Liquidity risk charges as a macro-prudential tool

Enrico Perotti, Javier Suarez 07 November 2009

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The recent financial crisis was unprecedented in scale and speed of propagation. The original housing shock was severely compounded by banks’ extreme funding fragility (Brunnermeier 2009). Banks’ risk-absorbing capacity had been reduced not just by lower capital buffers but also by extremely short-term funding. The panic withdrawals of wholesale short-term investors propagated and compounded losses as they forced massive distress sales (Gorton 2009). These in turn caused rapid asset price declines, triggered further margin calls and thus more fire sales across markets. The resulting uncertainty undermined access to new financing, leading to inefficiently rapid deleveraging (Brunnermeier 2009).

The crisis led to a consensus on the need to address systemic liquidity risk and its role in propagating a crisis. Last February, we proposed a new macro-prudential tool, liquidity risk charges, to discourage systemic risk creation by banks (Perotti and Suarez 2009). The charges target refinancing risk, so they need to be complemented by other reforms, such as capital requirements, aimed at asset risk.

The idea of liquidity risk charges is receiving the attention of policymakers engaged in defining the new framework for macro-prudential policy. In a new CEPR Policy Insight,  we refine the proposal, addressing frequently asked questions and implementation details.

Our proposal in a nutshell

Macro-prudential policy should discourage individual bank strategies that cause negative externalities by contributing to the financial system’s systemic risk. We propose to interpret systemic risk as “propagation risk”, which manifests when shocks spread beyond their direct economic impact, resulting in diffused distress and disruption of the real economy.

A lesson from this and other crises is that whatever the initial shock, the scale and speed of liquidity runs are the primary cause of propagation. Banks that rely excessively on short-term uninsured funding (i.e. excluding insured retail deposits) contribute to fire sales in a panic and thus excess propagation. In turn, propagation compounds losses and undermines confidence and access to finance, causing economic disruption.

Accordingly, our proposal aims at correcting the negative externalities caused by banks’ excessive reliance on short-term uninsured funding. It acknowledges that central banks and governments will be forced during a systemic crisis to provide significant liquidity insurance, replacing or otherwise guaranteeing significant portions of funding that is nominally uninsured during normal times.1

This de facto insurance calls for a system of liquidity risk charges, penalising short-term funding (as measured by the contingent maturity of liabilities). These would be essentially Pigouvian taxes, aimed at making banks internalise the negative systemic effects of fragile funding strategies. The goal is to prevent excess reliance on short-term funding in good times. As taxes, they would complement deposit insurance charges, without creating any explicit commitment to liquidity support. In their absence, there is a fiscal incentive to divert deposit taking to the shadow banking system, e.g. towards money market funds.

The intent is to start with low charges and adjust them so as to achieve a desirable funding structure. A tight benchmark would set them equal to the difference between the overnight and the rate on the “desired” minimum maturity. As in monetary policy, controlling “prices” will be more effective than controlling quantities (e.g. via liquidity requirements or direct constraints on the maturity of liabilities) and would avoid creating triggers.

Banks’ funding maturity is a simple and robust measure of propagation risk. Other bank characteristics critical to propagation such as size and connectivity should be used to scale up the charges.

Liquidity risk charges should be stable but adjustable by the macro-prudential authority in response to aggregate risk accumulation, such as asset bubbles based on fragile funding. The charges would grant some control over the build up of financial fragility without increasing the cost of credit for non-speculative (long-term) activities.

Macro-prudential policy choice would include additive or multiplicative shifts to the structure of the charges applied to various maturities. Policy tightening may be achieved by a further penalisation of very short maturities or by adding surcharges for increases in exposure above some baseline level, discouraging incremental expansion in short-term funding.

Footnotes

1 We state this as an observation rather than a normative suggestion. A normative defense of insurance can be found in Caballero (2009), among others.

References

Acharya, Viral, Lasse Pedersen, Thomas Philippon, and Matthew Richardson (2009), “Regulating Systemic Risk,” in Viral Acharya and Matthew. Richardson (eds.), Restoring Financial Stability: How to Repair a Failed System, Wiley, March.

Adrian, Tobias, and Markus Brunnermeier (2009), “CoVaR,” Federal Reserve Bank of New York Staff Reports, no. 348.

Brunnermeier, Markus (2009), “Deciphering the Liquidity and Credit Crunch 2007-08,” Journal of Economic Perspectives 23(1), 77-100.

Caballero, Ricardo (2009), “A Global Perspective on the Great Financial Insurance Run,” VoxEU, 23 January.

Gorton, Gary (2009), “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference, May.

Perotti, Enrico, and Javier Suarez (2009), “Liquidity Insurance for Systemic Crises,” CEPR Policy Insight No. 31, February.

Perotti, Enrico, and Javier Suarez (2009), “Liquidity Risk Charges as a Macroprudential Tool, CEPR Policy Insight No. 40, November.

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Topics:  Financial markets Macroeconomic policy

Tags:  bank regulation, macro-prudential regulation, Liquidity risk charges

Professor of International Finance, University of Amsterdam; Research Fellow, CEPR

Professor of Finance at CEMFI, Madrid; CEPR Research Fellow

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