«Jin Cao a,b, Gerhard Illing b,c,∗ a Munich Graduate School of Economics (MGSE), Germany b Department of Economics, University of Munich, D-80539 ...»
Endogenous systemic liquidity risk
Jin Cao a,b, Gerhard Illing b,c,∗
a Munich Graduate School of Economics (MGSE), Germany
b Department of Economics, University of Munich, D-80539 Munich, Germany
c CESifo, Germany
Traditionally, aggregate liquidity shocks are modelled as exogenous events.
Extending our previous work (Cao & Illing, 2007), this paper analyses the adequate
policy response to endogenous systemic liquidity risk. We analyse the feedback
between lender of last resort policy and incentives of private banks, determining the aggregate amount of liquidity available. We show that imposing minimum liquidity standards for banks ex ante are a crucial requirement for sensible lender of last resort policy. In addition, we analyse the impact of equity requirements and narrow banking, in the sense that banks are required to hold suﬃcient liquid funds so as to pay out in all contingencies. We show that such a policy is strictly inferior to imposing minimum liquidity standards ex ante combined with lender of last resort policy.
JEL classiﬁcation: E5, G21, G28 Key words: Liquidity risk, Free-riding, Narrow banking, Lender of last resort First version: April, 2008.
∗ Corresponding author. Seminar fur Makrookonomie, Ludwig-Maximilians¨ ¨ Universit¨ t Munchen, Ludwigstrasse 28/012 (Rgb.), D-80539 Munich, Germany.
a ¨ Tel.: +49 89 2180 2126; fax: +49 89 2180 13521.
Email addresses: firstname.lastname@example.org (Jin Cao), email@example.com (Gerhard Illing).
The events earlier this month leading up to the acquisition of Bear Stearns by JP Morgan Chase highlight the importance of liquidity management in meeting obligations during stressful market conditions....
The fate of Bear Stearns was the result of a lack of conﬁdence, not a lack of capital.... At all times until its agreement to be acquired by JP Morgan Chase during the weekend, the ﬁrm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard.
— Chairman Cox, SEC, Letter to Basel Committee in Support of New Guidance on Liquidity Management, March 20, 2008 Bear Stearns never ran short of capital. It just could not meet its obligations. At least that is the view from Washington, where regulators never stepped in to force the investment bank to reduce its high leverage even after it became clear Bear was struggling last summer. Instead, the regulators issued repeated reassurances that all was well. Does it sound a little like a doctor emerging from a funeral to proclaim that he did an excellent job of treating the late patient?
— Floyd Norris, New York Times, April 4, 2008 1 Introduction For a long time, presumably starting in 2004, ﬁnancial markets seemed to have been awash with excessive liquidity. But suddenly, in August 2007, liquidity dried out nearly completely as a response to doubts about the quality of subprime mortgage-backed securities. Despite massive central bank interventions, the liquidity freeze did not melt away, but rather spread slowly to other markets such as those for auction rate bonds. On March 16th 2008, the investment bank Bear Sterns which — according to the SEC chairman — was adequately capitalized even a week before had to be rescued via a Fed-led takeover by JP Morgan Chase.
Following the turmoil on ﬁnancial markets, there has been a strong debate about the adequate policy response. Some have warned that central bank actions may encourage dangerous moral hazard behaviour of market participants in the future. Others instead criticised central banks of responding far too cautiously. The most prominent voice has been Willem Buiter who — jointly with Ann Sibert — right from the beginning of the crisis in August 2008 strongly pushed the idea that in times of crises, central banks should act as market maker of last resort. As adoption of the Bagehot principles to modern times with globally integrated ﬁnancial systems, central banks should actively purchase and sell illiquid private sector securities and so play a key role in assessing and pricing credit risk. In his FT blog “Maverecon”, Willem Buiter stated the intellectual arguments behind such a policy
very clearly on December 13, 2007:
“Liquidity is a public good. It can be managed privately (by hoarding inherently liquid assets), but it would be socially ineﬃcient for private banks and other ﬁnancial institutions to hold liquid assets on their balance sheets in amounts suﬃcient to tide them over when markets become disorderly. They are meant to intermediate short maturity liabilities into long maturity assets and (normally) liquid liabilities into illiquid assets. Since central banks can create unquestioned liquidity at the drop of a hat, in any amount and at zero cost, they should be the liquidity providers of last resort, both as lender of last resort and as market maker of last resort. There is no moral hazards as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual ’liquidity haircuts’ on this fair valuation. The private provision of the public good of emergency liquidity is wasteful. It’s as simple as that.” Just the week before the breakdown of Bear Sterns, the Fed seems to have followed Buiter’s advice and increased lending against illiquid securities in exchange for Treasury securities on a massive scale. Even though central banks are still reluctant to play an active role as market maker (denying rumours of discussions about the feasibility of mass purchases of mortgagebacked securities as a possible solution), the prevailing main stream view seems to be that there is no moral hazard risk as long as the Bagehot principles are followed as best practice in liquidity management.
