a ROOF should be low in normal times, since liquidity crises are rare events and the cost borne by the buyers, should the option be triggered, is the unavailability of the invested capital, while the return would reflect current market prices for liquidity and credit risk. This should limit capital losses and, given that liquidity crises usually do not last “too long”, the inconvenience of not being able to dispose of funds should be relatively short. ROOFs should be attractive funding instruments for banks if one considers that liquidity crises are essentially about rationing: nobody wants to finance a bank even though returns would be very high, because of asymmetric information, while banks would be willing to pay very high spreads but there are no funds available.
Who would buy a ROOF? A ROOF would be an attractive proposal for an investor willing to bear systemic liquidity risk, i.e. to face the possibility of not being able to cash in a security during a liquidity crisis, although possibly without suffering capital losses by the end of the crisis. We believe that this is a case of diversifiable systemic risk since there are many possible investors that routinely invest a share of their holdings in liquid assets but that are not necessarily interested in selling them during relatively short-lived liquidity crises: pension funds, mutual funds, sovereign funds, hedge funds, and even households. ROOFs should be relatively attractive for these investors as the return would be higher than that of alternative assets with equivalent maturity, while the extra risk attached to them would normally be low.
The adoption of ROOFs, combined with regulatory reform, would provide a tool to address the systemic dimension of liquidity risk while limiting market distortions. It could help shift liquidity risk outside the banking industry, reducing the inter-connectedness of banks and spreading liquidity risk among a larger variety of investors. Moreover, since liquidity risk has a self-fulfilling component triggered by runs and fire sales, by containing funding requirements during episodes of financial turmoil it would make banks more stable ex ante, decreasing the likelihood of a crisis. Furthermore, it would help contain the costs of a crisis if banks can secure sufficient liquidity thanks to the widespread use of this contingent claim. Finally, this instrument would generate an additional form of market discipline as buyers would have the incentive to monitor more carefully general liquidity conditions in the markets.
Disclaimer: the views expressed in this column are those of the authors and do not necessarily reflect those of the Bank of Italy.
Basel Committee for Banking Supervision (2009), “International Framework for Liquidity Risk Measurement, Standards and Monitoring”, Bank for International Settlements, Basel, December.
Brunnermeier, Markus (2009), “Deciphering the Liquidity and Credit Crunch 2007-08”, Journal of Economic Perspectives, 23(1): 77-100.
Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash Persaud, and Hyun Shin (2009), "The Fundamental Principles of Financial Regulation", Geneva Reports on the World Economy n. 11.
Caballero, Ricardo (2009), “The “Other” Imbalance and the Financial Crisis”, Baffi Lecture, Bank of Italy, 10 December.
Hellwig, Martin (2008), “Systemic Risk in the Financial Sector: An Analysis of the Subprime Mortgage Financial Crisis”, Max Planck Institute for Research on Collective Goods, n. 43.
Nicoletti-Altimari, Sergio and Carmelo Salleo (2010), “Contingent Liquidity”, Bank of Italy, mimeo.
Perotti, Enrico, and Javier Suarez (2009), “Liquidity Charges as a Macroprudential Tool”, CEPR Policy Insight 40, London.
Weitzman, ML (1974), “Prices vs. Quantities”, Review of Economic Studies 41(4):477–491.