Center for Financial Innovation and Stability

Notes from the Vault

Larry D. Wall
November 2015

Many of the defining moments in the financial crisis were marked by liquidity problems. The first major shock occurred when BNP Paribas suspended liquidations from three of its money market funds, citing illiquid markets. There were also runs on Bear Stearns and Lehman Brothers that led to their collapse, and stress on the commercial paper market in the wake of massive redemptions in prime money market funds. Since the crisis, financial supervisors have taken a variety of actions to strengthen liquidity regulation, some of which I have previously discussed. However, as then University of Pennsylvania Professor Franklin Allen observed, when it comes to liquidity regulation the gaps in our understanding are such that "we do not even know what to argue about."

The recent research conference The Role of Liquidity in the Financial System, which was hosted by the Atlanta Fed and cosponsored by Georgia State University's Center for the Economic Analysis of Risk, sought to close some of those gaps.¹ The papers presented dealt with a wide variety of issues related to both market and institutional liquidity.

Shadow banks
Shadow banks played an important role in the crisis and were one of the topics of last year's conference (see my summary). This year, Giovanni di Iasio from the Bank of Italy and Zoltan Pozsar of Credit Suisse started the conference with a paper titled "A Model of Shadow Banking: Crises, Central Banks and Regulation." Their paper develops a model in which demand for higher returns by institutional investors drives the creation of private money. If demand is low relative to safe assets, private money is safe. However, if demand is high, the shadow banks take on riskier portfolios, resulting in shadow banks that are vulnerable to aggregate shocks.

Moreover, Stephan Luck of the University of Bonn, Princeton University, and Max Planck Institute for Research on Collective Goods, and Paul Schempp, at the Max Planck Institute for Research on Collective Goods, show that commercial banks may be vulnerable to shadow bank risk in their paper "Regulatory Arbitrage and Systemic Liquidity Crises." This linkage arose in large part during the crisis because of contractual linkages between shadow and commercial banks. However, the authors show that even if the banks are not being run themselves and are not directly exposed to the shadow banks, commercial banks could be vulnerable to runs on shadow banks that cause wholesale funding conditions to deteriorate.

Capital and liquidity
Although examiners have long supervised banks' liquidity positions, numerical liquidity requirements comparable to risk-based capital requirements have only recently been adopted. Gazi Ishak Kara from the Federal Reserve Board of Governors and S. Mehmet Ozsoy of Ozyegin University develop a model in which relying solely on capital regulation leads banks to reduce their liquidity holdings. Their paper "Bank Regulation under Fire Sale Externalities" shows conditions under which the combination of capital and liquidity regulations produces a better outcome than capital regulations by themselves.

Santiago Carbo-Valverde of the Bangor Business School, Eduardo Maqui from Universidad de Granada and the European Central Bank, and Francisco Rodriguez-Fernandez from the Universidad de Granada analyze the extent to which ex ante measures of bank liquidity, financial system liquidity, and bank solvency explain a sample of European banks' contribution to systemic risk before and during the crisis. Their paper "Insolvency and Liquidity Risk: Which Is More Systemic?" finds that their bank liquidity measure is only statistically significant during the crisis. In contrast, financial system liquidity reduced a bank's contribution to systemic risk before the crisis but increased it after the crisis.

Information and bank liquidity
An important determinant of a bank's liquidity position is its ability to obtain funds from the other banks connected to it in the funding network. Network analysis has been applied in various contexts, but it often takes the structure of the network as exogenous. Francisco Blasquesa of VU University Amsterdam, Falk Bräuning of the Federal Reserve Bank of Boston, and Iman van Lelyveld of De Nederlandsche Bank and Bank for International Settlements develop a theoretical model in which the structure of the network is endogenously driven by monitoring costs in their paper "A Dynamic Network Model of the Unsecured Interbank Lending Market.." Their paper also simulates their model based on parameters from the Dutch interbank market and finds simulated network to be similar to the actual network.

A bank's decision to borrow in interbank markets or sell assets is analyzed by Michal Kowalik of the Federal Reserve Bank of Boston in his paper "To Sell or to Borrow? A Theory of Bank Liquidity Management." Banks in Kowalik's model prefer to borrow rather than sell because there is less adverse selection risk on the bank's overall portfolio than on some of its individual assets.

Fabio Castiglionesi of Tilburg University, Zhao Li of Universitat Pompeu Fabra, and Kebin Ma of Warwick Business School address the problem of adverse selection in the markets for bank assets in their paper "Bank Information Sharing and Liquidity Risk." They argue that banks share information about loans even though that increases competition in the loan market. The offsetting benefit is that banks are able to obtain liquidity by selling their loans at higher prices in secondary markets.

Measuring liquidity risk
A practical problem for macroprudential supervisors is identifying periods when the banking system is coming under increased strain. Kartik Anand from the Deutsche Bundesbank, Céline Gauthier of Université du Québec en Outaouais, and Moez Souissi from the International Monetary Fund develop a model in which solvency, funding liquidity, and market risks are "intertwined" in their paper "Quantifying Contagion Risk in Funding Markets: A Model-Based Stress-Testing Approach." They then calibrate their model to Canadian domestically systemically important banks to show how it could be used to analyze a banking system in a stressful scenario.

Jennie Bai of Georgetown University, Arvind Krishnamurthy of Stanford University, and Charles-Henri Weymuller from the French Treasury take Brunnermeier, Gorton, and Krishnamurthy's (2011) theoretical model with time-varying liquidity weights and develop an empirical implementation. In their paper "Measuring Liquidity Mismatch in the Banking Sector," they find that the "liquidity mismatch index" works well both in identifying contemporaneous liquidity problems in the time series and identifying the extent to which individual banks need liquidity assistance in the cross-section.

