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POLICY INSIGHT No. 31 FEBRUARY 2009

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POLICY INSIGHT No. 31 FEBRUARY 2009 abcd a POLICY INSIGHT No. 31 FEBRUARY 2009 Liquidity insurance for systemic crises Enrico Perotti and Javier Suarez University of Amsterdam and CEPR; CEMFI and CEPR ecuritisation was meant to reduce risk by spread- The charge would be set according to the principle that ing it, but in practice it did not. With hindsight, it future regulation should work like Pigouvian taxes on Swas all about regulatory arbitrage. As banks placed pollution, discouraging bank strategies that create sys- long-term assets in boxes sustained by short term temic risk for everyone. Hence, it should be increasing wholesale funding, but with the backup of their credit in the maturity mismatch between assets and liabilities, lines in case of trouble, they kept a significant amount and should be levied on all institutions with access to of the whole risk, while reducing their own capital. safety net guarantees. Its purpose should be to make When subprime mortgages were repriced, the card cas- short and medium term (up to one year) bank funding tle fell apart. more comparable in cost. Retail deposits would be Yet the panic in money markets contributed to spread exempted, as they are more stable thanks to their own financial losses well beyond what subprime positions insurance. would have justified, precisely because of the massive refinancing risk to which the system was exposed. Short Our proposal is to establish a term wholesale lenders proved very prone to run. The mandatory liquidity charge, to be paid 1 extreme maturity mismatch was instrumental to the 3 continuously during good times to a spreading of panic. It forced fire sales across all mar- . kets, which in turn caused margin calls and more panic supervisor who, in exchange, will o in a deadly spiral (Brunnermeier, 2009). provide emergency liquidity (and N Basel capital requirements are not designed to cope perhaps capital) during systemic crisis. with systemic liquidity risk. In a panic, the issue is no T longer the cost but the availability of funding. If fund- H ing fails, no reasonable capital reserve can cope with the Revenues accruing from the charge would go into an generated trouble. Relying on frequent rollovers ampli- Emergency Liquidity Insurance Fund (ELIF), with legal G I fies the speed of fire sales and the pace of repricing, autonomy and pre-packaged access to central bank liq- S feeding further reinforcement to panic. uidity and government funds backing. Upon significant N aggregate liquidity runs (critically, not concerning iso- I What reforms can prevent this from lated runs at individual banks), the payment of insur- ance would be triggered by the relevant supervisor. This Y happening again? would result in immediate liquidity support, guarantees C The leading argument proposes higher capital require- on uninsured wholesale funding, and some automatic I ments indexed to asset growth, total leverage and capital injections. Specific conditions may be attached, L maturity mismatch (Brunnermeier et al. 2009). We pro- such as restrictions on executive compensation and div- O pose a related approach, a liquidity and capital insur- idends, as well as on prudential strategic choices. P ance arrangement, which is simple, offers better incen- The main goal of liquidity charges is to realign fund- tives and is likely to receive stronger political support. ing incentives among beneficiaries of the safety net. R Our proposal is to establish a mandatory liquidity Reducing reliance on short term market funding would P charge, to be paid continuously during good times to a reduce the spreading of panic in a confidence crisis, and E supervisor who, in exchange, will provide emergency ultimately systemic risk. Deposit withdrawal risk is nat- C liquidity (and perhaps capital) during systemic crisis. ural, as banks intermediate between retail customers' To download this and other Policy Insights visit www.cepr.org FEBRUARY 2009 2 preference for immediacy and long term funding of to excessively rely on short term maturity funding. With production. A short term bias in wholesale funding is this feature, the charges would be naturally counter- not equally justified. The lower cost of short term fund- cyclical, leaning against the wind when liquidity is ing reflects the fact that short term lenders bear little abundant and the yield curve is positively slopped (com- risk, which is shifted to other stakeholders, such as cap- mon features of good economic times). In addition, if ital and taxpayers. Thus the charges would make banks necessary, the proportionality factor may be designed to properly internalise the potential damage caused to be explicitly countercyclical, collecting even more others. charges on short term borrowing in good times. The charge for liquidity risk could be seen as a liquid- ity insurance premium; a pre-payment for the contin- The international implementation of gent support that banks eventually receive during those our liquidity insurance