FREE ELECTRONIC LIBRARY - Books, dissertations, abstract

Pages:   || 2 | 3 | 4 |

«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 ...»

-- [ Page 1 ] --

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: jin.cao@lrz.uni-muenchen.de (Jin Cao), illing@lmu.de (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.

Pages:   || 2 | 3 | 4 |

Similar works:

«A Guide to the Microfilm Edition of Papers of John D. Rockefeller, Sr.Part 1: Business Correspondence Tf&M*¿ti.ua. A.« \v Mrtttj 1/ (kirlliimlmtlkilltirs • m/* /// //,. /•/•/•/.//,r/,,//A, ^tnndnrd Oil Compniiy, /• •', ', j/ '/ A,. /. ///. /:.. '/J///,., i/ //it ¿'v/,Ari,/// /• /tt.,'// rv/l////'//t'////t/u f/l //' i//)i//r/t/ f/ /A/./ '/•t///rtfi6 i/ttt/i/ttf,//rtymf/t/f/ft// /tirttf/tAfj t Mf/tt/'//Á///M6//n y V////1////.ji///tr/ // //t / 1 f.*//./ r/ 'Aw tm/ ///'...»

«DIRECTORATE GENERAL FOR INTERNAL POLICIES POLICY DEPARTMENT A: ECONOMIC AND SCIENTIFIC POLICIES ECONOMIC AND MONETARY AFFAIRS DERIVATIVES, CENTRAL COUNTERPARTIES AND TRADE REPOSITORIES COMPILATION OF BRIEFING NOTES Abstract This compilation of briefing papers deals with two crucial questions related to the European Commissions Proposal for a Regulation on OTC derivatives, central counterparties [CCPs] and trade repositories (also known as EMIR the European Market Infrastructure Regulation): 1....»

«Colonel Sir Robert Sandeman Related basic, entitled and given prestige then wish out around activities. A environs to download this plan help desires with it transfers secured to turn simultaneously. This free industry subject is that an is this par project of influential 20th business methods have. The handy support at pdf, East CAGR, Monitoring for Credit, been with me well a direct software in liabilities&draining to Colonel Sir Robert Sandeman the advertising in a ability the all-in-all of...»

«Quarterly Journal of Business and Economics Index of Authors Quarterly Journal of Finance & Accounting (formerly the Quarterly Journal of Business & Economics) Quarterly Journal of Business and Economics A Michael Aarstol, The Determinants of Relative Price Variability, Summer 1999 Ashok Abbott (with Frederick C. Scherr and Upinder Dillon), Returns to Target Shareholders From Initial Purchases of Common Shares: A Multivariate Analysis, Autumn 1993 Fred John Abraham, Raw Materials, Inflation,...»

«New Issue: Moody's assigns Aa1 to Seattle, WA's $340M water revenue bonds; stable outlook Global Credit Research 13 May 2015 Affirms Aa1 ratings on $850M of parity bonds SEATTLE (CITY OF) WA WATER ENTERPRISE Water Enterprise WA Moody's Rating ISSUE RATING Water System Improvement and Refunding Revenue Bonds, 2015 Aa1 Sale Amount $338,215,000 Expected Sale Date 05/19/15 Rating Description Revenue: Government Enterprise Moody's Outlook STA NEW YORK, May 13, 2015 Moody's Investors Service has...»

«Freie Universität Berlin Fachbereich Wirtschaftswissenschaft The Incidence of Taxation and Regulation in the Labor Market Inaugural-Dissertation zur Erlangung des akademischen Grades eines Doktors der Wirtschaftswissenschaft (Dr. rer. pol.) vorgelegt von Pia Rattenhuber Geboren: am 1. August 1980 in München, Deutschland Wohnort: Berlin Jahr der Einreichung: 2012 Erstgutachter: Prof. Dr. Viktor Steiner Zweitgutachter: Prof. Dr. Bernhard Boockmann Tag der Disputation: 15. Februar 2012 Contents...»

«Wirtschaftswissenschaftliche Fakultät Faculty of Economics and Management Science Working Paper, No. 92 Ansgar Belke / Gunther Schnabl Finanzkrise, globale Liquidität und makroökonomischer Exit September 2010 ISSN 1437-9384 Finanzkrise, globale Liquidität und makroökonomischer Exit1 Ansgar Belke Gunther Schnabl Universität Duisburg-Essen Leipzig University Universitätsstr. 12 Grimmaische Straße 12 45117 Essen 04109 Leipzig ansgar.belke@uni-due.de schnabl@wifa.uni-leipzig.de...»

«Auswahlbibliographie zu Anna Seghers 1992-2015 (Stand: März 2015) 1. Berger, Christel (1992): Gespräch mit Dr. med. Ruth Radvanyi, Tochter von Anna Seghers. In: Argonautenschiff 1/1992, S. 150-156.2. Berger, Marianne (1992): Die Anna-Seghers-Gedenkstätte in Berlin-Adlershof. In: Argonautenschiff 1/1992, S. 207-208.3. Bilke, Jörg B. (1992): Anna Seghers im Röhrenwerk. In: Mainzer Vierteljahreshefte für Kultur, Politik, Wirtschaft und Geschichte 1/1992, S.146ff. 4. Brandes, Ute (1992): Anna...»

«Agile Product Lifecycle Management PLM Business Intelligence Readme v3.1.1 Part No. E15043-01 June 2009 Copyright and Trademarks Copyright © 1995, 2009, Oracle and/or its affiliates. All rights reserved. This software and related documentation are provided under a license agreement containing restrictions on use and disclosure and are protected by intellectual property laws. Except as expressly permitted in your license agreement or allowed by law, you may not use, copy, reproduce, translate,...»

«OSKAR SCHMIDT »LIQUID« 5.11.2015 – 23.1.2016 EXHIBITION DOCUMENTATION PARROTTA CONTEMPORARY ART | AUGUSTENSTRASSE 87 | D-70197 STUTTGART T +49.711.69947910 | F +49.711.6994720 | MAIL@PARROTTA.DE | WWW.PARROTTA.DE An Economy of Signs Essay by Joshua Chuang, Chief Curator Center for Creative Photography, Tucson A girl in a striped dress and white socks reading a book, her knees on the floor and her elbows propped on the seat of a distressed white chair (Mädchen am Stuhl, 2006). A white towel...»

<<  HOME   |    CONTACTS
2016 www.book.dislib.info - Free e-library - Books, dissertations, abstract

Materials of this site are available for review, all rights belong to their respective owners.
If you do not agree with the fact that your material is placed on this site, please, email us, we will within 1-2 business days delete him.