According to the Bagehot principles, a Lender of Last Resort Policy should target liquidity provision to the market, but not to speciﬁc banks. Central banks should “lend freely at a high rate against good collateral.”This way, public liquidity support is supposed to be targeted towards solvent yet illiquid institutions, since insolvent ﬁnancial institutions should be unable to provide adequate collateral to secure lending. This paper wants to challenge the view that a policy following Bagehot principle does not create moral hazard. The key point is this view neglects the endogeneity of aggregate liquidity risk. Starting with Allen & Gale (1998) and Holmstrom & Tirole ¨ (1998), there have been quite a few models recently analysing private and public provision of liquidity. But as far as we know, in all these models except our companion paper Cao & Illing (2007), aggregate systemic risk is assumed to be an exogenous probability event.
In Holmstrom & Tirole (1998), for instance, liquidity shortages arise when ¨ ﬁnancial institutions and industrial companies scramble for, and cannot ﬁnd the cash required to meet their most urgent needs or undertake their most valuable projects. They show that credit lines from ﬁnancial intermediaries are suﬃcient for implementing the socially optimal (second-best) allocation, as long as there is no aggregate uncertainty. In the case of aggregate uncertainty, however, the private sector cannot satisfy its own liquidity needs, so the existence of liquidity shortages vindicates the injection of liquidity by the government. In their model, the government can provide (outside) liquidity by committing future tax income to back up the reimbursements.
In the model of Holmstrom & Tirole (1998), the Lender of Last Resort ¨ indeed provides a free lunch: public provision of liquidity in the presence of aggregate shocks is a pure public good, with no moral hazard involved. The reason is that aggregate liquidity shocks are modelled as exogenous events;
there is no endogenous mechanism determining the aggregate amount of liquidity available. The same holds in Allen & Gale (1998), even though
they analyse a quite diﬀerent mechanism for public provision of liquidity:
the adjustment of the price level in an economy with nominal contracts. We adopt Allen & Gale’s mechanism. But we show that there is no longer a free lunch when private provision of liquidity aﬀects the likelihood of an aggregate (systemic) shock.
The basic idea of our model is fairly straightforward: Financial intermediaries can choose to invest in more or less (real) liquid assets. We model illiquidity in the following way: some fraction of projects turns out to be realised late. The aggregate share of late projects is endogenous; it depends on the incentives of ﬁnancial intermediaries to invest in risky, illiquid projects.
This endogeneity allows us to capture the feedback from liquidity provision to risk taking incentives of ﬁnancial intermediaries. We show that the anticipation of unconditional central bank liquidity provision will encourage excessive risk taking (moral hazard). It turns out that in the absence of liquidity requirements, there will be overinvestment in risky activities, creating excessive systemic risk.
In contrast to what the Bagehot principle suggests, unconditional provision of liquidity to the market (lending of central banks against good collateral) is exactly the wrong policy: It distorts incentives of banks to provide the eﬃcient amount of private liquidity. In our model, we concentrate on pure illiquidity risk: There will never be insolvency unless triggered by illiquidity (by a bank run). Illiquid projects promise a higher, yet possibly retarded return. Relying on suﬃcient liquidity provided by the market (or by the central bank), ﬁnancial intermediaries are inclined to invest more heavily in high yielding, but illiquid long term projects. Central banks liquidity provision, helping to prevent bank runs with ineﬃcient early liquidation, encourages bank to invest more in illiquid assets. At ﬁrst sight, this seems to work ﬁne, even if systemic risk increases: After all, public insurance against aggregate risks should allow agents to undertake more proﬁtable activities with higher social return. As long as public insurance is a free lunch, there is nothing wrong with providing such a public good.
The problem, however, is that due to limited liability some banks will be encouraged to free ride on liquidity provision. This competition will force other banks to reduce their eﬀorts for liquidity provision, too. Chuck Prince, at that time chief executive of Citigroup, stated the dilemma posed in fairly poetic terms on July 10th 2007 in a (in-) famous interview with Financial
Times 1 :
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” The dancing banks simply enjoy liquidity provided in good states of the world and just disappear (go bankrupt) in bad states. The incentive of ﬁnancial intermediaries to free ride on liquidity in good states results in excessively low liquidity in bad states. Even worse: As long as they are not run, ”dancing” banks can always oﬀer more attractive collateral in bad states — so they are able to outbid prudent banks in a liquidity crisis. For that reason, the Bagehot principle, rather than providing correct incentives, is the wrong medicine in modern times with a shadow banking system relying on liquidity being provided by other institutions.
This paper extends a model developed in Cao & Illing (2007). In that paper we did not allow for banks holding equity, so we could not analyse the impact of equity requirements. As we will show, imposing equity requirements can be inferior even relative to the outcome of a mixed strategy equilibrium with free riding (dancing) banks. In contrast, imposing binding liquidity requirements combined with a strict central bank commitment not 1 The key problem is best captured by the following remark about Citigroup in the New York Times report “Treasury Dept. Plan Would Give Fed Wide New Power”on March 29, 2008: “Mr. Frank said he realized the need for tighter regulation of Wall Street ﬁrms after a meeting with Charles O. Prince III, then chairman of Citigroup. When Mr.