arrangement is episodes. As such, it can make emergency intervention politically more acceptable, especially after the concern certainly complex but most desirable. raised by current bail-outs. The scheme we propose avoids imposing rigid restric- Why are higher bank capital ratios tions on banks' funding strategies and leaves to capital alone not a solution to bank liquidity requirements the traditional task of protecting against risk? asset risk. It is likely to make it more expensive for banks to rapidly expand their lending above their deposit base, First, banks' own capital would need to be very large but it will certainly not block it. A greater fraction of during normal times. This has several disadvantages. long term funding will go together with greater moni- Shareholders may be tempted to see bank capital as an toring from the corresponding creditors. Residual short asset to which they are fully entitled. Banks with plen- term creditors will be less prone to panic in a systemic ty of capital on their books may try to "lever it up", not crisis. necessarily through leverage (which is constrained by Sceptics may fear that the liquidity charges will capital requirements) but through riskier investment encourage the system to shift short term funding to a strategies. Additionally, shareholders' claims on bank shadow banking sector. This is not likely to occur if capital are a source of trouble in bank interventions, unregulated intermediaries enjoy limited recourse to since seizing a bank ahead of a formal default may be regulated banks. For deals between the regulated and seen as a violation of private property rights. the unregulated sectors, the scheme should assign In contrast, our insurance scheme arranges for a con- charges increasing in the unregulated borrowers' own tingent injection of capital and liquidity in systemic mismatch. To be sure, bank credit lines to institutions crises only, and may trigger clauses which force pruden- such as hedge funds might be treated as incontinent tial actions, such as dividend suspensions or other con- commitments, and the mismatched asset funding straints on management. Unlike the capital insurance should be fully charged. In any case, monitoring the scheme by Kashyap, Rajan, and Stein (2008), it penalis- boundary of the regulated sector is an indispensable es systemic risk creation and is more credible, as it relies step for any future regulation. 1 on a public regulator. It is also cheaper since most of The international implementation of our liquidity 3 the support would come as provision of temporary liq- insurance arrangement is certainly complex but most . uidity. desirable. Ideally, an international ELIF should be creat- o ed. Countries should choose to participate by requiring N The charge for liquidity risk could either all their regulated institutions, or at least the make emergency intervention largest ones, to join an international ELIF, pay its liq- T politically more acceptable, especially uidity charges, accept its supervision, and count on its H after the concern raised by support in a systemic crisis. G The establishment of an international ELIF may sort I current bail-outs. out commitment problems. Countries that do not join S should not benefit ex post. The scheme would consti- N A main advantage of liquidity charges is that maturi- tute an explicit coordination device for the rescue of I ty mismatch is easy to compute, and would discourage large international banks, preventing the issue of bur- systemic risk creation associated with short term fund- den sharing to be left for difficult ex post negotiations. Y ing. Systemic risk, namely the simultaneous realisation The liquidity charges, as insurance premia, provide a C I of correlated tail risk, is hard to estimate, as extreme co- mutually agreed metric for systemic risk and would L movements are rarely observed, and may be triggered by offer an objective basis for burden sharing. In case of a different asset class each time. However, liquidity runs need, countries might contribute to funding the ELIF in O are present in the escalating phase of all systemic crises proportion to the share of each national banking sector P and have a clearly negative amplifying effect. in the liquidity charges paid during the pre-crisis peri- Liquidity charges should be proportional to short term od, rather than some politically debatable country quo- R wholesale liabilities, weighted by the bank's maturity tas. P mismatch, which is easy to compute. They might be To conclude, the aim of the mechanism is to discour- E increasing in the slope of the short end of the yield age the forms of short term funding that create and C curve (up to one year), so as to eliminate the incentives amplify propagation risk. It is also a prepayment of To download this and other Policy Insights visit www.cepr.org FEBRUARY 2009 3 intervention costs, and a starting step to ensure that Brunnermeier, Markus, Andrew Crockett, Charles liquidity interventions occur on time and are based on Goodhart, Avi Persaud, and Hyun Shin (2009), "The ex ante rules.
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