Liquidity in financial markets
A number of analysts have expressed concern about recent changes and potential future changes in liquidity in important financial markets. One concern is rapid growth of bond funds specializing in corporate bonds. Price declines in this market could be exacerbated by forced mutual fund selling if corporate bond mutual fund investors demanded redemption of their shares during a decline. Itay Goldstein of the Wharton School, Hao Jiang of Michigan State University, and David T. Ng of Cornell University analyze how bond investors have responded to such declines in their paper "Investor Flows and Fragility in Corporate Bond Funds." They find some evidence that fund flows by bond fund investors have been more responsive to bad performance than to good performance, in contrast to equity investors who were relatively more responsive to good performance.

Another concern in some financial markets is the supply of liquidity by dealers. Jonathan Goldberg of the Federal Reserve Board analyzes the impact of dealer liquidity shocks on financial markets in his paper "What Drives Liquidity? Identifying Shocks to Market Makers’ Supply of Liquidity and Their Role in Economic Fluctuations." He finds that liquidity shocks play an important role in explaining changes in dealer market-making activity and the supply of liquidity.

Professor Larry Harris of the University of Southern California made a similar point in his dinner remarks. While many have raised concerns that dealers are withdrawing from fixed income markets, he noted that dealers tend to disappear when they are most needed. Moreover, he argues that buy-side traders could provide substantially more liquidity if markets were more transparent.

Fears of potential spillovers from failures in the over-the-counter (OTC) derivatives market have also led to regulatory initiatives—in this case, to force more heavily traded OTC derivatives contracts to be cleared with a central counterparty and to require higher capital for noncleared derivatives. Daniel Bauer, Enrico Biffis, and Luz Rocio Sotomayor, all from Georgia State University, analyze the effect of different collateralization procedures in their paper "Optimal Collateralization with Bilateral Default Risk." They find that standardized collateral rules can adversely affect the extent to which OTC derivatives are used for risk sharing.

Central bank lending programs
In response to liquidity problems during the financial crisis, many central banks created new facilities for lending to banks. The choice of U.S. banks between borrowing from the discount window, which existed since the founding of the Federal Reserve, versus the new Term Auction Facility (TAF) is analyzed by Celine Gauthier of the Université du Québec, Alfred Lehar of the University of Calgary, Hector Perez-Saiz of the Bank of Canada, and Moez Souissi of the International Monetary Fund. Their paper "Emergency Liquidity Facilities, Signaling, and Funding Costs" develops and tests a model in which weaker banks take advantage of the greater flexibility in discount window borrowing, whereas stronger banks signal their strength by using the TAF. The empirical part of the paper finds evidence consistent with their hypotheses.

The choice of the discount window versus the TAF is also empirically analyzed by Allen N. Berger of the University of South Carolina, Lamont K. Black of DePaul University, Christa H.S. Bouwman of Texas A&M University, and Jennifer Dlugosz of Washington University in St. Louis. In their paper "The Federal Reserve’s Discount Window and TAF Programs: “Pushing on a String?" they find the small bank users of these Federal Reserve programs were generally weak, whereas the large bank users were not. They also find evidence that these programs were successful in increasing the amount of lending relative to that which would have occurred in their absence.

Impact of unconventional policy
In addition to their normal programs for lending to commercial banks, some central banks have engaged in unconventional policy measures to support the financial sector and the real economy. The Federal Reserve extended the maturity of its portfolio of Treasury securities starting in 2011 in an attempt to stimulate economic activity by flattening the yield curve and reducing risk aversion. Nathan Foley-Fisher from the Federal Reserve Board, Rodney Ramcharan of the University of Southern California, and Edison Yu of the Federal Reserve Bank of Philadelphia find that the maturity extension did have the intended impact in their paper "The Impact of Unconventional Monetary Policy on Firm Financing Constraints: Evidence from the Maturity Extension Program."

Central bank interventions may also have less desirable impacts on financial markets. Viral Acharya of New York University, Diane Pierret of HEC-University of Lausanne, and Sascha Steffen of the European School of Management and Technology examine the consequence of European Central Bank (ECB) actions in their paper "Do Central Bank Interventions Limit the Market Discipline from Short-Term Debt?" They find evidence that prior to the ECB actions, U.S. money funds were disciplining European banks (reducing their supply of funds to higher-risk banks while maintaining the supply to lower-risk banks). However, after the ECB announced the Outright Monetary Transaction program in September 2012, money funds reversed course and increased the supply of funds to risky banks.

Conclusion
Although the conference dealt with a wide variety of liquidity related issues, almost all of the papers can be related back to one or more of three themes. First, the liquidity of an asset or institution depends on the extent to which other market participants are confident in the value of the underlying assets. In this sense, some of the papers harken back to Gary Gorton’s emphasis on the role of informationally insensitive assets.

Second, many aspects of liquidity are best understood in the context of the wider system in which they are embedded. For example, weaknesses in a bank's capital position can lead to liquidity problems and weaknesses in its liquidity position can force fire sales that weaken capital.

Third, there are important linkages across markets and institutions. For instance, shocks to shadow banks and to securities markets dealers' positions can feed through to affect the markets in which they operate.

We plan on following up this academic conference on liquidity with a more policy focused discussion at the 2016 Financial Markets Conference. Stay tuned.

Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments on the paper. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

Reference

Brunnermeier, Markus K., Gary Gorton, and Arvind Krishnamurthy. "Risk Topography." NBER Macroeconomics Annual 2011, Volume 26. Chicago: University of Chicago Press, 2011. 149–176.

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¹ The conference was organized by Glenn Harrison, Enrico Biffis, and Lixin Huang of Georgia State University, Albert (Pete) Kyle of the University of Maryland, and Larry Wall and Bin Wei of the Federal Reserve Bank of Atlanta.